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BIS Blasts Fed's ZIRP Policy, Warns About Negative Side Effects From Extended Low Interest Rates
Well, at least Ben Bernanke will never be able to conduct sworn testimony claiming nobody warned him about the adverse side-effects of ZIRP. As part of its 80th annual report, the BIS has dedicated an entire chapter to diagnosing Ben Bernanke's terminal Keynesianism, entitled: "Low interest rates: do the risks outweigh the rewards?" The openly negative, and borderline critical narrative, coming from the central banks' central bank, adds yet more fuel to the rumor that there is an open schism developing between the BIS and the Fed, with the IMF's increasingly fiat-y SDR likely to suffer as a result. Whether the BIS is planning the creation of some non-fiat currency, as some have speculated, is unknown at this point.
Here are some of the BIS' critiques of what an "extended" period of "extremely" low interest rate will bring to the world:
History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s.
First - "Low interest rates caused misallocations before the crisis …"
Previous episodes of low interest rates suggest that loose monetary policy can be associated with credit booms, asset price increases, a decline in risk spreads and a search for yield. Together, these caused severe misallocations of resources in the years before the crisis, as evidenced by the excessive growth of the financial industry and the construction sector. The necessary structural adjustments are painful and will take time.
Second - "...And are now delaying necessary adjustments"
In the current setting, low policy rates raise additional concerns since they are accompanied by considerably higher long-term rates. This may lead to a growing exposure to interest rate risk and delays in the restructuring of the balance sheets of both the private and public sector. The situation is further complicated because low interest rates may have caused a lasting decline in money market activity, which would make the task of exiting from loose monetary policy more delicate.
Third - "Low interest rates have an impact on risk measures and perception. This contributed to rising asset prices
before the crisis. And may be at work again today."
Standard economic models predict that a decrease in real interest rates causes faster credit growth, if it is expected to be sustained. Moreover, it raises asset prices since it drives down the discount factor for future cash flows. Other things equal, this leads to a rise in the value of collateral, which may induce financial institutions to extend more credit and to increase their own leverage to purchase riskier assets. Rising asset prices are also often associated with lower price volatility, which is reflected in lower values for commonly used measures of portfolio riskiness such as value-at-risk (VaR). These factors in turn reinforce the amount of capital invested in risky assets and the increase in asset prices and lead to a further narrowing of measured risk spreads. This mechanism is widely seen as a major driving force behind the increase in asset prices and the decline in risk spreads in the run-up to the financial crisis of 2007–09. Starting in the spring of 2009, a fast recovery in global equities and a rise in house values in many economies (the euro area and Japan are exceptions) were accompanied by a reduction in corporate bond spreads and other risk premia (Graphs II.1 and III.2, top panels), though some risk measures have meanwhile risen again in the context of the Greek sovereign debt crisis. The broad rise in asset prices and the reduction in risk spreads that took place in 2009 and the early months of 2010 is thus best seen as reflecting both the success of these policies and a new build-up of potentially overly risky portfolios.
Four: "Low policy rates can induce a search for yield"
Risky portfolios can also result from a search for yield, whereby low nominal policy rates lead investors to take on larger risks in pursuit of higher nominal returns. In the years preceding the financial crisis, many investors targeted a nominal rate of return that they thought was appropriate based on past experience. Furthermore, institutional investors, such as insurers and pension funds, faced pressure to fulfil implied or contractual obligations made to their customers at a time when nominal returns had been higher; they looked for those returns in alternative investment opportunities. The fact that many compensation schemes were linked to nominal returns also contributed to the search for yield.
Five: "This may drive up asset prices fuel financial innovation and discourage real investment"
A number of symptoms can indicate a search for yield. The first is an increase in asset prices and a reduction in risk premia. While the recovery in many asset markets in 2009 and early 2010 in part represented a reversal of crisis-related risk aversion, the search for yield phenomenon, against the background of near zero policy rates, may have started to play a role towards the end of this period.
A second symptom is distorted financial innovation. In the early 2000s, intermediaries responded to investors’ desire for higher returns by engineering financial products that appeared to minimise the risk associated with them. A large variety of these “structured” products were widely sold in the years before the crisis. On the surface they appeared to embody the investor’s holy grail of low risk and high yield, but during the crisis their character proved to be the opposite. As a consequence, the market has become reoriented towards less exotic investment products. That said, financial innovation is difficult to monitor and the shortcomings of new products are easier to spot with hindsight.
