A role for gold?

Gold recently moved towards US$1400, a two-year high, having risen over 30% since January 2016.

This has been largely based on broad negative pressures in the global economy: ongoing economic troubles and terror attacks in the Eurozone; weakening demand in China; and domestic crises ending positive growth prospects for the BRICS. Not to mention political events Brexit and the growing uncertainty around November’s US presidential election too.

During pressures such as these, investors habitually “flee to gold”, assessing it as a safe bastion of value. However this tendency has been in direct contradiction to the most famous investor of the last 30 years, Warren Buffett, who famously dismissed gold as a “non-functioning”.

Still – from a historical central banking perspective – an oscillating value for gold was surprising. Historically, money in economies have been tied to gold – either using it physically for trade or symbolically under the Bretton Woods system. Then, when President Nixon ended the gold window in the August 1971 at $35, many economists predicted a collapse of the price of gold – because the core demand for gold as state reserves disappeared. Paper money was supposed to allow more direct control over economies through currency manipulation and gold would simply be used for jewellery. However, this has not been the case – with US$:oz values rocketing and gold becoming a consistent investment tool like no other.

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What’s the point in low interest rates?

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It’s the simplest of all policies. If a central banker wishes to stimulate an economy – they cut the central bank base interest rate. If they wish to moderate it – they raise the rate. The classical theory being that manipulating the rate alters the cost of credit and thus encourages/hampers individuals and firms spending incentives accordingly.

As we can see from the charts above, developed economies have maintained persistently low interest rates ever since 2008 and the Global Financial Crisis (and in Japan’s case, a lot longer…). The central banks have been attempting to gee up economies with cheap credit, exactly as the theory advises. However, as has been seen in the years subsequent – economic growth in each of the same economies has been relatively anaemic in spite of the historically low interest rates.

Thus this post will investigate the channels that interest rates are supposed to affect the economy – looking how it is supposed to affect both individuals and firms. Although it is an elementary discussion, its apparent ineffectiveness in recent years highlights that an assessment is a worthy exercise.

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It’s Not The What, It’s The How: Central Banks And Their Ever Expanding Balance Sheets

The balance sheets of central banks have massively expanded since the Global Financial Crisis in an attempt to help stimulate demand.

Between 2008-2015 the Fed’s balance sheet grew from $858 billion to $4.3 trillion. Relative to the US economy, this was a massive expansion from 6% of GDP to 25.4% of GDP. Similarly the Bank of England’s (BoE) balance sheet grew from 5.9% of GDP to 22.5% of GDP. However the biggest expansion was in Japan – where the balance sheet grew from 22.1% of GDP pre-crisis to 30% of GDP mid-2012, and then exploded to 65.4% of GDP in 2015 in the Abenomics climate. It is now a huge 320441.8 billion JPY.

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Defending a Peg: Theoretically weighing the benefits of Denmark’s Fixed Exchange Rate

This week, Denmark’s Central Bank promised the market to defend the Krone’s unilateral currency peg against the Euro. The methodology and the phraseology came directly out of the standard Central Banker’s playbook in an attempt to solidify and engage market sentiment. The Central Bank governor Lars Rohde said:

There is no upper limit to the size of the foreign exchange reserve… The Danish National Bank has the necessary instruments to defend the fixed exchange rate policy for as long as it takes.”” [BBC; 2014 – emphasis added]

In parallel, the bank simultaneously lowered interest rates from -0.5% to -0.75% on top of the $16 billion of Open Market Operations already actioned. To put this into some context, this is the fourth time that Denmark has lowered its interest rates in three weeks and to a rate lower than even the most serious point of the Global Financial Crisis.

The immediate impetuses of this situation is fairly clear – in reaction to the ECB’s increasingly loose 2014-2015 monetary policy and surprisingly large promised figure of QE (€1.1 trillion), and Switzerland’s unforeseen retraction of its own currency peg, Denmark has been pressured to assure the market that “We’re not next”. The Danish National Bank (DNB) will uphold the status quo, no matter the cost.

In these circumstances however, it must be asked – is it worth it? Many nations have vainly attempted to defend currency pegs in the past, with varying policy success -vs- uniform punishment of foreign exchange reserves, employment rates and output costs. Famously, the UK (1992 – £3.3 billion) and Thailand (1997 – $5 billion) provide the counterfactuals of failure and success.

This piece will attempt to weigh the theoretical benefits of maintaining a currency peg against the practical costs that the policy incurs.

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Forward Guidance: Should the SNB have shocked the world?

There has been a very public divergence in central bank practice this week.

For six months, the European Central Bank (ECB) has been slowly building towards an expected announcement implementing Quantitative Easing (QE) in the Eurozone. Carefully tailored releases and winks have unsubtly alerted the markets that QE was coming to Europe and that market actors better be prepared.

By contrast, the Swiss National Bank (SNB) shocked the markets with a surprise announcement that it would be both abandoning their 3 year-old currency peg to the Euro and cutting interest rates. The effects have been likened to a future “nuclear explosion” [Logutenkova & Vögel; 2014], with immediate impacts including a 41% increase in the Swiss Franc against the Euro and a 20% decrease in Credit Suisse’s stock price.

Whilst it is clear that the policies themselves are debatable, the issue to be discussed here is not centred on evaluating economy management strategies.

Rather this week has highlighted a broader question: what is the best style for central banks to take action? Should banks use a long lead-up time to corral market agents into calmly closing arbitrage opportunities and perhaps suffer a reduced impact of their actions? Or should they hide their planning and shock economies into a given direction and risk volatilit and credibility?

This piece shall first explore what is the currently recommended practice and critique it. Subsequently we will look into the merits of the alternatives and attempt to highlight the best approach.

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Critiquing “Orthodox” Central Banking

Modern mainstream economic recommendations for central banking encourage a strict monetary policy remit of singularly managing inflation through the policy interest rate. [e.g. Woodford; 2004] The justification for this position mainly arises from New Consensus Economic’s abstract micro-foundations methodology and the practical inhibitor of the Lucas Critique. By complying with this simplified framework, orthodox central bankers believe their modern practices have a supposed universality of applicability that defends their narrow intentions and renders creative thought unnecessary .

Yet, even a simple analysis of the methodological idiosyncrasies of the mainstream practice immediately expose the limitations of its recommendations. Furthermore once heterodox economic opinions are introduced to recount theoretical oversights and contrasting suggested practices, it becomes apparent that the supreme universality claimed by the orthodoxy collapses. Additionally, political economy evidence of monetary policy from central banks around the world illustrate the feasibility and greater beneficial capacity of contrary practices – especially for developing nations and during times of economic stress.

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