Navigating the Nexus of Geopolitical Crises: Implications for Global Financial Stability

The current geopolitical landscape, marked by escalating tensions in the Middle East and the Russian invasion of Ukraine, presents formidable challenges to global financial stability. As military conflicts disrupt financial markets, trade, and energy supplies, the intricate interplay of factors necessitates a multifaceted approach to risk management and policy coordination.

The Russian aggression in Ukraine has not only heightened regional instability but has also reverberated across global financial markets. Heightened uncertainty has eroded investor confidence and triggered capital flight, exacerbating volatility in asset prices and currency markets. Of particular concern is the disruption in energy supplies, notably natural gas, which has led to a surge in European gas prices. The ripple effects extend to households, businesses, and energy-intensive industries, compounding inflationary pressures worldwide.

Geopolitical tensions further strain global trade dynamics, causing supply chain disruptions that impede cross-border flows and challenge export-dependent economies. As counterpart risks escalate, financial institutions grapple with diminished market liquidity, amplifying the vulnerability of the financial system to shocks.

Amidst these challenges, policymakers confront the imperative of balancing energy security with climate imperatives and mitigating market fragmentation risks to ensure financial integration. The role of the US dollar in asset allocation warrants careful scrutiny, especially as tighter financial conditions and heightened portfolio outflow risks loom large.

China's vulnerabilities, compounded by property stress and COVID-19 outbreaks, underscore the urgency of coordinated fiscal support for affected businesses and households. Emphasizing risk management and transparency, policymakers must institute robust stress tests and contingency plans to bolster financial institutions' resilience.

Internationally, a paradigm shift towards rule-based policy coordination is imperative. Western countries must synchronize responses to geopolitical risks, collaborate on trade policies, and eschew arbitrary sanctions that undermine international trade and prolong hostilities. Clear communication from central banks and governments is paramount in managing market expectations and averting destabilizing speculation.

Against this backdrop, reforms to the global financial architecture are indispensable. Enhancing the IMF's role as the central institution entails recalibrating its quota formula to ensure equitable representation and bolstering lending facilities to effectively address crisis situations. Strengthened surveillance and early warning mechanisms are vital for detecting vulnerabilities in member economies, while macroprudential policies must be rigorously enforced to forestall financial crises.

Crucially, the financial architecture must align with sustainable development objectives, ensuring that financing for development prioritizes policies benefiting all segments of society. Coordinated efforts to address global imbalances and assess systemic risks are pivotal for fostering inclusive and balanced growth.

In navigating the nexus of geopolitical crises, steadfast commitment to comprehensive oversight, prudent risk management, and collaborative policymaking is imperative to safeguard global financial stability and advance sustainable development goals.

Global Depression and the Phillips Curve -- Is Fed Using the Right Tool?

The probability of a sharp global growth downturn is increasing by leaps and bounds, not only because of the international trade wars, including the Brexit, and US government shutdown, but also mainly due to the global increase of economic imbalances that are exerting their downward impact that may end in a depression. The  slowdown in Chinese economy that grew by 6.6 percent last year, which is China's slowest growth pace in 28 years is but one of the signifiers of this  emerging recessionary and perhaps depressionary tendency. The IMF's global economic outlook presented at the World Economic Forum in Davos, Switzerland, on January 21st, lowered the agency's global growth estimates for  2019  by 0.2 percentage points to 3.5%, which is perhaps far too optimistic. According to the  White House estimate, the economic impact of the government shutdown, which has left about 800,000 government employees either furloughed or working without pay, reduces growth by 0.13 percentage point per week, that should be added to the other signifiers such as the recent decline in the US existing home sales which had their worst month in more than three years this December , and the recent downward sloping trend in the stock price the leading indicators of a recession.

However, according to the most recent report of the US Labor Department, the  economy added 312,000 jobs in December, 77 percent more than the number that was previously expected. This increase, of course,  appears to be positive for consumption, which has been stimulated by the 2018 tax reductions. But  would the consumption, that is fuelled by debt and deficit  prevent the recession?  The  Federal Reserve Chairman,  Jerome Powell, recently announced that the central bank will be patient in raising interest rates. Nevertheless, in a speech in the Economic Club of Washington he understandably expressed concerns  about the ballooning amount of the US debt, that is a harbinger of upward pressures on rates. As well, Mr. Powell,  has also said that the Fed's balance sheet will be reduced significantly from where it is now, which  according to the old macroeconomics textbooks, would be much the same as a leftward shift in the LM curve, which also would be exerting upward pressures on rates, thus reducing the GDP growth.

In short, the Fed's Chairman has  talked about  the strengths of the economy but also has signaled that the monetary authority would remain flexible in its management of interest rates. He has  opined that the link between unemployment and inflation may be loosening  rather than poised for a revival. However, this link, which is in fact a Phillips curve type relationship,  usually becomes operative at the long-term full-employment level of output, that  corresponds to the long-term minimum efficient scale of aggregate production. In this note, I would argue that the US economy is not, and has not been, operating at this scale level, and the current quasi-full-employment level of output  corresponds to the short-term scales, associated with optimizations along the aggregate short-term aggregate average costs.    A failure to realise this fact would result in a costly error.

In fact, the current Phillips curve relationship is the theme that Mr. Powell has developed last October in his speech to  the National Association for Business Economics,in  Boston, Massachusetts, where he stated:

 [The] dynamic between unemployment and inflation is known as a Phillips curve relationship, and at times it can pose a fundamental tension between the two sides of the Fed's mandate to promote maximum employment and price stability. Recent low inflation and unemployment have some analysts asking, "Is the Phillips curve dead?"  Others argue that the Phillips curve still lurks in the background and could reemerge at any time to exact revenge for low unemployment in the form of high inflation.

Mr. Powell attempted to spell out  "how changes in the Phillips curve help account  for the somewhat surprising but broadly shared current forecasts of continued very low unemployment with inflation near 2 percent," and while admitting that   "no one fully understands  the nature of "  changes in the Phillips curve explanatory components "or the role they play in the current context, "  nevertheless,  maintained that;

 I do not see it as likely that the Phillips curve is dead, or that it will soon exact revenge. What is more likely, in my view, is that many factors, including better conduct of monetary policy over the past few decades, have greatly reduced, but not eliminated, the effects that tight labor markets have on inflation.   

In this note I would propose to examine these claims and to suggest that the framing of the unemployment-inflation relationship in terms of the Phillips curve, in abstract, as a guide for monetary policy would be a grave mistake, as there are ample evidence that the macroeconomic imbalances  emanating from the drastic developments  in both the supply side, and the demand side of the economy, operating under uncertainty, have generated a short-term  local equilibrium configuration, well below the long-term full-employment equilibrium. As we argue, again, the recent declines in the jobless rate are in fact due to the rises in contingent employment, and as such cannot be regarded as genuine inflationary pressures derived from a Phillips curve.   