A third symptom can be an increase in dividends and share buybacks. If investors expect high nominal returns and if these are difficult to come by, non-financial corporations may find themselves under pressure to return funds to investors rather than pursuing risky but economically profitable real investments in new plants or research and development.
Six: "Low policy rates can steepen the yield curve exposing banks to interest rate risk"
Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies. However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines.
Seven: "Low policy rates can delay the restructuring of balance sheets"
One legacy of the financial crisis and the years preceding it is the need to clean up the balance sheets of financial institutions, households and the public sector, which finds itself in a poor fiscal position, partly as a result of the rescue measures adopted during the crisis. Low policy rates may slow down or even hinder such necessary balance sheet adjustments. In the financial sector, the currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets (see also Chapter VI). Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.
Eight: "The adjustment of public finances may also be delayed"
Low interest rates may also delay necessary balance sheet adjustments in the public sector (see Chapter V for more details). By shifting their debt profile towards shorter-term financing, governments can reduce interest rate payments. While this provides them with useful breathing space for returning sovereign debt levels to a sustainable path, it also exposes fiscal positions to any increase in policy rates if the needed budgetary adjustments are not put in place in a timely manner. This can raise concerns about the independence of monetary policymakers.
Nine: "Low policy rates can paralyse money markets and complicate the exit"
Once central banks begin the exit and raise their policy rates, it is essential that money markets transmit this change to the wider economy. However, low policy rates can paralyse money markets. When the operational costs involved in executing money market deals exceed the interest earned – which is closely related to policy rates – commercial banks may shift resources out of these operations. Japanese money markets suffered such atrophy: the turnover in the uncollateralised overnight call market fell from a 1995–98 average of more than ¥12 trillion per month to a 2002–04 average of less than ¥5 trillion. As a result, the tightening of Japan’s monetary policy in 2006 was complicated by overstretched staff on the money market desks at commercial banks. In the current setting, one reason why many central banks have refrained from lowering their policy rate all the way to zero during the recent financial crisis has been to avoid precisely this problem. International differences in how close policy rates got to zero are probably related to diverging money market structures.
Ten: "Low policy rates also cause distortions abroad"
Low interest rates in the major advanced economies cause side effects beyond their borders, both in emerging markets and in commodity-exporting industrial countries, which fared comparatively well in the crisis. The initial impact of the financial crisis on these countries was in most cases a sharp decrease in exports (Graph III.4, top panels), a withdrawal of US dollar funds by foreign banks, liquidation of equity and bond holdings by investors, and a drop in equity prices. The large emerging economies and the advanced commodity exporters experienced a considerable weakening of their exchange rates against the US dollar in the autumn of 2008, except in the case of China, which held the renminbi fixed (Graph III.4, middle panels). Monetary policy was loosened, both through lower interest rates and – in China, India and, later, Brazil – through lower reserve requirements (Graph III.5). Moreover, many central banks locally offered US dollar funds that some had obtained through swap lines with the Federal Reserve.
And the BIS' damning condemnation:
The recent market turbulence associated with sovereign debt concerns is likely to have postponed the necessary return to more normal monetary policy settings in a number of advanced economies. Exactly when monetary conditions will be tightened will depend on the outlook for macroeconomic activity and inflation, and on the health of the financial system. But keeping interest rates very low comes at a cost – a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments. Furthermore, the resulting yield differentials encourage unsustainable capital flows to countries with high interest rates. Because these side effects create risks for long-term financial and macroeconomic stability, they need to be taken into account in determining the timing and pace of normalisation of policy rates.
Bernanke - you have now been officially warned. Playing dumb is no longer an option.
Full BIS Report:
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Krugman thinks we are headed towards the third depression
http://www.nytimes.com/2010/06/28/opinion/28krugman.html
The first hasn't even ended yet!
Paul should know, he brought us here.
It must suck being Paulie now, his life's work being exposed as the sham it is. But no, I doubt this fruitcake will ever admit failure; he will probably go to his grave shouting, "if only they had printed/borrowed more ...".
How's the view from your ivory tower Dr. Krugman? From the ground, I can tell you, it sucks down here.
"Fractional Reserve Banking: It's Not Just for Social Control and Enslavement Anymore."
The BIS pot has no room to point fingers.
True, but IMHO, it's a power grab.
The BIS keeps its role only if there *is* international banking. We are quickly approaching the point where there will NOT be. That's why they are making this move: They know the Fed is cornered, and the Fed is about to go super-nova (no stopping that now).
