Intelligentguess

Alan Greenspan has written an article in the Wall Street Journal on the ongoing mortgage crisis in America.

In it, he lays the blame for the crisis on almost everything else (including the collapse of the Soviet union) but for his own actions of keeping rates too low for too long as the Fed Chairman, even at times expressing helplessness.

Read this excerpt for an example

There was clearly little the world’s central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century.

There is a clear unwillingness to take responsibility for the consequences of the Fed’s actions (or should I say inactions). I would tend to agree with Mark Thoma who at the end of this post says

Was the crisis his fault? I wouldn’t go that far. Could he have done more to prevent it or reduce its severity? Here I think the answer is yes.

While Greenspan laments the lack of control that central banks had on long term interest rates, most of the crisis has been caused by loans taken on very low adjustable rate mortgages (ARM) which in turn fueled a rise in asset prices to bubble type levels. ARMs are marked to short term interest rates, which have a more or less direct relationship to central bank policy action.

On this count too, the maestro seems to have got it wrong.

Finally, the punchline is delivered by Paul Krugman who says that

He once described Greenspan like a man who suggests leaving the barn door ajar, and then - after the horse is gone - delivers a lecture on the importance of keeping your animals properly locked up.

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The US Dollar gets into a free fall against most other assets after a Chinese official hints at diversifying deployment of reserves into stronger currencies

• The Euro sped past 1.47. It appears it’s only a matter of time we see 1.50
• Crude nudges $100 per barrel. Still a little short of it but not much
• Gold goes past $845 /oz and is within reach of an all time high of $850 / oz

I could go on and on….

Amidst all this we see some evidence of decoupling

The Australian Central Bank raised interest rates today. The ECB is expected to maintain a hawkish stance on monetary policy
Amidst all this the Reserve Bank of India has announced that it has loaded up on more ammunition to defend the Indian Rupee against the deluge of dollar flows. The ceiling for issuance of Market Stabilisation (or MSS) bonds has been raised to INR 2.5 trn. That’s almost two times the gross yearly government borrowing (in other words the fiscal deficit).

It’s time they realise that such measures only add to the flows, emboldening potential investors of the near surety that the currency would not depreciate. In addition it allows them to test the limits of the abilities of the central bankers in managing these flows.

It’s time RBI realises that these measures are an exercise in futility.

Remember the “Impossible Trinity“.

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The Reserve Bank of India has released its semi annual review of monetary policy.

Key measures

• Increase in cash reserve ratio (CRR) by 50 basis points.
• No change in policy interest rates

While many analysts are calling the policy statement neutral and attributing the CRR hike to liquidity management, the accompanying statements seem to convey a fairly hawkish view from the central bank of the country.

More on this later - possibly as an update.

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This is a guest post by KRG, treasury head of a leading financial institution in Mumbai, India.

As the October credit policy is round the corner, few thoughts on what we could expect from RBI….

To start with, there is some pressure from the global quarters, with the US Fed likely to cut the next day of RBI policy. This could however be countered by the argument that if China could continue to tighten reserve requirements so can we.

There is some perceived slowing of credit growth and headline inflation numbers. Are these good enough to “anchor inflation expectations”? With the strong Rupee, new peaks in Oil prices seem to be more manageable than before. The FM also wants the banks to reduce lending rates. May be there is no case to hike rates or reserve requirements.

But, how does RBI address the stronger-than-ever Fx inflows in all eligible asset classes? And that too, with reasonable costs of intervention, a new found monetary constraint. The chances of a stronger correction in asset markets thru the P-Note regulation seem to recede, while new theories of decoupling are being pushed to suggest investment in Emerging markets as a de-risking strategy to hedge the potential risks in developed markets.

And, the headline inflation will go back above 4.5% by next quarter if we were to extrapolate the recent WPI numbers. Can the Central bank slacken its tightening bias at this stage? Perhaps not. Hence there seems to be no case for a rate cut either.

Perhaps, the alternative left for the Central bank is to stay put on all fronts.