Firms in the supply side have changed their production strategies in response to the various prevailing sources of uncertainties. In fact, an inflation targeting of about 2%  that had necessitated a very low real interest rate of close to zero, or even a negative  rate,  arising from a leftward shift in the aggregate demand in conjunction with the recent unconventional monetary policies have been creating a quasi-equilibrium that in the dynamic literature is known as local equilibrium. This type of equilibrium, as opposed to the global equilibrium, which is stable and can provide an Augmented Expectations Phillips type relationship, is unstable and any resulting pattern of inflation-output gap from it would be sparious.   As we have argued in the past, in recent years  firms,  in response to the prevailing levels of uncertainty, were  shying away from productivity enhancing (putty-clay) investment strategies and aimed at utilizing  various short-term contingency (putty-putty) technologies, in order to satisfy any temporary upticks  in the  aggregate demand. One such uptick in 2018 was emanating from the  tax reductions that was not perceived by businesses  as sustainable over the medium to longer term -- particularly with the crowding out impact of the debt and deficit. As well, the $500bn repatriation of offshore dollar holdings by US companies responding to Mr Trump’s tax reform, does not appear to have had a material impact on the US capital formation, however it has drained the dollar funding markets in Europe and Asia, squeezing credit, which would adversely affect the US external trade balance in its GDP.  .

Therefor, due to various  uncertainties, in fact,  the short-term aggregate supply curve in an  inflation- output space has shifted to the left.  Moreover,  the planning horizons for capital expenditures have shortened dramatically.  As well, firms' choices of technique have shifted towards the  less capital-intensive technologies.  In other words, businesses have been relying on part-time workers to operate more intensively with the existing machinery and equipment, and instead, of investment in new smart technologies,  were introducing more labour overtime, and upgrading the existing production lines with repaired or used equipment. 

Against such background, firms have been utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technologies. This would imply that the underlying cost mechanism, which determines the short-run aggregate supply curve,  in a price-output space (as opposed to inflation-output space),  was determined by the short-term average cost curve. In a nutshell, the output capacity in the current circumstances  does not reflect  the minimum efficient scale of production, that is  the weak observed  inflation rates corresponds to the Klein (1960) and Berndt and Morrison (1981) definitions of capacity  that are determined by the short-term aggregate average cost curve.  Such an upshot is corroborated by the recent weak commodity prices. In fact, the S&P GSCI (formerly the Goldman Sachs Commodity Index) is more than 7% below its level around 2014, and copper price, often used as bellwether for the global economy due to its wide-ranging industrial applications, is more than 10  per cent lower over the same period.

On the demand side, the recent tightening of  the credit and money markets,  that have shifted the LM curve to the left,  have caused a flattening of the yield curve. At the same time the high level of consumer and corporate indebtedness, the changes in international trade, particularly with respect to trade wars, and the precarious state of the global finance are adversely impacting the various components of the IS curve (i.e. C+I + [G-T]+[X-M]).  Given that the wealth gap have been expanding in recent years it is clear that  the consumption component of GDP  cannot be relied upon to prevent the buildup of recessionary forces, particularly when most of the new employment is of the contingency nature.

The Treasury High Quality Market (HQM) Corporate Bond Yield Curve
Monthly Average Par Yields, Percent

Wealth Gap

Source: Federal Reserve

An  illusion of a buoyant market was created by the January Labor Department report; in which unemployment fell more than forecast in September, to 3.7 percent. This was the  lowest since December 1969. As well, average hourly earnings climbed 2.8 percent from a year earlier.  However,  the fact that the U-6, or underemployment rate, edged up to 7.5 percent from 7.4 percent, despite  a 48-year low jobless rate, provides a powerful verifying evidence for the contingency nature of the recent rise in employment.  Note that the U-6, includes part-time workers who would prefer a full-time position and people who want a job but are not actively looking.

Unemployment Rate and Core Inflation Rate  

In his October speech,  Mr Powell,  contrasted the two very different periods i.e., (i.)  the period 1960 to 1985, which in the literature is known as the Great Inflation era, and (ii.) the period from 1995 to today which includes both the Great Moderation and the distinctly immoderate period of the Global Financial Crisis and its aftermath, as depicted in the above charts.  He argued:

There is a dramatic difference in the unemployment-inflation relationship across these two periods. During the Great Inflation, unemployment fluctuated between roughly 4 percent and 10 percent, and inflation moved over a similar range. In the recent period, the unemployment rate also fluctuated between roughly 4 percent and 10 percent, but inflation has been relatively tame, averaging 1.7 percent and never declining below 1 percent or rising to 2.5 percent. Even during the financial crisis, core inflation barely budged. As a thought experiment, look at the right panel and imagine that you could see only the red line (inflation), and not the blue line (unemployment). Nothing in the red line hints at a major economic event, let alone the immense upheaval around the time of the global financial crisis.

This breakdown of the Phillips curve relationship into two periods clearly demonstrates  that the current full-employment output does not correspond to the long-term minimum efficient scale, since  had the economy was operating close to its global potential output,  Phillips curve would have become operative over the later period. 

Showing the results of  Fed's estimates of the coefficients of Phillips curve, based on a  rolling 20-year-sample, that starts  from 1965 to 1984 and ends at 2017,  Mr. Powell  maintained that:

 "during the Great Inflation samples, the value of coefficient of the lagged inflation rate was near 1, meaning that higher inflation one year tended to translate almost one-for-one into higher inflation the next."   

This is of course  what econometricians call nonstationarity inflation series, that  stems from rational expectations. The Fed's estimates show that the so-called Phillips curve coefficient on the lagged inflation rate has  declined to about 0.25, "meaning that roughly one fourth of any rise or fall in inflation carries forward".   As we have argued  the reason that inflation has become stationary in the recent times,  is precisely due to the fact that the aggregate  output gap does not currently corresponds to the aggregate minimum efficient scale of production. That is to say, the recent inflation rates were the results of the offsetting of deflationary pressures  by unconventional monetary policies. 

The Fed's estimated coefficients of the labour market slack in the Phillips curve (defined as the unemployment rate minus the current estimate of the natural rate of unemployment at each point in time)  have also declined. This coefficient drops from 0.5 percent to near zero.  Thus the  Phillips curve  that, in Mr. Powell's words, was "relatively steep in the Great Inflation samples" is nearly flat in the most recent sample.  Thus, according to him:

The baseline forecasts of most FOMC participants and a broad range of others show unemployment remaining below 4 percent for an extended period, with inflation steady near 2 percent. I have made the case that this forecast is not too good to be true and does not signal the death of the Phillips curve. Instead, the outlook is consistent with evidence of a very flat Phillips curve and inflation expectations anchored near 2 percent. 

Of course, the Chairman warns  that such forecasts are rarely come to pass, and this is why  the FOMC

"takes a risk management approach, which has three important parts: monitoring risks; balancing risks, both upside and downside; and contingency planning for surprises".  

Based on our analysis, we argue that the possibility of an emerging recessionary dynamics emanating from the current imbalances are quite real, and any risk management that relies on monitoring of lagged data on inflation expectations and wage settlements may not be of much use.  In fact, such monitoring-based risk management would be similar to Messrs  Greenspan and Bernanke's idea  that   'monetary policy  tools would be  far more effective in cleaning up the mess after bubbles burst'! which proved to be quite a disaster.

 In fact, Mr. Powell has offered three examples of  risks: First;  the possibility that inflation expectations surge again? Second; the "revenge of the Phillips curve" scenario, or the possibility that inflation pressures move up more than expected in a hot economy.  Third, the possibility that the natural rate of unemployment to be lower than expected. Our old textbook models of the Expectations  Augmented Phillips Curve  suggests that all these three risks are exactly of the same origin, in the sense that they are all emanating from  similar shocks on the various components of the Phillips curve. Given that short-term aggregate average cost curve is incapable of generating a stable Phillips curve, these risks need to be evaluated in a more sophisticated framework.