It's unclear what the next system looks like. I understand the assertions that this was all "planned", and that's possible, but that's irrelevant at the moment. People either will or will not accept as a unit of exchange the "next offered" centrally-planned unit. If people choose to not accept the BIS basket-o'-currencies, then the BIS is toast, and they know it.
Yes, this is a house of cards, designed to collapse as per "the plan." As far as I can see its divide and annihilate on a grand scale. At this point the owners do not want to save populations as those populations have grown some eyes.
As much as I want to believe in a big "master plan" I'm starting to think that there isn't one or at least that there isn't one that is working according itself. To have stripped economics of the fact that humans are really QUITE irrational was a gargantuan load of bullshit that we are now all forced to swallow. The animal spirits will prevail no matter what TPTB try. They are scrambling to react to forces that are well beyond their ken but have unfortunately (for them) reached a point where no matter how fast they bail, the boat continues to sink.
The IMF has a basket-o-currencies.
What makes you think the BIS has a similar plan (if they have one, that is)?
Is this a PhD versus PhD discussion???? I think the Fed's worthless PhD's lose this one hands down.
Nop, it Mupet vs. Mupet
Didn't Alan Greenspan already try "exceptionaly low interest rates for an extended period of time"? Seems to me he did, and the results were not that good.
I think you underestimate Zimbabwe Ben's ability to play dumb. He is a master at looking foolish and ignorant, a real savant.
Besides who is there to hold him accountable, Congress?
Anyone smell that? Smells like a Euro bank run in progress. Check out the EUR/CHF.
First, Krugman's an idiot. I just wanted to get that out of the way.
Second, I think Bernanke is well aware of the risks associated with extended ZIRP. At issue is the Fed's willingness to maintain its ZIRP policy for political reasons (which will likely backfire on the party in power, anyway).
The BIS is right on the mark in indentifying the distortions in asset prices a ZIRP policy brings to the table. And yeah, the longer it lasts, the more perverse the asset dislocations become.
For all intents and purposes, the Fed is trying to side step the effects of a balance sheet recession-- when what SHOULD be done is let the balance sheet correct itself. But that would be too painful in an election year, now, wouldn't it?
"Writers who have not taken a year of PhD coursework in a decent economics
department (and passed their PhD qualifying exams), cannot meaningfully
advance the discussion on economic policy." -from the richmond fed
How dare the Great Unwashed challenge the establishment!
The only decent economics department in the country resides in Princeton, NJ with its luminary contributors to economic discussion. None other than Ben Bernanke and Paul Krugman
I love all these articles discussing how the rats can get out of the trap. There is no right direction, just like entering the event horizon of a black hole, you can use your rocket boosters in any direction you wish, you are not going to get out.
"induce a search for yield and delay balance sheet adjustments."
Everyone is searching for yield but nobody can find it. Duh. It's called game over.
You can have the Fed raise the Fed's Fund Rate to 5%, the mushroom cloud will look very pretty.
"what SHOULD be done is let the balance sheet correct itself."
Yeah, you are saying collapse, sorry that is not the purpose of the Fed, the Fed is put in there to keep the Lemmings marching as long and hard as possible, when the Lemmings stop it's game over. The books never balance, never will.
Welcome back Mako - I thought maybe you'd gone to Vegas, had a few drinks, gotten laid, and would come come back with a cheerier disposition.
But no, it's the same ol "math never lies", "the end is nigh".
Well fuck it, I think I'll to to vegas instead (while its still there) lol
Math is the ultimate truth - that's why they prefer economists over people that can add.
No shit - I got $5 on some pussy for Mako - and not even Lemming pussy, but real live Human pussy - who's with me?!
I'll put in 20 if i get to hit it first
I certainly agree with the premise of crossing that event horizon. While the timing may vary, I believe we crossed it that rubicon when Greenspan avoided the last balance sheet correction opportunity in 2000. Shoulda. Woulda. Coulda.
Yeah, I'm saying collapse, Mako. Here's what the Fed is saying: "let's keep the lemmings marching as long as possible-- and when the lemmings stop-- there will be collapse on an even grander scale".
Same result, but from a higher perch. Collapse now. Or collapse later.
Yeah, the books may never balance... but nature has a nasty way of making the books irrelevant.
