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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The Minskyian Model of Economic Crises

Minsky - Credit Supply and Crashes

Minskyian economic theory directly links an oscillating aggregate supply of credit in an economy to the potential for economic crisis. It suggests that credit supply has a cyclical nature in highly financial economies. Thus the seeds of crisis are endogenously sown during seemingly productive booming previous periods. This piece will describe the model’s principles and note how its theories stray from mainstream economic thought. This analysis will come in useful in future posts, as the model seems to well approximate numerous historical crises – and of current importance: the ongoing travails of the Chinese economy in 2015.

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Negative Interest Rates: Not Coming To Your Bank Soon

Negative interest are yet another paradox in economics. Mainstream theory suggests that a rate of interest below zero should be impossible. Rational actors would never accept negative rates, choosing to hold on to cash instead and withdraw it from the financial system. However exercises in Denmark in 2012 and the ECB and Switzerland in 2014 have shown not only that negative interest rates are practically possible, but that they are gaining some acceptance in the central banking community as a legitimate tool. Furthermore, with developed economies trapped near the zero nominal lower bound and therefore needing additional stimulative tactics, their wider use seems increasingly more attractive. However the fact that negative rates have not been widely implemented in a world where extraordinary policies like Quantitative Easing has become common place, in spite of their obviousness, suggests that there are crucial reasons why policy makers have been so reluctant to use the tool. Reasons that will prevent mainstream implementation in the future.

This piece will discuss the premise of negative interest rates, their potential as a stimulative tool and their systemic impact to economies.

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Brazilian Forward Contracts – A Revolutionary Tool in Exchange Rate Management?

From August 2013, the Brazilian Central Bank (BCB) began a novel strategy of currency intervention. The BCB directly auctioned forward contracts in the shape of currency swaps to market participants. Every week until December 2013, the bank released US$2 billion worth of swaps that were priced in US dollars and paid out in Brazilian Real. The programme was then extended from January 2014 until the 31st March 2015, albeit at a reduced rate of US$100 million a day from the previous rate of US$200 million a day.

These contracts completely contravened orthodox economic recommendations of non-intervention and the traditional methods used by emerging economies to manage exchange rates. The swaps were explicitly built to provide additional foreign exchange hedging opportunities to stimulate participants and provide additional liquidity in the domestic market. Their careful design meant that the BCB did not need to use their valuable foreign exchange reserves nor demand sterilisation. Furthermore, as the auctions were in US dollars, the swaps were actively attracting valuable foreign exchange into Brazil to help smooth the path of the Real during the peak of the “Taper Tantrum”, reversing the pattern of currency outflows away from Brazil.

This piece shall evaluate the performance of Brazil’s experimental intervention tool and contrast it against the traditional tools available to central banks. Whilst undertaking its analysis, the essay will consider the development path of the Brazilian financial sector and whether such foreign exchange swaps offer other emerging economies a revolutionary way to manage their exchange rates.

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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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