This past year has been the first time since the Bank of England was made operationally independent in May 1997, that monetary policy has been politically difficult.  From a technical point of view, designing the right monetary policy has also been slightly more complicated than usual, but nothing that a bunch of moderately intelligent graduate students in economics wouldn’t be able to handle. The same applies to the ECB, which started functioning as the central bank of the euro area on January 1, 1999.  The Fed has not gone through any institutional  transformation since the Humphrey-Hawkins act of 1978, but it too has not been in the current painful policy position since the early 1980s.

So far, these three leading central banks have failed the test.  They have looked inflation in the face, blinked and hoped for a better tomorrow. (more…)

The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics.

There are two open-ended (possibly permanent) measures by the US Treasury and one supposedly temporary measure by the Fed.  The Treasury’s proposals require Congressional approval to become effective, something that should be forthcoming some time next week.  The Fed measure does not require Congressional approval. (more…)

Are Fannie Mae and Freddie Mac adequately capitalised, as asserted recently by US Treasury Secretary Hank Paulson, Federal Reserve Board Chairman Ben Bernanke and their regulator Office of Federal Housing Enterprise Oversight Director James B. Lockhart III? The answer is: obviously not, if these two government-sponsored enterprises of the US federal government had to make a living on normal private commercial terms. Obviously not if they were subject to the market discipline preached by Paulson and Bernanke, but not practiced when it comes to large financial institutions perceived as systemically important (too large or too interconnected to fail) or too politically sensitive to fail. (more…)

How far will the real price of oil and other carbon-based resources rise? Experts (I am not one of them) differ widely in their medium-term and long-term predictions, but my reading of the evidence suggests that there is a fair chance that the sky is the limit. In the short run (the next 2 or 3 years) a global cyclical slowdown may provide some temporary relief from rising commodity prices in general and rising oil prices in particular. This temporary cyclical energy price comfort will be deeper and longer-lived if the key emerging markets that have let inflation get out of control (effectively all of them except for Brazil) tighten monetary and fiscal policies to bring inflation down to politically tolerable levels. The resulting cyclical slowdown in emerging market growth will be bad news for economic activity in the industrial world, but will put downward pressure on commodity prices. We will be unemployed but able to afford petrol.

Once global growth returns to its underlying trend, however, say three or four years from now, I expect the relentless upward march of commodity prices, including oil, gas and agricultural commodities, to continue. The reason is simple. Global demand growth is heavily biased towards energy-intensive production and consumption in emerging markets. Even if common sense breaks out in India, China (perhaps even in the Middle East and other oil and gas producers) and domestic oil and energy use is priced at its global opportunity cost, the energy-intensity of global production and demand will be rising for quite a while. At a horizon of a decade or more, high energy costs may reduce the energy intensity of production, investment and consumption, but total energy demand is still likely to rise even if global real GDP growth averages only 3 or 4 percent per annum. (more…)

With a slight modification of the all-time classic referee’s report,  I can say the following of the Treasury’s recently released consultation document Financial stability and depositor protection: further consultation: this document contains much that is new and much that is good.  Unfortunately, what’s new is no good and what’s good is not new. (more…)

The consistent lack of manners of the Treasury

The Treasury - shorthand for its political leadership and the politicised section of its permanent establishment - is institutionally nasty.  It ever was thus.  The Treasury is ruthless, and at times unprincipled and unscrupulous in the pursuit of what it wants.  Its indifference to the collateral damage this may cause to people’s reputations, self-esteem and feelings is legendary and well-documented.  Recent examples include letting former Governor of the Bank of England, Eddie George and current Governor Mervyn King twist slowly in the wind - unnecessarily dragging out the decision on their reappointment when they were up for reappointment at the end of their first terms as Governor.  Apart from being rude and kak-handed, it also did nothing to promote financial stability, especially in the case of Mervyn King’s reappointment, which came at the high of the North Atlantic area financial crisis. (more…)

At its regular meeting yesterday, the Fed opted to keep the target for the Federal Funds rate unchanged at 2.00 percent. With the most recent figure for headline CPI inflation coming in at 4.2 percent yoy, US monetary policy continues to be strongly stimulating.