Paul "Freddie" Krugman is providing a glimpse into Obama's campaign strategy for 2012. Transition from blaming Bush to blaming everyone in the world for failing to heed the economic strategy of the false prophet.
Krugman's assertions on the market's interpretation of "harsh" austerity is wrong. The market knows the "harsh" austerity is, well, not harsh at all as it will never be implemented by the parliments across Europe thus the larger premium required to attract investors who rightly percieve a large risk on return of their principal.
since the Bis isn't a blogger can we listen to them
only if the Fed gives you permission
Tyler: this post is one of many examples of what you do being so much more valuable than that which the MSM does, even when the MSM is straight up (or relatively so) about the news. Here is a link to a much less valuable Marketwatch report as documentation (no need for anyone to actually go to it), which of course does not even direct the reader to the full report, whereas you save us the search and provide the link. Thanks!
http://www.marketwatch.com/story/tighter-budgets-bank-reform-needed-now-says-bis-2010-06-28?reflink=MW_news_stmp
Do you really think that stupid oaf bernanke is going to understood even if he were to read this ... that guy is only interested in seeing whether his theories work or not .. he cares a damn about how his follies are screwing up main street...
Reminds me of that guy who was experimenting on the reactor at Chernobyl. He ordered the reactor techs to disable one safety system after another, dismissed their objections and concerns as obviously uninformed and unqualified, and then .... BOOM
Those reactor techs didn't have phDs, see; they obviously couldn't contribute meaningfully to the theory and practice of reactor dynamics. .... BOOM
Reactor dynamics is hard, there's so much going on, the little people with their pedestrian understanding shouldn't expect have a voice ... BOOM.
These things should be handled by experts only .... BOOM
Do you really think that stupid oaf bernanke is going to understand even if he were to read this ... that guy is only interested in seeing whether his theories work or not .. he cares a damn about how his follies are screwing up main street...
Excellent article.....
At last....COMMON SENSE...
Wrong.
The reality is that it's ALL IRRELEVANT.
We have left the world in which the opinions of ANY of these economists matter! High rates low rates, it's ALL IMMATERIAL. It won't change a fucking thing. The real world is NOT YIELDING, who cares what men want to charge as "interest"?
Every single economist was trained to model growth climates. We are no longer in one. They will resist and deny this admission because it means that the knowledge of 100% of them is useless and that bankers' products are no longer needed.
Debt only works in concert with growth.
Hoenig of Kansas City Fed has been a voice of sanity on this, and he should be recognized for his courage of speaking out against his colleagues views.
Yep, it takes balls to back your judgement when it goes against consensus.
Personally I admire folks who do that. All of my heroes have that quality.
"Standard economic models predict that a decrease in real interest rates causes faster credit growth,"
This is IT. The lynchpin of what is wrong and why economists are saying "this stuff is really hard."
Their basic fundamental models/premises/theories have been falsified in front of their eyes and they don't know what to do.
1) Decreases in real rates are NOT caused by banks.
2) Decreases in nominal rates in a contractionary climate will not lead to credit growth.
Problem is that nobody understands (1) and nobody EVER bothered to consider (2). It's never really been studied as to wtf to do in a contractionary climate. Mother nature is batting, and she's up 2-0 in the count.
The bases are loaded, no outs, and look out for a suicide squeeze!
As John Willilams told subscribers in his June 25 report, regardless of the Fed’s “language games,” U.S. households suffer contracting real income and “where consumers accounted for 73.4% of the just-revised first-quarter 2010 GDP (including housing) — sustained positive real growth in personal consumption — is impossible without positive real growth in consumer income."
It was just June 10, 2010 that Robert Barone, head of Ancora West, and Matt Marcewicz wrote in Waiting for Inflation? It’s Already Here of the dire effects of below-inflation interest rate yields on consumers. IMO, the current up tick in selected private-sector wages and salaries in this recession still is not large enough to significantly negate the effect of reduced income from low interest rates, even with the BEA's so-called "rise" in personal income. It also fits in with today’s report that nondurables were down .9%. Said Barone:
“Artificially Low Interest Rates: In the US, we have a rapidly aging population. Many of these baby boomers are at or near retirement age. As they have aged many have shifted a larger portion of their liquid assets into fixed-income securities. It's also true that many of the ultra-wealthy, having already made their fortunes, have a significant portion of their assets tied up in fixed income. Comparing today's yield curves with the yield curve of 2007 makes it clear that fixed-income investors are taking a haircut on yield. Three years ago, a bond portfolio of similar duration would have earned an investor between two and 4.5 percentage points more in interest return. On a million dollars, today's fixed-income investors are earning $20,000 to $45,000 less per year, pretax. For many fixed-income investors, this has meant a 40%-75% reduction in income, depending on the duration of the portfolio. A similar reduction in income can be seen for corporate bonds. This represents a significant fall in consumer income. With the price indexes continuing to rise (although slowly), living standards have been impacted, and, as a result, these segments have endured the equivalent of a virulent inflation.
