Brexit Sterling panic rescues ‘Remain’

Consider the following scenario.

First, for reasons set out in my previous post, the news that Boris Johnson favours Out causes a sell-off of Sterling, and a credit downgrade for the UK.

Second, the commentariat explains why this happened, concluding – as I suggested in my previous post – that it’s because markets take the macroeconomic consensus view that Brexit would be bad for the UK, and, regardless, entails a number of severe event risks.

Third, voters slowly appreciate this, and polls tilt decisively towards Remain, compressing the uncertainties in Sterling assets, lowering the probability of Brexit, and Sterling recovers.

The panic and uncertainty are not themselves good, but ultimately it saves the Remain campaign, as prices reveal the risks that Boris seeks to downplay in his Telegraph column, and the consensus central-case view that Brexit would be a mistake.

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Boris’ speech, the fall in Sterling and identifying the Brexit effect

This post is for Giles Wilkes at the FT, who wanted a follow-up to my Tweets about the falls in Sterling reported as markets opened.  We might guess that this fall is the reaction to the news that Boris Johnson had declared that he would campaign for the UK to leave the European Union.  In that respect the news provides quite a clean experiment to identify the effects of Brexit, since not much else has changed since Friday.

The standard macro-finance way to view this would be as follows.

There are two forces pushing down on Sterling.

The first is that the perceived risk premium on Sterling assets increases.  This could happen for a number of reasons.  But an illustrative line of logic is:  Boris campaigning for out increases the chance that the UK will exit the EU.  Exit is an as yet ill-defined long-run state and there are many possible outcomes, ranging from not much different to In, to much worse.  Aside from the long-run uncertainty, exit also involves a series of event risks, including the referendum itself, and key milestones along the exit negotiation journey.  At these points, there will be heightened concerns about many things including self-fulfilling runs on markets, akin to – and perhaps including – old-fashioned bank runs.   The effect of this uncertainty is to make holding Sterling denominated assets less attractive, hence the price of them has to fall to leave investors indifferent.

The second force pushing down on Sterling is the effect of a projection of lower long-run GDP per head.  It’s possible to conceive that exiting raises long run prosperity, but, in expectation – and, I maintain – in the expectation of markets, GDP per head will fall somewhat.  With less income, the money available to compete for non-traded goods in the UK falls, and their price falls.  This lowers the real exchange rate, which is some complex weighted average of traded and non-traded prices.  A lower real exchange rate, other things equal, lowers the nominal exchange rate.

This is the Balassa-Samuelson effect, or, as I rather unfortunately abbreviated it in the first draft of my specimen international macro exam, ‘the BS effect’.

Three final remarks.

First, even if things don’t actually work like this, it may be enough that people think they will for these things to happen.

Second, my ‘BS effect’ joke should be a reminder that many things in the macroeconomics of exchange rates remain puzzling to macroeconomists.  In fact, there is an industry in generating ‘puzzles’ about exchange rates, where a puzzle is defined as a very stark difference between the implications of a macro model that is held dear and the data.  The most pertinent is called ‘the exchange rate disconnect puzzle’, which, as the name suggests, documents how the exchange rate is disconnected from things that you’d expect to determine the exchange rate in a standard macro model.  So this reasoning has to be taken with a pinch of salt.

Third, it is actually possible to reverse the correlations described above with determined spanner-work on the models’ innards, but I’d say that the correlations I highlight are where most macro people would start.

 

FOMC: Conspiracists to the left of them, conspiracists to the right

Paul Krugman worries that the reason why the Fed hiked by a quarter point in December 2015, and won’t immediately reverse course, is that their judgement has been impaired by talking to too many who work in banking, which industry suffers from very low interest rates.

As Paul noted in one of his earlier blogs, there are those on the right of the Fed who think that rates are so low, and quantitative easing was undertaken, as part of a liberal conspiracy to help Obama;  or, to impoverish those who live off savings.

If I was on the FOMC, I’d probably feel comfortable that there were conspiracists accusing me of having been corrupted by interest groups on opposing sides.

Addressing PK’s most recent charge, his worry seems pretty unlikely to me.  The FOMC had no problem dropping interest rates like a stone – from 5.5%, to 0.25% – when the crisis hit, and holding them there for almost seven years.  All of a sudden, because rates are put up by 25 basis points, this is evidence of a pro-bank bias?  I don’t buy it.

Concern about banks wasn’t mentioned as part of the narrative about raising rates;  so we have to believe that somehow banking contacts distorted the information about the rest of the economy in favour of their ulterior motive.  And that that survived battle with the prominent Fed staff view, delivered by Laubach and co..  And continues to survive the temptation to gossip disapprovingly about it to other private sector contacts.  Unlikely.

Even if this concern had figured materially, there would be a prima facie case for thinking it through.  Recall the UK Monetary Policy Committee’s argument for not cutting rates below 0.5% [a floor since revised down].  Lowering rates beyond some point would harm bank profits and cause them to push up lending rates, undoing much of the effect of the central bank interest rate cut.  Less finance is bank intermediated in the US, and there is a greater proportion of fixed-rate loans to the personal sector.  But the argument holds true in principle.