From a macroeconomic stability perspective - price stability and the highest sustainable levels of employment and growth - monetary policy is far too expansionary. Inflation has been persistently above the Fed’s comfort zone for years. Inflation expectations have now moved up sharply. Dislocating these inflationary expectations will require either a period of low inflation brought about by excess capacity and high unemployment or a miracle. The Fed apparently believes in miracles. I only hope and pray for miracles. I don’t consider them a substitute for the right policies. (more…)

The effective fulfillment of the lender-of-last-resort function of the central bank requires that during a liquidity crisis the central bank lend freely to an institution that is illiquid but not  insolvent (if assets can be held to maturity), against collateral that would be good during normal times but that may have become illiquid during disorderly market conditions, and at a penalty rate.  The requirement that lender-of-last-resort facilities are only offered on punitive terms is key to the minimisation of moral hazard and thus to discouraging future imprudent, reckless lending and borrowing.

The same principle of providing assistance to illiquid but solvent institutions only on punitive terms applies when market illiquidity rather than funding illiquidity is the problem facing the troubled private financial institution and the central bank intervenes as market maker of last resort.

Any illiquid assets the central bank accepts as collateral in repos, at the discount window or at any of the more recently created special liquidity facilities, such as the Term Securities Lending Facility and the Primary Dealer Credit Facility in the USA or the Special Liquidity Scheme in the UK, must be valued or priced in a way that ensures that the transaction does not involve a subsidy from the central bank to the borrowing institution.  The repo, collateralised loan or swap should earn the central bank an appropriate risk-adjusted rate of return.  The same would apply if the central bank purchased illiquid private securities outright from a financially challenged private financial institution.  There is nothing wrong in principle with the central bank taking credit risk onto its balance sheet, as long as it earns a rate of return that adequately compensates it for that risk.

There is a growing suspicion in the markets that the ECB is subsidizing some euro area banks that are eligible counterparties at its discount window (the Marginal lending facility) or in repos, by overvaluing or overpricing illiquid collateral offered to the Eurosystem by these euro area banks. (more…)

I am pleased to be able to bring you another wonderful piece of writing by Uwe Reinhardt.  In some ways it is a a sequel to his earlier piece on this blog “I hate mom (and the government too)”, but it also stands very well on its own.  This article was first published in The Daily Princetonian, on Tuesday, April 29th, 2008.  The marine referred to in the column is Uwe’s youngest son, Mark (aka Hsiao Hoo or Little Tiger).  I knew him as a tiny tot, when he used to hang around the pool and fountain next to the Woodrow Wilson School at Princeton University. (more…)

In his open letter to the Chancellor of the Exchequer, Alistair Darling, Mervyn King, Governor of the Bank of England, has given his explanation of why inflation in the UK has increased since last year. The open letter procedure is a useful part of the communication and accountability framework of the Bank of England. It requires the Governor to write an open letter to the Chancellor whenever the inflation rate departs by more than 1 percent from its target (in either direction). In that letter the Governor, on behalf of the Monetary Policy Committee (MPC) gives the reasons for the undershoot or overshoot of the inflation target, what the MPC plans to do about it, how long it is expected to take until inflation is back on target and how all this is consistent with the Bank’s official mandate. The current inflation target is an annual inflation rate of 2 percent for the Consumer Price Index (CPI). With actual year-on-year inflation at 3.3 percent in May 2008, it was time to sharpen the official quill and write an open letter.

I am distinctly underwhelmed by the Governor’s explanation of the reasons for the increase in CPI inflation. In the intermediate undergraduate macroeconomics courses I used to teach, his would have been a failing answer to the question: “What caused inflation to rise in the UK during the first half of 2008?”

(more…)