"It's clear that the Shadow Bailout (artificially low interest rates) has helped the banks repair their toxic balance sheets. It's also clear that the manipulation of interest rates through the Fed Funds rate, the provision of near zero rate loans by the Fed to the large banks, and the resulting near zero deposit rates to consumers has drastically lowered the incomes, and hence purchasing power, of a large portion of American savers. These reduced rates have also lowered the returns of pensions and endowments, further exacerbating their funding gaps, and putting future payouts in serious jeopardy. It's a tragedy that many hard-working, trusting Americans will be forced to face a future with lower incomes and less purchasing power, which will reduce consumption, the bedrock of American GDP. Lower incomes for the wealthy will also leave less money for investment (as will high taxes, currency issues, and regulation), helping to ensure slower economic growth”
Also, this statement in May subtracts credibility from current BEA analysis:
“The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,” said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics. “It’s a transfer from savers to banks.”
And, in that low interest rates are still the Fed’s game plan, this statement in March in the WSJ by Charles Schwab, Low Interest Rates Are Squeezing Seniors, remains significant:
“In February 2006, when Ben Bernanke was first sworn in as chairman of the Federal Reserve, the federal-funds target rate stood at 4.5%. That same year, the average yield on a one-year certificate of deposit was 5.4%. A retiree who diligently saved for a lifetime and had amassed a nest egg of $100,000 could count on an added $5,400 in retirement income per year. That may not sound like much to the average Wall Street Journal subscriber, but for a senior on fixed incomes that extra money improved the quality of his life.
“[T]hese unprecedented low rates have now been in place for almost 18 months. As a result, banks have enjoyed virtually free access to money while retirees have been deprived of any meaningful yield on their fixed-income portfolios. For a large segment of our population—people who worked long and hard, who followed the rules by spending less than they earned and putting the remainder away to keep themselves independent in retirement—the ultra-low interest rate is more than a hardship. It’s a potential disaster striking at core American principles of self-reliance, individual responsibility and fairness…”
This appeared in ZH in August 2009 (ZH adding, Is it any wonder that in March of 2006 the Fed Board of Governors quit reporting M3, which included CD’s of $100,000 or more?):
Treasuries: Bearish consensus will likely be proved incorrect. Households currently own $8.8 trillion of equities, $7.7 trillion of deposits and cash (earning next to nothing in yield), and $273 billion of treasury notes and bonds.
http://www.zerohedge.com/article/putting-it-all-together-managing-money-you-peer-abyss
If I understand it correctly, the Federal Reserve Act says that the only way a Chairman can be removed from his position is by the President, "for cause". Being relieved "for cause" is fairly common in the Navy and can be imposed for many reasons, great and small. It is the prerogative of the commanding officer and at times is the best way a senior officer can save his own skin. So my thinking is that the only way we'll ever see Benwah Benny separated from his perch of sublime criminality is if the peasants become restless enough to cause Obammy to offer up Benwah to save his own hide. When TSHTF, nobody will be safe.
The executive summary/overview, pretty much lays out in 3 easy to read pages why the Fed and Congress (courtesy of the voters) are going down the wrong track. Looks like all of the chapters are worth a gander, although most of it will probably be familiar to regular ZH readers.
The statement "As the crisis worsened, central banks adopted unconventional policies to help prevent what many observers feared might become a second Great Depression." reminds me of a quote from, of all things, Kung Fu Panda's turtle master. To paraphrase, "One often mets his destiny on the road he takes to avoid it."
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7857595/RBS-tells-clients-to-prepare-for-monster-money-printing-by-the-Federal-Reserve.html
"Entitled "Deflation: Making Sure It Doesn’t Happen Here", it is a warfare manual for defeating economic slumps by use of extreme monetary stimulus once interest rates have dropped to zero, and implicitly once governments have spent themselves to near bankruptcy. The speech is best known for its irreverent one-liner: "The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost.""
BIS primping to look good.