The Fed's risk-management  for the  first two of these  cases include  monitoring survey- and market-based proxies for inflation expectations  as well as monitoring of a wide array of wages and compensation data.   The monitoring aim is to look for a material shock on inflation expectations  and/or wage costs. As for the possibility of a lower natural rate the chairman  believes that it would be the flip side of the "revenge of the Phillips curve" risk, which would be manifested through lower inflation rate.   Thus, to balance these risks the Fed is opting for  a  path of gradually removing accommodation, while closely monitoring the economy. "As always, there is no preset path for policy," Mr. Powell has stated. "And particularly with muted inflation readings that we've seen coming in, we will be patient as we watch to see how the economy evolves." As we have  argued if the economy is indeed exhibiting a local equilibrium corresponding to the aggregate short-term average cost, the monitoring of inflation expectations will not provide any useful information, because the Phillips curve would not be operative over the various local optima.

Slope of the Fed's Estimated Phillips Curve

The shaded area is the 70 percent confidence interval. 

Source: October 02, 2018 Monetary Policy and Risk Management at a Time of Low Inflation and Low Unemployment, Chairman Jerome H. Powell Speech At the "Revolution or Evolution? Reexamining Economic Paradigms" 60th Annual Meeting of the National Association for Business Economics, Boston, Massachusetts

As the above Fed chart shows, the slopes of the Phillips curve in recent years, based on the Fed's rolling 20-year-sample estimates,  have been very close to zero. Of course, given the somewhat chaotic nature of post-financial crisis one may have certain doubts about the accuracy of such estimates. Nevertheless, and more importantly, the hypothesis of a recession (i.e., a negative slope) cannot be rejected at 95% confidence level (note that the shaded area in the above chart depicts only the 70% confidence level). In fact, given the enormous expansion of the Fed's balance sheet the appearance of such low  estimates of the coefficient of the Phillips curve since 2012,  are  another evidence for the fact that the economy has been operating below the measure of the full-employment output gap -- that is associated with the long-term  minimum efficient scale. In other words the quasi-vertical aggregate supply curves associated with different short-term aggregate average cost curves are not the real long-term aggregate supply curve that  is determined by an  optimal capital formation trajectory.

The US  historical Phillips curve  type inverse relationship between the unemployment rates and wage  inflation rates;
2009-2018  

As the above chart shows, the employment cost inflation has increased with the decline in unemployment rate over the past 10 years . However, this increase in the employment cost represent the rise in short-term average cost. In the normal circumstances and in the absence of uncertainties,  with increased capital formation of putty-clay type and new firms entry, the theory suggests that, the average short-term cost would be shifting down along a U-shaped trajectory of the long-term average cost curve, and towards the minimum efficient scale.  Such a shift still  is still absent in the data.

As we have argued, instead of investing in productivity enhancing capital formation, the recent data shows that firms are resorting to share buybacks. For instance, from 2015 to 2017 the restaurant industry spent 140 percent of its profits on buybacks, meaning that it borrowed or used its cash balances  to purchase its own shares. The corresponding percentages for retail and food-manufacturing industry  have been nearly 80 percent  and 60 percent of their profits respectively. All in all, public companies across the American economy spent roughly three-fifths of their profits on buybacks in recent years.

Shares of gross domestic product: Gross private domestic investment

Real Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment
Percent Change from Preceding Period, Quarterly, Seasonally Adjusted Annual Rate  

As well the extremely low levels of the real interest rates have distorted the capital allocation across industries in favour construction industry. Growth rate in the construction employment at 4.9% from October 2017 to October 2018 was nearly triple the 1.7% increase in total nonfarm payroll employment. In fact, investment in construction rose at annual growth rates of between 11% to 14% over  2012 -2015,  7% in both 2016 and 2017, and  3% in 2018, reflecting the impacts of the imposed tariffs on steel, aluminum, and   lumber, and some other imported construction materials.

To be prepared for a global depression there is an urgent need for a global coordinated response.

How deep would be the recent plunge in the stock market and how far the slowdown would last ?

On Wednesday 19th December , the Federal Reserve announced its 25 basis-point rate hike. The   Dow Jones industrial average and other major indexes  tumbled , and this was perhaps the reason why some of my students wrote me to ask for an update on my July note, in which I had stated:

[B]ased on some theoretical guesses,  the probability of a sharp economic slowdown has increased by an order of  magnitude. There are reasons to believe that the short-term aggregate supply curve and the long term potential have began to shift to the right, while because of "borrowing  from the future" and large budget deficit  the aggregate demand will shift to the left. The result would be the onset of recessionary forces that their amplitude  could be wider than the previous one in 2008-09.

 I have to confess that last February, against his advice  I told my broker that I do want to get out of equities, and  as stock markets were rising again, for couple of months I had to bear with his grumbling noises about my unwise decision. In this note I am about  to reiterate my argument that we are going to see a major and frightening correction of Dow, to a level perhaps around 14000, that would augur the emergence of another financial crisis. It goes without saying that the economy may go sideways  and we may be dealing with an stagnating market until 2026, and perhaps beyond. Obviously some short term reversals of the recent declines  are to be expected, since as the saying goes even a dead cat will bounce  when it's dropped from a towering height. 

 

Dow Jones - 10 Year Daily Chart

To be sure, the Fed has been under scrutiny in recent months for its efforts to normalize monetary policy.  It had kept its benchmark interest rate anchored near zero for seven years, and in numerous occasions,   in these notes, we have discussed the futility and the risks of the QEs which have been exacerbating the global imbalances.   We have argued for a new global financial order based on a meaningful restructuring of global debts, and a fundamental rebalancing of the global imbalances.  Of course, we have been aware  that the Quantitative Easing policies (QEs) had provided some artificial support for the stock market, keeping it aloft, and we have been expecting that  with the onset of  Quantitative Tightening policies (QTs) we would  be seeing some opposite effects. However, these effects would pale in comparisons with the dramatic correction to be expected in response to  a rapidly deteriorating structural imbalances, associated with  high levels of governments and corporations debts, inflated central banks balance sheets, and trade conflicts.

It would be a misguided argument, drawn from a conventional stabilization policy analysis, to maintain that a correctly formulated set of QTs could somehow prevent the danger of the upcoming financial crisis. We  have argued that the impacts of conventional stabilization policies, including the unorthodox QEs and QTs  in a disequilibrium context, in which the equilibrium conditions in virtually all markets have been highly distorted, are not easily quantifiable. We have argued that the conventional methodology for calculating the output gap would be misleading in the current situation  in which, due to the prevailing  uncertainties, firms investment strategies  are focused on the utilization of contingent labour and contingent capital.

Unfortunately, the appearances, from time to time of,   quasi- equilibrium conditions, which have been local and highly unstable, have been misinterpreted by many analysts, including the policy makers, as the long-term global equilibrium. Although  such short-term equilibria, arising from agents' optimizations, under obstreperous QEs, had provided the illusive dynamics of a healthy growth, with the associated  increase in employment and consumer confidence, in reality they  were based on highly unstable supply and demand functions. Expectations of a soft-landing, in such a flimsy circumstances are a wishful thinking that always, and to a large extent,  aggravate  the severity of a crash. 