While this would help RBI buy time, the liquidity problem will keep coming back in some form or fashion. If the Fed cuts, the interest differential to existing Indian rates would be an added incentive for the Fx inflows to India. By not responding with a rate cut, RBI would be enlarging the scope of the regulatory arbitrage

Is there a better solution? May be, especially after the monetary policy changed track with reintroduction of CRR hikes, imposition of a ceiling on reverse repo amount for about 2/3 months (haven’t the fx inflows dried up in that period?), widening of LAF corridor and reinstatement of good old controls (risk weights, ECBs etc) whenever in doubt.

At the current juncture, our political economy does not and may be cannot control flows into equity markets, the main source of Fx inflows. The policy will have to then deal with the additional constraint of the debt markets having to undertake the entire burden of monetary adjustment.

What RBI could do is to go a few more steps further and widen the LAF corridor further by a cut in the reverse repo rate to discourage incremental flows. Lest this be mistaken for an easier monetary policy, it could introduce the good old incremental CRR. And, since CRR is a blunt instrument with LT effects, may be design this as a special deposit with RBI. And perhaps pay a small interest rate; say 1% below reverse repo. And banks could be allowed to use the deposit in special situations; say as an alternative to repo borrowing from RBI.

Will all this not take us back few years in terms of development of monetary policy? Yes. But we had taken the initial control route to manage the impossible trinity. Might as well keep going forward in the same path rather than trying to find non-existent alternatives.

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I wrote a piece for DNA after the release of the quarterly review of monetary policy by the Reserve Bank of India yesterday. This has been published in the Money section of DNA today

Given below is the full text of the piece

While governor Reddy has answered some questions through his policy actions, several others remain unanswered.

The hike in cash reserve ratio and removal of cap under the reverse repo facility is an implicit acknowledgement by the RBI of the futility of trying to manage exchange rates by keeping the money markets oversupplied with local currency.

The central bank has been unusually tolerant of near-zero short-term rates for long periods, hoping that it would ease its job of exchange rate management.

The policy moves announced are an implicit acceptance of the failure of such a policy regime.

The withdrawal of the second liquidity adjustment facility window, which was introduced after persistent demand from bankers, would mean that banks would now have to bear the burden of intra-day liquidity management.

Expect more intra-day volatility in overnight rates.

These measures clearly bring out the primacy of liquidity management in the revised scheme of RBI’s policy formulation.

It also enables the RBI to get back control of the short-term interest rate, something generally considered sacrosanct in central banking circles.

In other words the central bank now at least has a semblance of control on monetary policy.

The experiment of abdicating monetary control has lasted a little over three months. Purely for the sake of policy clarity, it’s a good thing that this experiment has now come to an end.

What remains unanswered though is the type of exchange rate policy that the central bank would now pursue.

While all indications are that the policy of active intervention to protect a particular level of the rupee against the dollar would continue, the market would have expected the governor to dwell on this with a little more clarity and frankness.

Under normal circumstances a 50 basis point hike in CRR would have led market men to cry blue murder.

However, such is the nature of times that it barely registered as a whimper. However, using the CRR as a tool to impound liquidity has severe drawbacks. It imposes a banking system wide penalty and would generally add to the cost of funds for banks. To those, who are predicting a drop in short term interest rates, I say this is wishful thinking. And let’s not forget the RBI itself had a medium term target of moving the CRR to 3%.

A much more efficient method of liquidity pre-emption is through open market sale of bonds. This ensures that the costs, if any, are borne selectively. However, supply of bonds on RBI’s books have dwindled significantly and thus limits its capability to conduct these operations.

The MSS scheme, which was conjured to tide over this, involves fiscal costs, something that the government may not wish to bear endlessly.

Unusual situations require out-of-the-box thinking to generate out-of-the-box solutions. It may be time to think of allowing RBI to issue its own bonds.

This would require legislative change, but in the end may be worth the effort.

It would provide the central bank would another tool to carry out its policy prescription. Additionally, it would relieve the government of the burden of bearing the costs of monetary and exchange rate policy.

It would also serve to shift the costs to where they duly belong. There are examples of such central bank bonds in the global context.

The People’s Bank of China (PBC) regularly issues bonds to pre-empt funds. What’s more, the PBC bonds are compulsory purchase bonds for commercial banks. Of course, one does not need to go to that extent in India.The central bank issuing its own bonds would also provide the true meaning to the current misnomer, “RBI Bonds”.

