Category: Elham’s Money View Blog

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Elham's Money View Blog

What Rules Inflation Targeting? A Time for Abandoning Taylor Rule

By Elham Saeidinezhad

“No matter how much suffering you went through, you never wanted to let go of those memories.”
― Haruki Murakami

Following the Global Financial Crisis (GFC), most central banks around the world are facing pressing challenges to reach the inflation target. Most recently, for example, Bank of Japan’s Governor Kuroda warned against threats to price stability and added more pointed language about a possible interest-rate cut. He promised to keep a close watch on the inflation target. As a result, the views are quietly shifting from targeting an inflation level to alternative approaches such as “average inflation targeting.” The more fundamental issue, however, is the fact that the target has never been sustainably achieved even though it has been in place since 2012. Against this backdrop, this is the right moment to steer the debate away from how to reach the 2 percent inflation target towards why we continuously fail to do so. Inflation targeting, enabled by Taylor Rule and based on rational expectations hypothesis, assumes that the public announcement of a medium-term target for inflation shapes the expectations of the future price level. However, once accounting for the financialization of modern economies, it becomes clear that it is not central banks’ abilities to form inflation expectations, but the extent of their influences on securities prices, that equip them to stabilize price levels. Nonetheless, central banks’ magic power to affect inflation might have mostly vanished.

To elaborate on this point, let’s start by defining inflation targeting and its premises. Inflation targeting is a monetary policy framework that aims at getting inflation to 2 percent and recognizes the readings above and below as universally undesirable. The structure that allows central banks to achieve the target is called “Taylor Rule,”- a principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate. The premise of this model is that central banks adjust the short-term interest rate and the quantity of reserves in the inter-bank lending market to influence components of the real economy, such as investment, trade balance, and consumption on residential housing through different channels. These channels are called “monetary transmission mechanisms” collectively and their ultimate goal is to achieve price and output stability.  This structure used to work in the old times when banks used reserves as a primary source of funding to lend to the real economy.

Today, arguably, we are living in a market liquidity system where most of the expenditures in the economy are financed in the capital market through a process known as “securitization.” In these circumstances, when the central bank changes the short-term interest rate and alters the spread between the overnight rate and the term rate, it effectively influences the incentives for dealers in both the money market and the capital market. The money market dealers establish the price of funding liquidity while the securities dealers determine the price of capital, including mortgage-backed securities (MBS). When the central bank increases the rates, it tightens the spread for money market dealers. In response, money market dealers increase the term interest rates and make it more expensive for securities dealers to finance their inventories. This process puts downward pressure on securities prices, including the price of MBS, which in turn increases the interest rates on the underlying loans such as mortgage and auto loans. Measuring the strength of these effects on the prices of the corresponding assets such as houses is notoriously difficult. To conclude, in modern economies, the interest rates on bank loans in most cases are not determined in the overnight domestic money market, where the central bank is the dominant player, but the global capital market. Thus, it is not the ability of monetary authorities to change inflation expectations, but the extent of their effect on securities prices that asset price stability. To retrieve their strength to influence the economy, central banks should start by fixing their understanding of the transmission structure of the monetary policy. Even so, central banks’ magic to affect the price level might have gone for the most part.

Discussion Questions:

  1. What is the main intellectual obstacle in fully understanding the extent of central banks’ power to influence price level?
  2. How are mortgage rates determined in advanced economies such as the U.S.?
  3. What is the main premise of Taylor Rule and Inflation Targeting?
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Central Counterparties: When Monetary Policy is Not Enough

By Elham Saeidinezhad

The overall picture of the U.S. economy, though far from stable, is hardly threatening. For instance, U.S. payrolls grew by 128,000 in October. Nevertheless, the Fed cut the interest rate for the third consecutive quarter in late October. The turmoil in the repo market in September seems to be a significant stressor for the Fed. The Fed started to add large amounts of liquidity to markets about seven weeks ago after repo markets faced a shortage of money that sent short-term borrowing rates soaring. The Fed’s focus has been on loosening credit conditions in the market for short-term funding. However, these measures might not be enough to save all systemically important financial institutions in this market, including clearinghouses (known as CCPs) that clear repo contracts, from becoming illiquid.

The least well-understood effects of the recent instabilities in the repo market are on the CCPs. Fixed-income financing, also known as a repo, is a type of short-term funding in which the counterparties, usually securities dealers, borrows cash by posting collateral. After the financial crisis, regulators required repo transactions between dealers to be centrally cleared through CCPs. Consequently, the risk concentration within CCPs has grown dramatically. In a typical cleared repo trade, a CCP would borrow $100 from a cash-rich lender (e.g., a money market fund) and then on-lend the proceeds to a cash borrower (e.g., a securities dealer) in exchange for collateral. As part of this, the CCP would have to put up its own capital against $100 of repo exposure. During a liquidity crunch, when cash is scarce and rates are high, cash borrowers, including securities dealers who do not have access to the Fed’s balance sheets, are more likely to default. A cascade of such defaults can make CCPs illiquid even though the collaterals should help CCPs to remain solvent at least at the beginning of the liquidity spiral.