The Fed rate hike came in a background of  softening global growth,  relatively low inflation and  volatile stock market, with the monetary authority  expecting two more rate hikes in 2019,  as compared to their previous forward guidance of three increases next year.  Also, the Fed statement sounded  slightly more nervous, as it did not include  the qualifier 'some' in its previous statement, stating:

“The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

Moreover, Chairman Jerome Powell said that he would keep reducing Fed's balance sheet by up to $50 billion per month. It should be noted that since the beginning  of the QT  process in October 2017, the Fed has trimmed its dangerously  inflated balance sheet by  a meager $365 billion to $4.14 trillion, relative to what is really needed, which is a virtually impossible to attain reduction of some $3 trillion.  According to the chairman:

“We thought carefully about how to normalize policy and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy to adjust to incoming data. I think that has been a good decision,”

Total Assets of the Federal Reserve ($million)

  

Year-on-year change in  the Federal Reserve balance sheet ($000)

 Some analysts were quick to blame President Trump for this sorry state of affairs. According to CNBC;

The end of 2018 makes clearer every day that the president himself represents a fundamental problem for America's economy and national security alike. Trump's erratic behavior and weak leadership have unsettled Wall Street and Washington alike — and there's every reason to expect things will get worse. :

While, I am not certainly a fan of president Trump's shenanigans and at times his irrational behaviour, nevertheless,  I find this kind of accusation bordering to nothing more than a cheapshot. On the other hand it is hard to understand  Treasury Secretary Steven Mnuchin's declaration on the weekend of December 22, that markets have enough liquidity for lending. Yes, it is true that according to Goldman and Sachs data the large Banks have now 39% more liquidity as compared to 2010, and the comparative rates for trust banks and regional banks in the US are 73% and 71% respectively. However, in  a world with close to $1.3 quadrillion of financial debt instruments, including derivatives, and a global GDP of close to $90 trillion these percentages would be meaningless, particularly  in the event of a major financial crisis, when the Fed balance sheet has increased close to 500 percent, and the US public debt has increased by about 63% over this time span.

The problem is that with the imminent appearance of a severe recession the policy makers may decide to resort to another round of QE, which unfortunately would be even more ineffective than the previous rounds. Furthermore, with the federal funds rate target at a range of 2.25 percent to 2.5 percent, the Fed will not simply have enough ammunition for an effective interest rate response. The fact is that the discussion about the level of neutral rate at this juncture is a red herring. Nobody  can predict the new long-term equilibrium conditions before the cleansing of all excesses.

Economic growth, has already exhibits a decline from its 4.2 percent rise in the second quarter, and it is clear that it will be slowing  dramatically in 2019, as not only the impacts of artificial boosters such as tax cuts and spending increases wanes, but more seriously as the global uncertainty that is flared up already, triggered by Brexit,  European financial situation, debt overhang in China, massive global corporate debt  and the trade war exerts its impact.  These impacts could be magnified by the rise of artificial intelligence-driven electronic trading as it accelerates  financial transactions, allowing them to be conducted across multiple markets at the same time. Thus, a possibility of an emerging sudden deflationary dynamics cannot be ruled out.

The European Saga

According to the European Financial Stability Review, November 2018;

The euro area financial stability environment has become more challenging since the publication of the previous Financial Stability Review in May. On the positive side, a growing economy and improved banking sector resilience have continued to support the financial stability environment in the euro area.

As for the Brexit, the Bank of England has already warned Britain would be tipped into a recession worse than the financial crisis in the event of a no-deal disorderly Brexit. The Bank's analysis of various EU withdrawal scenarios, shows that in the event of a disorderly Brexit, Britain's GDP could fall by 8%. The Bank of England has also investigated the impact of an stress scenario on the British financial institutions.  The scenario assumes, gross domestic product would fall by 4.7 per cent in the UK and 2.4 per cent worldwide, while residential property prices in the UK would fall by a third and the BoE’s base rate would rise to 4 per cent.

Under this relatively optimistic  scenario, British lenders would be able to withstand a global recession more severe than a disorderly Brexit.  The test indicates that British banks would be able to keep lending to customers even if there were a major financial crisis, while continuing to pay billions of pounds in fines and compensation to address wrongdoing.   “The test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the [2008] global financial crisis,” the BoE wrote in the introduction to the stress test results. Despite, the fact that the results appear to have been presented to appease the bickering Brexiteer politicians,  still  the Bank's efforts are more encouraging than those of the Fed, which perhaps being worry of provoking President Trump's wrath  has been resistant to conduct broad-based, macro stress tests on its systemically important financial institutions (sifis).

Some central bankers are more vocal with regard to their  concerns about the upcoming financial crisis. For instance,   Bank of France governor Francois Villeroy de Galhau  has stated: “To measure the global impact of shocks, we need in particular to have macro stress tests of liquidity, including for investment funds."   In France, where national debt is set to hit 98.7 percent of GDP in 2018, president Macron, who thought pursuing a Gerhard Schröder's type of more business-friendly reforms,  would be improving its long-run growth potential suddenly faced with the so-called ‘yellow vest’ protests. Outraged by his wage and welfare reducing policies, under a highly skewed distribution of income in favour of rich, Gilet June  protesters torched cars, attacked shop windows and clashed with police. The president was forced to deliver a much-watched mea culpa in mid-December to mollify protestors, and offered a handful of concessions; raising the minimum wage and slashing some taxes that would push next year’s fiscal deficit well beyond the EU-mandated threshold of 3.0% of GDP.  The French government has warned of slower economic growth as a result of the protests and Bruno Le Maire, the country's finance minister,  has stated that the current protests would cost France 0.1 percentage point of quarterly economic growth. France growth  rate was a meager 0.4 percent in the third quarter from the previous quarter.

With large French and German banks owning billions of Italian sovereign debt, including BNP Paribas  €9.8 billion, BPCE   €8.5 billion and Crédit Agricole €7.6 billion, at the end of 2017, the chronic financial problems of Italy is the prime trigger for a financial crisis that could spread across the EU. These problems include  Italy's huge accumulation of nonperforming loans on its banks’ balance sheets, amidst of the efforts by its populist government to spend money, that it doesn’t have, to improve the country's long lasting lethargic growth  Rome's debt is more than  €2 trillion and 131 percent of its GDP, the second highest in the EU after Greece.

And Finally China's Slowdown

In China a weaker credit growth, slowing global demand and higher U.S. tariffs on Chinese shipments  are affecting its investment and export prospects, and thus its GDP.  Her GDP growth slowed to 6.5 percent in the third quarter, the weakest pace since the global financial crisis, and with the recent data  showing softness in November factory output and retail sales, it is quite clear that the economy is already slowing down. China's official Purchasing Managers' Index (PMI)  fell to 50, from its previous level of 50.2. A reading below 50 indicates that an economy is contracting. The last time China saw a no-growth headline figure was in July 2016:

China's  domestic  economic imbalances are serious.  The country's regional banks are heavily incentivized to keep loss-making companies alive. To avoid  the appearance of  loan losses, the banks extend loans to zombie firms,  allowing them , in the short term, to maintain an illusion of profitability.  The asset quality of many banks  are quite poor, and  they rely heavily on interbank borrowing as source  of funding, which can dry up fast when it is most needed during a financial crisis. For instance,  according to  data from 244 Chinese lenders,  the share of deposits in total liabilities at regional banks fell from 73 per cent to 64 per cent between 2013 and 2017.   Once banks levering up through non-deposit sources, the cost of funds increases and the odds for an interest rate shock or a liquidity shock rise substantially.

The country's debt levels are soaring  from 140 percent of GDP in 2008 to more than 260 per cent now. Despite  four reductions to banks' reserve requirements, tax cuts and increased construction spending, lending remains tight and money supply now sits near record lows.

  

The evidence for the upcoming recession!