At the time of the December hike, I thought there was a pretty good case for it.  I doubt, however, that if the FOMC had had special foresight into the market chaos that would unfold subsequently that they would have moved then.  Which leads me to think that, other things equal, they ought to reverse course now.  And that we might conjecture that one thing that is stopping them is, not a surfeit of nice dinners with the head of bank treasury operations, but a worry about seeming to look stupid by changing course so quickly:  a worry I’d hope could be set aside when the stakes are so high.

 

ICYMThem, 2 pieces for Nikkei Asian Review: on Japan; and on the market routs

In case you did not get these via Twitter, I wrote two pieces for NAR, which is an online newspaper that is owned by Nikkei the behemoth that recently swallowed the FT.

This piece is on the BoJ’s move to negative rates.

And this one is on the recent market routs, applying the Caballero and co-authors story about safe-asset flows.

 

So, farewell then, Nick Macpherson. /You changed our constitution. /Even though. /As some said. /There wasn’t one. /Or that you didn’t.

Nick Macpherson, of course, isn’t dead.

But EJ Thribb of Private Eye might well have written something like that about his latest speech, of which there cannot yet remain many more in his capacity as Permanent Secretary to the Treasury, a post from which he has said he will step down in April this year.

The speech is a great read.

It opines on what economic policy can achieve, and how it should go about achieving it.  And the history of the ‘Treasury view’ about these questions.

There are two things to respond to in it.  1) Its economic substance.  2) issues thrown up by the fact that there exists such a thing as the ‘Treasury view’.

Despite being qualified only to write about 1), I’m going to confine myself to 2) and leave the rest to another day, or perhaps Ben Chu, economics editor at The Independent, whose hot-under-the-collar Tweets alerted me to some of the interesting aspects of the text.

The Treasury is full of clever economists and other talented thinkers.  So it is bound to produce views.  These views may coalesce.  And one would expect them, if they don’t, to get filtered, synthesised, so that they can be consumed effectively by their clients – the Treasury ministers.  So could there be any issues about the apparently harmless and obvious reality of a ‘Treasury view’?

Well, the speech has to be placed in the context of Nick’s previous public interventions.

Most notably, the letter he wrote summarising the Treasury view of whether it was sound to allow a hypothetical independent Scotland to participate in a currency union with the rest of the UK, without a fiscal union to back it.

At that moment, Nick was acting as an independent advisor, and emphasising the objectivity in the Treasury paper, and his summary of it, so that the rest of us could weigh what he was saying as the words of an economist, and not the words of a politician, who might have reasons to bend an economic case.   (For the record, I thought that letter, and the Treasury view it covered, spot on).

In the context of that previous letter written as independent advisor, Nick’s speech can’t help but be read similarly.

His comments about the rightness of the Coalition government’s approach to the crisis have the subtext: ‘I’m an independent, objective guy, and I think that what the government did to respond to the crisis was pretty much right.  I understand you wouldn’t trust George Osborne to tell it how it really was, but you can trust me.’

We are then led to wonder how independent Nick is.  I have never met or interacted with him.  Those that I know who speak of him say that he has a first-rate mind and is of unimpeachable integrity.

But not everyone can convince themself of that.  They may be led to wonder how he came to be confirmed in his position.  Was he kept there on account of his objectivity, or his preparedness to subordinate his or the ‘Treasury’ views to the political imperatives of the day?  If he or his staff wanted to dissent from the position of the Government, could they really do it?  If not, what weight can we attach to public views expressed by Macpherson or his staff?

One line in the speech that pressed Ben Chu’s buttons hardest was this one:

“It is no surprise to me that the response to the recent crisis has focused on monetary policy and the credit channel rather than on fiscal policy.”

Ben’s Tweeting responded that of course it was no surprise, since the Treasury was either instrumental in persuading the Government to this view, or was commandeered to market and implement it.

But taken at face value, the words want us to understand that the Treasury did not influence the governments on this course.  The government’s strategy was meditated by the governments alone, but their decisions weren’t a surprise, since, had Nick been involved in the thought process, this is what he and his staff would have concluded too, since that’s where the evidence points [on this I disagree, incidentally].  I am caricaturing somewhat for effect, here.

I am not against Treasury civil servants speaking out independently.  But the model of sometimes speaking out, and sometimes not, is a curious one.  Matters might be improved if it could be codified when independent views were to be offered in public.  Some of the responses to my blogs on the Macpherson indyref letter pointed out that the independence referendum was an existential issue for the UK, therefore an exception to the norm of civil service silence.  The efficacy of the Darling/Coalition fiscal consolidation is hardly in that category.

I wonder about whether it’s possible for a single person, or body of persons, to combine the role of private implementor and public commentator/critic.  Given the legislative and other care devoted to the Bank of England and now the Office for Budget Responsibility, both of which are charged with always ‘speaking out’, it seems neglectful not to attend to this other, influential body-economic lurking inside the civil service, sometimes speaking out, sometimes influencing government towards its Treasury view, sometimes not.