At the heart of this problem is the simple fact that securities dealers are both the cash borrowers in the repo market and the providers of market liquidity. As the matter of Lehman-Brothers revealed, securities dealers’ ability to continue providing market liquidity vastly depends on their access to funding liquidity or cash. The vanishing market liquidity would compromise CCPs’ financial positions during the financial crisis. In the case of systematic defaults, CCPs can sell the collaterals to protect their capital. In the process, they might become illiquid for at least two reasons: first, if the dealers stop making the market, which is the case during the financial crisis, CCPs might not be able to sell these collaterals quickly enough to pay back the original loans. Second, the sale of the collaterals could lead to a phenomenon known as “firesale” which involves selling these assets at hugely discounted prices. CCP’s temporary cash flow problems could create a permanent solvency crisis if they cannot sell the collaterals cheaply, quickly, and without changing the market price.

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Is Libra Money? Depends on Where in Credit Cycle We Are

By Elham Saeidinezhad

“What institutions build, they can destroy.” Anonymous

Mark Zuckerberg’s testimony to Congress on October 24th, 2019, created anxieties on whether Facebook would circumvent financial regulators as it readies its planned cryptocurrency, Libra. This concern by policymakers was logical, given the magnitude of the 2008-09 global financial crisis and its effects on the international monetary system. The company’s promise to move forward with Libra only when they had explicit approval from all U.S. financial regulators seem to calm some of those fears. However, a more fundamental enigma at the heart of Libra is a classical puzzle in monetary economics of what is the nature of “money” and its relationship with the payment system. When examining Libra, we have too often overlooked the fact that although the medium of exchange and the means of payments coincide with each other when the financial condition is stable, they are not the same. In doing so, we have lost some valuable insights into Libra’s state during a financial crisis.

To shed some light on this mystery, let’s start by focusing on the technical definition of the monetary system, which is money plus the settlement mechanisms to execute payments. In mainstream economic literature, the focus is totally on money and its role as a “medium of exchange.” Therefore, as long as people “trust” Libra and use it to purchase goods and services, the monetary system should work seamlessly. During economic and credit expansion, when the financial market is elastic, mainstream interpretation of the monetary system seems to work. The problem is that during the financial crisis, guaranteeing this trust is a complicated task. Under these circumstances, the precondition for a well-functioning monetary system is the trust that payments will be executed, and the object functioning as a medium of exchange is convertible to the means of final payments.

This condition has substantial implications for the position of Libra in the future financial crisis.  On the one hand, alongside regulatory agencies, central banks’ role in backstopping the payment system becomes critical in securing convertibility and trust. On the other hand, Libra is a decentralized currency that is issued by private entities. Therefore, when confidence evaporates in the financial market, it is very likely that Libra cannot be converted to the means of final payments unless it receives a public bailout. The hiccup is that in the process of understanding Libra as a form of money, we have too often ignored the more intangible aspect of the monetary system- the payment system. The danger is that the public will pay the bill.

Discussion Questions:

  1. In your opinion, why do standard economic theories tend to overlook payment systems in their models?
  2. What is the prerequisite for Libra to continue its function as a currency when a severe financial crisis hit the economy?
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Quantitative Easing: No Words to Describe It

By Elham Saeidinezhad

“Words have no power to impress the mind without the exquisite horror of their reality.” – Edgar Allan Poe

The experience of the global financial crisis (GFC) was a painful reminder that central banks were not equipped to save the modern financial markets from failing. To this end, the Fed reimagined its role by employing “unconventional tools” to restore market liquidity and stopping the freefall. While the Fed used to flush the banking system with liquidity in earlier crises, it was engaged in the outright purchases of long-term government bonds and mortgage-backed securities (MBS) during the GFC. This procedure was later known as ‘’Quantitative Easing” or QE. Similarly, to respond to the most recent turbulences in the repo market, the Fed has started the same kind of operations by purchasing short-dated government bills from September. The difference, however, is their resistance to label this procedure as a QE.

The experience of the global financial crisis (GFC) was a painful reminder that central banks were not equipped to save the modern financial markets from failing. To this end, the Fed reimagined its role by employing “unconventional tools” to restore market liquidity and stopping the freefall. While the Fed used to flush the banking system with liquidity in earlier crises, it was engaged in the outright purchases of long-term government bonds and mortgage-backed securities (MBS) during the GFC. This procedure was later known as ‘’Quantitative Easing” or QE. Similarly, to respond to the most recent turbulences in the repo market, the Fed has started the same kind of operations by purchasing short-dated government bills from September. The difference, however, is their resistance to label this procedure as a QE.

Regardless of whether or not to call it a QE, the seismic shift in the Fed’s role away from being a lender of last resort to the banks towards the dealer of last resort in the capital market continues a decade after the GFC. This new role of the Fed reflects the evolving nature of the financial market where liquidity provision has shifted from the business model of the large banks to nonbanks. These nonbanks, who are collectively known as ‘’shadow banking system,” are mostly dealers who are financing their long term investments in the capital market by borrowing in the wholesale money market using short term instruments such as repo.

Capturing this evolution is a welcome development in the world of central banking. The point is that QE is a new normal way of executing monetary policy and is better-adjusted to deal with fluctuations in the financial system. Against this background, it seems like we have to start calling the asset-purchasing program of the Fed what it is: a permanent tool of implementing monetary policy. This task of reimaging central banking has been long overdue, and QE is a first step in the right direction. Besides, it is here to stay.

Discussion Questions:

1. What is the main difference between the Fed’s QE and the new round of asset purchasing program?

2. Do you think the Fed should react to liquidity problems outside the traditional banking system?

3. Do you think the growth of the shadow banking system in the financial market should be curbed using financial regulations?

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