(c) Guity Novin

These posts have been interrupted for a number of reasons.  Nevertheless, I must add that, had  they continued uninterrupted their information contents would have been severely limited. This is  because  the election of President Trump and his unconventional approach to economic policies have introduced a paradigm shift, reducing substantially the signals-to -noise ratio of many economic models.  It should also be added that there were other unusual noise-creating events in Europe, including  Brexit, the financial situation in southern Europe; particularly with regard to the  Italian debt problem, and finally the geopolitical and trade tensions.

Many of these sources of uncertainty are still unresolved, but one has a bit of more clear perspective with regards to  their possible trajectories.  Of course, as many commentators have already mentioned the 4.1percent growth in the second quarter is just a one-quarter- performance of economic growth, and it is not reasonable  to consider it as signifying the emergence of an upward sloping economic trend.  In other words,  the growth may not be sustainable.

Of course,  the  global economy has gone  through a synchronized  recovery in its major economies, mainly stimulated by a very expansionary monetary policy -- that its adverse impacts are somehow disguised by the increased noise in the data.This note will argue that based on some theoretical guesses  the probability of a sharp economic slowdown has increased by an order of  magnitude. There are reasons to believe that the short-term aggregate supply curve and the long term potential have began to shift to the right, while because of "borrowing  from the future" and large budget deficit  the aggregate demand will shift to the left. The result would be the onset of recessionary forces that their amplitude  could be wider than the previous one in 2008-09.

Aggregate Short-run Supply and Long-run potentials have began to shift to the right:

A shift to the right of  the aggregate short-run supply curve is usually stemming from declines in costs of production, which are induced by technological progress.  However, the shift this time has its origin in some increased trade policy noise. In particular, the U.S. administration's protectionist trade policies including the proposed 10 percent tariff on $200 billion in Chinese goods,  and its predecessor of $50 billion of  tariffs on imports from China have disturbed the equilibrium conditions  in the associated markets, providing incentives for some entrepreneurs to enter into the markets to substitute the imported supply from China-- i.e.,   a shift of the short-term aggregate supply to the right.  This would have been positive had the Say's law that 'supply create its own demand'  would have been operative, which we would argue it wouldn't happen  in the current circumstances.

 A  50 per cent reduction in the value of imported goods from China last year, and the expected  retaliatory  measures by China  would, of course, be of major adverse consequences for employment and demand, which will be exacerbated by the increasing  production costs due to the imposition of tariffs -- more on the demand shift later in this article.

Furthermore, the rightward shift in the Short Run Aggregate Supply is enhanced by corporate tax cuts, which are also expected to simulate business spending on capital and equipment. In fact, companies have already started to invest again. Unfortunately, a well established prediction of the economic theory is that tariffs would distort the nature of such investments. This is because relative price signals would be sending wrong information about the prospects of goods that are relatively inferior, aginst the goods that would enhance the competitiveness of the economy. Thus investors invest in wrong projects, a mistake that many less-developed countries committed during 1950-60s. 

 It is easy to see that as a result of these capital expenditures, the long-term potential would transiently shift to the right.

A Shift of Aggregate Demand to the Left

  We have already mentioned some reasons for the expected leftward shift in the aggregate demand. However, the main force behind this expected shift would arise from  a necessarily drastic fiscal tightening in order to reduce the budget deficit, which according to the Congressional Budget Office estimates would be about $1tn over the next fiscal year. The uncertainty, unleashed by these cuts would, of course, exacerbate the consumer entrenchment and the leftward shift in aggregate demand,.

Both rational businesses and consumers, anticipating a rising prices due to tariffs have began to "borrow from future"  i.e., buying consumer and capital goods  before tariffs take effect and raise the prices of those goods. The halt of these purchases  during a fiscal tightening period would remove  their stabilizing effects and would aggravate  the uncertainty.

Of course, the impact of tariffs on prices in the short term would cause an upward movement along the aggregate demand curve which would be adding to the complexity of the  gauging  the magnitude of the leftward shift in  aggregate demand by policymakers.

Global Economy

According to World Bank forecasts global growth this year will reach 3.1 percent, as compared to about  3 percent rate for 2017. The growth is expected to be mainly concentrated in emerging economies, which will be rising to  4.5 percent  this year relative to 4.3 percent in 2017. This global growth pattern does not bode well for the sustainability of global growth,  as it emanates  from a greater sensitivity of emerging markets to advanced economies growth-- which itself is  a consequence of the export-led-growth strategies of these countries. This situation is exacerbated by the trade wars with China,  a country that would be unable to reduce her  burden of debt, now at about 260 percent of national output, with a shrinking global trade.

 Meanwhile, central banks need to refurbish their monetary policy instruments in order to be able to fight the upcoming recession. In other words they need to raise interest rate - for the ironic reason that this would enable them to reduce them by a sufficient amount that could provide  effective stimulus in a fight against the expected recession. Recall that the  current recovery has been fostered by the extraordinary monetary expansions of the Federal Reserve, ECB and Bank of Japan, which included negative interest rates via expansion of their balance sheets by purchase of risky  assets on a massive scale.

On the Reignition of a Global Banking Crisis: The Case of Deutsche Bank

The intensification of banking crisis signals at the end of September has created tumultuous conditions for the stability of the global economy.   Deutsche Bank's predicaments, with its worldwide interconnectedness and operational linkages  are aggravating   the  global financial imbalances and threatening the market toward a disorderly resolution. Expressing concerns about the precarious state of the European banking sector that stems from leveraging their equity capital since the inception of euro, in some cases by forty to one or more, we wrote on July 2015 that:

The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

Then on February this year, after the global bank stocks crushed amid a selloff that erased more than $4 trillion from global equities, with shares of Goldman Sachs and Morgan Stanley dropping by close to 10 per cent  below their tangible book value,  French and German banks like Société Générale and Deutsche Bank seeing their shares fall by more than 10 per cent ,  Italian and Greek banks by 31 per cent  and 60 per cent  and Japanese banks by 36 per cent   we argued that  the legacy of sovereign debt crisis is still haunting the banking sector and wrote:

 For much of the last few years various central banks have been performing an extensive set of “stress testing” their balance sheets against a chain of purportedly worst-case economic scenarios, in order to identify which banks do not have sufficient capital to meet the hypothetical shocks, gauging the amount of recapitalisation the banks require. However, policy makers are well aware that no bank can survive these tests when confidence in the banking system has been shattered. As well, nobody knows how the structural parameters of the underlying models for these tests have changed in response to unconventional policies such as negative interest rates. In other words the results of these tests are at best unreliable.

Indeed, share price of Deutsche Bank  that has had three massive re-capitalisations  since the financial crisis of 2008-09, and had passed the ECB's stress test this July, underwent a highly volatile session on September 30th, when its shares crashed by more than 7 per cent  in the US and Germany in the early hours of trading, after reports that some hedge funds were trimming their exposure to the bank. This was after Deutsche's share price had plummeted close to 30-year lows earlier in that week, when reports surfaced that the US Department of Justice intended to impose a $14 billion fine for mortgage-backed toxic security  in the run-up to the financial crisis. However, after an Agence France-Presse report that the bank was nearing a deal with  the U.S. authorities, to reduce its fine to $5.4 billion its share was partly recovered, trimming its year-to-date loss to a still-sizable 46 per cent.

Nevertheless, the volatility was a clear sign that market anxiety about  European economy has reached its  critical limit. This is in the context of a very fragile global economy, where the  distortionary impacts of QEs and negative interest rates together with costly Basel-III regulations  have reduced  financial institutions  earning prospects in a market where competitions by highly agile and low-cost fintech companies are becoming more aggressive. 