 

On loosening by yield curve talking and cutting rates

Since Mark Carney took over the Governorship of the Bank of England in July 2013, expectations of the first hike in rates from 0.5 have been pushed further and further back.

Accommodating this – with a few hiccoughs along the way – has been the MPC’s sole tool for easing monetary policy.  Carney inherited the collective view of MPC formed under Mervyn King that the practical floor to rates was 0.5%.  So loosening then meant either more QE – which Carney was clearly able to persuade other MPC members was undesirable, or ineffective, or both – or yield curve loosening.

In February 2015, however, the Bank of England made clear that it no longer considered the floor of 0.5% to be operative.  So at that point, it obtained a new option for easing, on top of yield curve talking.  Yet since then, policy has been eased without using this extra tool.

This isn’t obviously wrong.  It’s entirely possible that the best path for rates involved keeping them just where they were, but where adjustment was purely through the timing of the first hike.

But a clear starting point for thinking about how to change the plan for rates offered by models like the Bank’s own COMPASS would be that as conditions worsen, rates are lowered – relative to the old path – for a while, and then raised again subsequently.

This latest Inflation Report could have been the point to do just that.  The forecast under the market path the BoE used involved a small overshoot of the target.  But this doesn’t rule out a cut now, and a more marked tightening path later on.  I wonder:  have these trajectories been tried out in the Bank, but ruled out?

I wonder also if the reluctance not to use anything other than yield curve tightening is the worry that if rates were cut, without a device – like an interest rate forecast – to communicate clearly how the BoE would make up for it later, they would loosen monetary conditions too drastically, or at any rate inject more uncertainty into longer rates than they wanted.  Consequently, confining themselves to the broadest of verbal hints, the MPC are thus disproportionately reluctant to breach the 0.5% that has been the floor to rates since March 2009.

 

You can’t have your helicopter money cake and eat high interest rates, Adair

Prompted by Adair Turner in an exchange on Twitter, I read this paper of his delivered to the IMF.  The paper is one to set current and former central bank pulses racing.

It’s a measure of how far the crisis has led some to think the previously unthinkable that a name mentioned as a candidate for the Governorship of the Bank of England is now writing forcefully about the advantages of helicopter money.  Even pushing it as an option to be preferred over debt financed fiscal policy and forward guidance.

The exchange with Adair was prompted by him pointing out that helicopter money was a less dangerous option for the economy than negative interest rates.  To my mind, this does not make sense.

Helicopter money leads to an increase in the supply of money and liquidity, and this will depress the price of money/liquidity, lowering the interest rate, in other words.  Put differently, the discount at which securities trade below face value will include compensation for the absence of liquidity, or moneyness.  But as money and liquidity become more abundant, money-like assets command less of a premium, and the compensation for its absence falls, raising the price towards the face value of the security, or, equivalently, lowering the interest rate.

Before the crisis, I would have doubted that rates would be pushed negative, even by large-scale helicopter drops.  But with Denmark, Sweden, Switzerland, the ECB and now Japan setting negative rates without dire consequences, I would not bet against it.  That detail aside, the main point is that you can’t control both the quantity and price of money at the same time, which is what Adair claims.

Actually, as put, what I have qwritten above is not quite right.  And in his paper, Adair notes that the central bank can require banks to hold reserves, and charge whatever negative rates it liked on those reserves.   However, this is just a tax, one that takes banks off their central bank reserve demand curve.  And one that won’t inhibit the injection of money through the helicopter drop from affecting the interest rates on all other assets, along the spectrum of liquidity from very close substitutes to central bank money, to more distant ones.

It will be those interest rates which will, subsequently, most meaningfully express monetary policy, and, since those are not monopoly-supplied by the central bank, the authorities have to live with agents being ON their demand curves for those assets, and, having affected the relative quantities through the helicopter drop, will have to live with the interest rates that emerge afterwards.

In that sense, central banks can’t control the supply and price of money/liquidity at the same time.  And this is the only sense that is of material consequence, particularly for the question that worries Adair, namely, the effect of low rates of borrowing on spending, borrowing and leverage.

The tax isn’t irrelevant, but it is best understood as part of fiscal policy.  It’s no more an indicator of monetary policy than if we were to hear that the central bank required bank CEOs to deliver trays of cupcakes to Mark Carney every morning.

To carry out this thought experiment, I have – without mentioning it explicitly above – had to imagine that the BoE stops paying interest on reserves.  Without reverting to the old monetary policy implementation framework, helicopter money will simply increase the quantity of reserves out there – either directly, or indirectly – on which the central bank has to pay interest, in the form of more interest bearing reserves, leading to an explosion in liquidity.  Adair explains this himself in his paper, and MPC members Carney and Vlieghe have both talked about these consequences too, the former at Treasury Committee, and the latter during a Q and A after his first public speech as MPC member.

Abandoning interest rates on reserves is not a material reason to refuse to contemplate helicopter money, in my view.  But that is probably worth a post on its own, so I will not go into it further here.