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Economist Ila Patnaik has written an excellent piece on the non tenability of India’s currency policy, specifically the Reserve Bank of India’s resolute defence of the Indian Rupee’s spot level against the US dollar.

Coming as it does on another addition of USD 3 bn to India’s forex reserves last week and the upcoming monetary policy statement on Tuesday, the lessons to be learnt from the article are timely.

In particular note the last two paras - repeated here:

A consistent monetary policy is one that is speculation-proof. The Bank of England never gets into a dogfight with speculators. It learnt its lessons in 1992. Now it calmly targets inflation. An inconsistent monetary policy invites speculative capital flows. The policy mistakes of the RBI are a source of risk. They induce unstable speculative capital flows.

The defence of the dollar is the root cause of these difficulties. The task of the credit policy announcement on July 31 is to show an exit strategy from this no-win situation. The goal must be to improve on the messy events of March 2007, when the rupee appreciation took everyone by surprise while the RBI stayed resolutely non-transparent. This requires improved transparency and communication by the central bank, and a programme to increase currency flexibility.

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This is my second piece for DNA, which looks at the options before the RBI Governor when he unveils the first quarterly review of monetary policy for the financial year 2007-2008. /the policy review is due July 31, next Tuesday.
Here’s the link to the article.

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The ECB at at today’s meeting decided to leave the key ECB interest rates unchanged at 4.00%. The ECB stated that Monetary policy is still on the accommodative side

The ECB’s percepective on its future expectations is explained below:

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Economic Activity

• Economic activity in the euro area in the second quarter of 2007 continued to expand in line with the ECB’s baseline scenario.
• The medium-term outlook for economic activity remains favourable.
• The strong rate of monetary and credit expansion reflects, in part, favourable financing conditions and solid economic growth.

The risks surrounding this favourable outlook for economic growth are broadly balanced over the shorter term. At medium to longer horizons, the balance of risks remains on the downside.

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Price Stability

• The short-term profile of annual inflation rates continues to be determined largely by current and past energy price developments.
• The medium-term outlook for price stability remains subject to upside risks.
• Annual inflation rates are likely to fall only slightly in the months ahead before rising again significantly towards the end of the year.

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Capacity Utilisation

Capacity utilisation is high and labour markets continue to improve, constraints are emerging which could lead in particular to stronger than expected wage and profit margin developments.

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Monetary expansion

• There are indications that higher short-term interest rates are now influencing monetary dynamics, although they have not, as yet, significantly dampened the overall strength of the underlying rate of monetary and credit expansion.
• The underlying rate of monetary expansion remains strong.

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Given the vigorous monetary and credit growth in an environment of already ample liquidity, a cross-check of the outcome of the economic analysis with that of the monetary analysis supports the assessment that upside risks to price stability prevail over the medium to longer term.

The next Monetary Policy decision is due on August 2nd 2007

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(Click on image for a larger Visual)

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Situation

• The Federal Open Market Committee ( FOMC ) met on June 27th 2007. The FOMC releases a statement after their meeting - reflecting the Interest rate decision and their thinking about the future.
• Statements are standardized so that there is no room for a mis - understanding.
• Comparing statements of the past - to the current statement can give us a clue on how the FOMC thinking is changing and in which direction they are pulling towards.
• Have broken down and then compared the current statement released to the  statement made in the last meeting . Items in Bold  Italics highlight the differences in thinking.
• The next FOMC meeting is on  August 7th 2007.. 

Comments

• The Feds primary concern remains inflation ( though they feel that it has moderated). As such rate changes cannot be expected in the next meeting to be held on August 7th 2007. Any sustained rise in inflation (need to observe inflation data in Jul’07 and Aug’07) could however trigger a rate hike.

• The Fed does not seem have any fears that the current rates could act as an impediment to growth. As such it is not currently considering rate drops. Any change of such a stance would depend on the preliminary GDP data for Q2 2007 ( expected on July 27th 2007). The earliest communication of any change in stance (regarding growth fears)  would therefore happen in the August 7th meet.  

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Related link

USA - Inflation (specially core) faces a rising risk

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