Deutsche Bank is the 12th largest bank in the world (8th largest non-Chinese bank) with a market valuation of about €67 billion, which operates in 70 countries. However, its balance sheet is contaminated by a massive amount of toxic assets, particularly concentrated in its investment banking unit, which constituted much of its earnings  before the financial crisis of 2008-09. The negative interest rate and financial regulations have fundamentally overturned its  traditional  business model. The bank  as a balance-sheet lender  tended to be heavily reliant on net interest income, but its net interest margins have been severely slashed as a result of ECB's negative interest rate policies, while at the same time the bank has been under pressure  to recapitalize in order to build a larger financial buffer. In a low growth environment with limited investment opportunities the bank,  like other European banks, has seen its profit margins being  plummeted  to  a record low.

More specifically, Deutsche Bank's $1.75 billion 6 per cent Additional Tier 1 bonds (AT1), known as contingent convertible capital instruments or CoCo bonds,  callable in 2022 became  under severe downward pressure when were bided at 69.55 cents on the euro, and when the US Department of Justice asked Deutsche to pay the aforementioned massive fine to settle an investigation into its selling of toxic mortgage-backed securities. This was lower than  February's sell-off low of 70.2 cents on the euro -- 83 cents earlier in September.

CoCo bonds with 6 per cent coupon

Chief executive  of Deutsche Bank, John Cryan, who  two days earlier in an interview with the German tabloid Bild   had stated that a capital increase was "currently not an issue" was forced to issue an statement on September 30th, highlighting  the bank's resilient financial position, emphasizing that it has an "extremely comfortable buffer" when it comes to liquidity. “There are forces now under way in the markets that want to weaken confidence in us,” he wrote. “Our job now is to ensure that this distorted perception does not more strongly influence our day-to-day business,” Cryan added. "At no time in the last two decades has Deutsche Bank been as safe as it is today," reporting that the bank's liquidity reserves amounted to more than 215 billion euros. As well, in a brief to journalists, Deutsche Bank pointed out that most of it's 200 derivatives-clearing clients had stayed with the bank, and that its recent risk management  efforts only affected the bank's sales and trading operations, and not areas such as corporate finance or transaction banking. Felix Hufeld, the head of Germany's financial regulator Bafin, told the Sunday edition of the "Frankfurter Allgemeine" newspaper: "I warn people not to let themselves be drawn into a kind of downward spiral of negative perception."

Nevertheless, the  alarming situation was aggravated when the German finance ministry refuted a report on the weekly newspaper Die Zeit that suggested the German government was working on a contingency plan for Deutsche Bank, which could include taking a government stake in the bank. It is of note that bank made a loss of €6.8 billion in 2015 and is expected to show another €1.6 billion loss this year. According to Reuters a Milan judge had on October 1st charged 13 people over questionable past derivative transactions by the Banca Monte dei Paschi di Siena, which six of them were former managers of Deutsche Bank.  It is noteworthy to recall that as we wrote, on August,  Monte dei Paschi was the only bank this summer that was reported insolvent in the European Banking Authority(EBA)'stress test, with a common equity tier one (CET1) ratio of -2.44 per cent, requiring emergency recapitalisation. It too has a balance sheet contaminated with massive amount of toxic debt.


Will  Deutsche Bank's crisis trigger  a  new global financial crisis?  Can the new crisis be  as severe as the 2008 that was triggered by the collapse  Lehman Brothers which created a deep freeze in credit markets?

Capital ratio versus regulator requirement (as of the second quarter '16)

Source: Credit Suisse, company data

Regional distribution of Deutsche Bank Share Ownership: in per cent year-end 2016

Source: IMF. Staff calculations based on the Diebold and Yilmaz (2014) methodology and daily equity returns from Oct. 11, 2007, to Feb. 26, 2016. Groupe BPCE and the Agricultural Bank of China (ABC) not included due to lack of public traded data and short sample size.

Contagion of Bank Share Prices  

 Reflecting the interconnectedness of banking sector, as the above chart indicates, there are strong correlations among the banks' share prices.   In fact, Goldman  Sachs  share prices,   despite the fact that  has been benefiting from a relatively stronger U.S. economy,  have been exhibiting somewhat strong correlations  with those of Credit Suisse  and Deutsche Bank  since August 2015. One also needs to be reminded that Deutsche Bank's recent crisis hit bank shares across Europe with Lloyds Banking group, Barclays and Royal Bank of Scotland all falling by more than 4 per cent per cent at the start of trading in London. Commerzbank, Germany's second-biggest lender, was down by nearly 6 per cent. Swiss, French and Italian banks were down by about the same amount.  Thus, should  anxiety takes over, and investors dump holdings indiscriminately, this interconnectedness has the potential to generate a massive tsunami that would be impossible for the overstretched central banks to fight against. Such financial tsunami would slush the value of even non-toxic assets on bank balance sheets, devastating even the more robust financial institutions. As Deutsche Bank with its massive size rely less heavily on its deposit-taking  activity and its earnings have been concentrated in its investment banking operations it is especially prone to reignite market anxiety.

The German officials , of course, have denied any attempt on a rescue plan to help Deutsche Bank, as new rules introduced to prevent misguided investments by large financial institutions prohibit taxpayer-financed bailouts. German  authorities have been quite vocal in their oppositions to relax   these regulations, spurning a recent rescue proposal by the Italian government, allowing them to inject public funds into the Italian banking system. Germans have been steadfast in criticizing  southern Europeans for the euro-zone financial crisis and admonishing them for their lack of fiscal discipline. Thus, after so many non-German European banks  being collapsed or drifted  into insolvency because of unavailability of public funds, it would be politically perilous to relax the rules to rescue their own bank.

Even if Deutsche Bank would not be the bank that would trigger  the next financial crisis, there are many other vulnerable banks that are also suffering from negative interest rates, high-cost regulations and competitions from fintech companies that could do so.  Some  of them like Barclays, Credit Suisse, Royal Bank of Scotland and UBS are also being investigated by the US Department of Justice for their roles in creating toxic  residential mortgage-backed securities. Should a hefty fine be imposed on them that would affect their share prices and the resulting  reverberations would almost certainly affects the share prices of those banks that have already agreed to pay a fine to settle allegations of misleading mortgage bond investors including  Goldman Sachs (more than $5 billion ), Wells Fargo  ( $1.2 billion), Bank of America ( almost $16.7 billion) and JPMorgan ($13 billion).


The seething financial crisis of course cannot be detached from the current tepid global productivity growth and lack of capital formation that have caused the global production possibility frontier to shrink. The deriving policy responses in the form of QEs and negative interest rates that have eroded the financial institutions profitability and altered the traditional  behavioral relationships in the  saving investment markets,  have created a vicious circle. Governments facing a shrinking tax revenue and rising expenditures are becoming more and more dependent on the banks purchasing their debt, and the banks become reliant on government to earn returns.   This is why recent  Standard and Poor’s data show that banks across the EU have been investing more heavily in government debt, increasing their exposures. In fact, Western European banks have more than doubled their holdings of their own governments’ debt from a low of €355 billion in September 2008 to €791 billion today. Such a massive exposures between states and financial institutions adversely affects the health of both. Against this backdrop, a German bailout of its largest bank would only exacerbate such a tendency.  Once again we repeat our suggested remedy.

The world urgently needs a global financial accord to cleanse the system of its toxic assets, realign currencies, and reestablish trade links. 

An Uneasy Truce In the Currency War and Bank of Japan's Policy Reboot

On September 21st the Bank of Japan (BOJ) plunged into a mission impossible kind of rebooting its monetary policy framework. The Bank switched to targeting the slope of yield curve, which sounded as if it overhauling more than three years of massive quantitative easing,  which did  very little to stimulate an economy that was stuck in the doldrums for more than two decades, yet in reality the mechanism to control the yield curve was the same as for the old policy.  While Governor Haruhiko Kuroda said the central bank will not hesitate to ease policy further, BOJ  did not force the rates further into the negative territory, and  announced that it wants to  keep rates steady at their current levels, which may indicate a temporary truce in the currency war among the central banks in order  to allow a smooth transition of the Chinese renminbi into the SDR reserve currency basket on October 1st. However,  the door is left open for the resumption of the war to weaken yen, if the Fed opts out again of the so-called normalisation policy in its December meeting.

The BOJ's press release read:

the Bank decided to introduce "QQE with Yield Curve Control" by strengthening the two previous policy frameworks (...). The new policy framework consists of two major components: the first is "yield curve control" in which the Bank will control short-term and long-term interest rates; and the second is an "inflation-overshooting commitment" in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner. 

 The BOJ 's  unexpected  heterodox move to targeting yield curve, aiming  to maintain both the current short-term policy rate and the 10-year Japanese government bonds (JGBs) yield  at their current levels of minus 0.1 and  about zero per cent respectively, in conjunction with its modified ETFs purchase plan aimed at stimulating investment and growth is fraught with many perils. Not only this adventure would create more market distortions, but also adds to the prevailing uncertainty.   In order to mitigate the market anxiety, BOJ offered a nonbinding pledge of maintaining the current pace of the annual increase of  about 80 trillion yen  ($788 billion), -- which may  either  be too little or too large for achieving the zero per cent target yield for the 10-year JCB.  To wit, they may need to purchase more than the 80 trillion yen or to stop short of it, in order to achieve their target, depending on borrowers'  demand.

As for the Bank's inflation target, despite the fact that controlling the slope of the yield curve will most probably alter the transmission mechanism of the monetary policy and will introduce serious unintended consequences, the Bank announced its intention to exceed "the price stability target of 2 per cent", staying "above the target in a stable manner" by  the expansion of the monetary base.  It is, of course, unclear as how can  the BOJ engineer an inflationary process when, as a result of the global slowdown, the economy in all likelihood is heading towards a deep recession.

The desperate idea of controlling the yield curve and challenging the market forces was suggested by the former Fed chair Ben Bernanke  who wrote recently in his blog:

The Fed normally operates by influencing very short-term interest rates. However, we know that targeting rates for securities of longer durations is feasible, under some circumstances, since the Fed did it during World War II and the immediate postwar years. (...) Although the Fed’s pegs of 65 years ago were aimed at minimizing the cost of war finance, the same basic tool could be used today to advance the Fed’s macroeconomic objectives.  

Of course, the investment prospects were quite different from today's conditions of tepid demand and low productivity growth either during the war, when the American economy expanded at an unprecedented rate, war related demands directly consumed over one-third of the output of industry and the surge in productivity stemming from scientific and technological innovation more than doubled the corporate profitability; or in the period immediately after the war, with its the pent up demands, and productivity growth that benefitted from reconstruction activity and commercialization of numerous scientific and technological innovations during the war. Moreover,   the idea of manipulating the yield curve appears quite absurd from any theoretical perspectives of the term structure of interest rates, be it the liquidity premium theory, expectations hypothesis, preferred habitat theory, or market segmentation.

In general, yield  curve control like any other price control would distort the information content of prices, would generate distributional biases and would exacerbate the current feeble  level of capital formation.  Ironically, investigating the Operation Twist, launched in early 1961 by the incoming Kennedy Administration, that intended to manipulate the yield curve by raising  short-term rates while lowering, or at least not raising, long-term rates,  Bernanke,  Reinhart, and  Sack (2004) argued that if the financial pricing approximates the equilibrium, then trying to target  a ceiling on the long-term yields would be successful if those targets were  "broadly consistent with investor expectations about the future value of the policy rate." A condition that is hardly satisfied in today's situation of Japan. They wrote:

If investors doubted that rates would be kept low, this view would predict that the central bank would end up owning all or most of the targeted security. Moreover, even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the possibility exists that the yield on that security might become “disconnected” from the rest of the term structure and from private rates, thus reducing the economic impact of the policy.

Overall, the authors conclusion was that:

Operation Twist is widely viewed today as having been a failure, largely due to classic work by Modigliani and Sutch

Thus, it is surprising that in his recent commentary about the BOJ's move to yield curve targeting, Mr. Bernanke poses the question  "Is the BOJ’s switch to a long-term rate peg a good idea? "  and writes:

I think the announcements are good news overall, since they include a recommitment to the goal of ending deflation in Japan and the establishment of a new framework for pursuing that goal. As the BOJ noted explicitly, the Bank will now be able to cut either the short-term rate or its target for the longer-term JGB yield if future policy easing is needed. The follow-through will indeed be crucial: Japan has made significant progress toward ending deflation, but that progress could still be lost if the public questions the BOJ’s commitment to its inflation objective. The commitment to overshoot the inflation target will be constructive if it helps to kill market speculation that the BOJ was contemplating abandoning its fight.

 Of course, he reiterates his previous argument about the risk of pegging the long-term bond yields, which may cause a central bank's balance sheet to balloon, and states:

That risk is particularly acute if the peg is not credible—if market participants expect the peg to be abandoned in the near term, for example—because then bondholders will have a strong incentive to sell as quickly as possible. 

Surely,  because of its seriously harmful adverse selection effects,  it would be most rational for the agents to expect that the peg will be short lived.  Thus, it would be hard to imagine that the acute risk  identified by Mr. Bernanke would not be materialized.

Japan's  Evolution of Yield Curves 

It is interesting to note that investors are quite sensitive to the slope of the yield curve. In fact the reason yield curves are informationally rich stems from the ease that bond markets respond to maturity preferences as well as other market conditions. For instance, before the BOJ's announcement, as the above chart demonstrates, concerns over a possible change in the BOJ's monetary policy  caused  an upward shift in the country's  yield curve, as investors worried that the Bank's introduction of more risks along various maturities  would cause a decline in their prices, which may also have encouraged a large and abrupt exit of the other bondholders, similarly the downward shift of the curve relative to the end of 2015 was largely related to investors' concerns about the global slowdown after China's  stockmarket crash.

Japan's Government Bond  Yield Curve, Source MarketWatch 

Acknowledging the fact that an excessive decline and flattening of the yield curve , as were observed this summer, may have a negative impact on economic activity due to raising  uncertainty associated with financial stability,  the BOJ noted that  short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. However, it ignores the fact that by targeting various maturities it would alter the transmission mechanism and the nature of those impacts would change.

Evidently, the Bank hopes that  the link between the impact of interest rates and the shape of the yield curve would change favourably as firms explore new ways of raising funds such as issuing super-long-term corporate bonds, which presumably could offer higher yields to improve the business prospects for pension funds  and insurance companies. However, one should not discount the reasonable probability of an steeper yield curve arising from an adverse selection process, whereby the good businesses may judge the new policies as distortionary and thus exit the market, while riskier firms with poorer prospects would be crowded in.

Mr. Kuroda has acknowledged that the BOJ may introduce more fluctuations  in the bond market,  stating: "Now we have a yield curve control, the amount of bonds we buy could fluctuate." This, of course, would introduce an added source of uncertainty in the market, whereby the participants not only must try to decipher the price signals, but also must now predict the quality of the information of the policy makers and the nature their reaction.

Japan's Bank Lending

It is important to note that, as the above chart shows, despite BOJ's three years of ultra-loose policy  the Japanese  bank lending has remained stagnant over that period, mainly reflecting the prevailing global uncertainty.   It is not clear that  a wishful thinking about the ability to target the yield curve or to allow inflation to overshoot its 2 percent target will alter the bank lending, particularly  at a time when virtually all central banks' are experiencing a loss of policy effectiveness.

A key factor contributing to the recent lack of capital formation has been the distortionary impacts of BOJ's purchase of ETFs , at an annual rate of around 5.7 trillion yen ($56.12 billion), as part of its QQE program, which have been approximately  proportional to the ETF's market values of the three indexes: the Topix, the Nikkei 225 and the JPX Nikkei 400. As well,  300 billion yen of ETFs were committed to "supporting firms proactively investing in physical and human capital". This policy, as a matter of course, would arbitrarily discriminates in favour of the firms that are publicly traded against  those that are not, and the criteria of investing in physical and human capital raise the question as what expertise  the BOJ possesses in order to  assess and select these  investment. But apart from such problems,  the market was further distorted in favour of those firms registered in the Nikkei index, which is weighted by the price of individual stocks, compared to other indexes, such as the broader Topix, which are weighted by market capitalization.

The BOJ's  rebooting aimed at rectifying some of these distortions is utterly vexing. The Bank arbitrarily divides the 5.7 trillion yen into two parts, the first part, which  includes a $3.7 million yen would still  favour the purchase of the Nikkei-based ETFs over the other two aforementioned indexes. The second part includes the remaining 2.7 trillion yen that would be aimed only at funds tracking the Topix index. It is not clear  how these modification would improve the investment climate.

As the chart below demonstrates, despite a lack of productivity growth businesses have added markedly  to employment since 2012, indicating  that Japanese businesses, like their counterparts in the U.S. and Europe, have  also been  opting for intensive margin mode of of production, and instead of investing in capital formation were using more labour intensive technologies that would allow a greater use of contingent labour in a highly uncertain post-global-financial-crisis era.

Japan's Labour Productivity, and Employment

The problem is that BOJ's QE policy,  implemented over the 2001-06 period,   resulted in a drastic shrinkage of Japan's production possibility frontier because of its various  distortionary impacts, resulting in a prolonged stagnation of the  productivity growth, which  has caused the economy to stall. Haphazardly, similar to other central banks, the BOJ attributes its policy ineffectiveness to a fall in  the unobservable natural rate of interest, which  is supposed to have disguised the insufficient  size of the policy accommodation.  For Instance, in his 23 May 2016 speech  Mr Hiroshi Nakaso, Deputy Governor of the BOJ, has stated that:

 Japan's natural rate of interest had been falling due to the decline in the potential growth rate; at the same time, real interest rates remained high due to the zero lower bound on nominal short-term interest rates and the decline in inflation expectations. As a result, QE did not provide sufficiently accommodative financial conditions. 

A similar reasoning was used by the US Fed's chair, Ms. Yellen who on September 21st  invoked the specter of a falling neutral rate of interest, an unobservable variable, as the main  reason for why the current ultra-low policy rate is only modestly  accommodative, and thus does not justify a September rise in the policy rate, or in her words:

"With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives, 

and  in the same vein, the ECB  president, Mario Draghi,   using the term 'real return', defined as ''generated by the balance of saving and investment in the economy", instead of 'neutral' or 'natural'  has also used a similar argument in his May 2016 speech:

Over the past decades, however, we have seen long-term yields trending down in real terms as well, independent of the cyclical stance of monetary policy.  (...) The forces at play are fairly intuitive: if there is an excess of saving, then savers are competing with each other to find somebody willing to borrow their funds. That will drive interest rates lower. At the same time, if the economic return on investment has fallen, for instance due to lower productivity growth, then entrepreneurs will only be willing to borrow at commensurately lower rates. 

As we have argued in various posts in this forum, the Wicksellian natural rate is an equilibrium long-term concept that is irrelevant for the consideration of short term transitory dynamics in getting on toward a new equilibrium. In fact, this theoretical sloppiness  causes serious inconsistencies in the arguments  of  central banks that invoke this excuse. Hence,  the whole idea that the unobservable natural rate has declined is a non sequitur argument. In fact, a decline in the potential growth rate would be diminishing the size of the output gap which should be positive for the inflation and inflationary expectations. In a frictionless market the resulting real interest rate decline should induce capital formation and growth. In contrast, when there are uncertainty and policy distortions the investors will wait, producers would shift to intensive margin and therefore any speculation about the latent neutral rate in a disequilibrium state would be absurd.

What caused the Japanese lack of productivity growth, were the slow growth  of the 1990- 2005 period  and its associated lack of capital formation, resulting in a decline in Japan's growth potential by  the second half of the 2000's which was aggravated by the global financial crisis and inappropriate policy responses.The economy contracted severely and the year-on-year rate of  consumer price exhibited  deflationary tendencies. The decline in the capital formation and a shrinkage of Japan's production possibility frontier  triggered  a slowdown in Japan's productivity growth.

Japan's CPI Inflation and Core Inflation Rates

As the above chart shows, despite the BoJ’s large QE programme and negative interest rates , which have contributed to pushing the yields on about $13 trillion  of government debt globally below zero, the country is now slipping  back into deflation.

What about the currency wars? One may speculate, with some reasonable likelihood,  that perhaps there were a tacit understanding  among the US, Eurozone, Japan and China's authorities, in the recent G20 meetings, that  the near recessionary situation in China  and the prospects of renminbi devaluation, which on October 1st this year is supposed to become part of the new SDR basket of reserve currency,  warrant  a relatively less volatile exchange market. Thus,  the September inaction by the Fed,  the BOJ and the ECB would allow the US dollar not to appreciate and would help to maintain a less volatile currency markets,  which would buy some times for the China's monetary authority to deal with the country's economic slowdown. In this regard it is interesting to note that on September 22nd, the spokesman for the IMF, discussing the question of inclusion of renminbi in the SDR  has said:

[I]n the last 12 to 18 months there have been a lot of changes in the value of currencies or exchange rates (...) if the underlying  currencies are volatile, then the [SDR] basket will move more. It depends on how the currencies move against each other in the periods ahead. (...)

[I]n simple terms we look at the average exchange rate of the basket currency over the last three months that will end on September 30th, and that’s one determiner. The other is that the value of the SDR basket is unchanged as a result of the transition, and from that we can determine what currency amounts using those average exchange rates will give you the rates that the IMF Executive Board has decided. And that can only be determined on September 30th because we are using exchange rates that run all the way through September 30th. So that will be decided on September 30th.

US Dollar to Japan's Yen and to China's  Yuan Exchange Rate

To conclude, BOJ's policy shift toward yield targeting would create further economic distortions that would hamper growth. The BOJ may be  successful in influencing short-term bond yields into negative yields. But, as Governor Kuroda himself has admitted,   negative rates particularly hit the profit of financial institutions, while low long-term yields hurt some other businesses by forcing them to put aside more money for long-term pension obligations. All these indicate that the current truce in the currency war would be a short-lived one.

Bank of Japan's Monetary Policy Actions, Source: BOJ