Category Archives: Central Banking

Democratic Financial Reform Platform Summary

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The Democratic platform position on financial regulation begins with an endorsement of Dodd-Frank. The Democrats state that they will “vigorously implement, enforce and build on the landmark Dodd-Frank financial reform law” while “stop[ping] dead in its tracks every Republican effort to weaken it.” When addressing the financial industry, a term used interchangeably with “Wall Street,” the Democrats aver that it is marked by “greed and recklessness” and that it is “gambling trillions” for the benefit of a “handful of billionaires.” To combat this, the Democrats would “support stronger criminal laws and civil penalties for Wall Street criminals who prey on the public trust” and would support “extending the statute of limitations” to prosecute such people.

The Democrats propose to:

  • support the Department of Labor’s new fiduciary rules;
  • “oppose any efforts to change the CFPB’s structure from a single director to a partisan, gridlocked Commission” and “oppose any efforts to remove the [CFPB’s] independent funding and subject it to the appropriations process”;
  • “nominate and appoint regulators and officials who are not beholden to the industries they regulate”;
  • “crack down on the revolving door [sic] between the private sector . . . and the federal government,” and “ban golden parachutes” [payable to those leaving private industry to work in government];
  • “limit conflicts of interests by requiring bank and corporate regulators to recuse themselves from official work on particular matters that would directly benefit their former employers”;
  • “bar financial service regulators from lobbying their former colleagues for at least two years”;
  • adopt an “updated and modernized version of Glass-Steagall”
  • impose a “financial transactions tax on Wall Street to curb excessive speculation and high-frequency trading,” although the platform does “acknowledge that there is room within our party for a diversity of views on a broader financial transactions tax”; and
  • “defend the Federal Reserve’s independence,” but also “reform the Federal Reserve so that it is more representative of America as a whole, and . . . fight to make sure that executives at financial institutions are not allowed to serve on the boards of regional Federal Reserve banks or select its members.”

The Democratic Party emphasized its determination:

Democrats will not hesitate to use and expand existing authorities as well as empower regulators to downsize or break apart financial institutions when necessary to protect the public and safeguard financial stability, including new authorities to go after risky shadow-banking activities.

The Democratic platform envisions not only a continuing expansion of financial regulation, but also seems to promote the idea that government should play a very major role as a direct provider of financial services.

As a provider of financial services, the federal government would:

  • expand the powers of the Postal Service so that it may offer “basic financial services such as paycheck cashing”; and later, the platform again emphasizes that the Democrats “believe that we need to [provide additional banking services] by empowering the United States Postal Service to facilitate the delivery of basic banking services”;
  • create an “independent, national infrastructure bank that will support critical infrastructure improvements” and “provide loans and other financial assistance for . . . multi-modal infrastructure projects”;
  • continue to support the interest tax exemption on municipal bonds . . . to encourage infrastructure investment by state and local governments;
  • defend the “Export-Import Bank”;
  • “provide direct federal funding for a range of local programs that will put young people to work”;
  • “provide targeted funding and support for entrepreneurship and small business growth in underserved communities”;
  • “double loan guarantees that support the bio-based economy’s dynamic growth”; and
  • expand “federal funding for New Markets Tax Credit, community development financial institutions, and the State Small Business Credit Initiative.”

G20 Describes Path to Global Economic Recovery

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The Group of 20 Finance Ministers and Central Bank Governors (“G20”) reviewed efforts to respond to “key economic challenges, as well as the progress . . . made since the beginning of this year.” The meeting was held over two days in Chengdu, China.

In a Communiqué issued at the end of the conference, the G20 members conveyed the following:

  • “The global recovery continues but remains weaker than desirable.” This is due in part to high financial market volatility and geopolitical conflicts, and to fluctuating commodity prices and low inflation, both of which could be prevented by sharing the benefits of growth within and among countries in order to promote inclusiveness.
  • The G20 will use “all policy tools – monetary, fiscal and structural – individually and collectively to achieve . . . strong, sustainable, balanced and inclusive growth.” Achieving that goal will involve making tax policy and public expenditure more “growth-friendly” by prioritizing high-quality investments.
  • Structural issues, such as excess capacity in certain industries, are “exacerbated by a weak global economic recovery and depressed market demand” and have affected trade and workers negatively.
  • Multilateral development banks (“MDBs”) have a “unique role in supporting infrastructure investment.” G20 has asked MDBs to undertake joint actions that support “quality infrastructure development, which aims to ensure economic efficiency in view of life-cycle cost, safety and resilience.”
  • The G20 supports the “continued effort to incorporate enhanced contractual clauses into sovereign bonds.”
  • The G20 prioritizes “building an open and resilient financial system,” by implementing the total-loss-absorbing-capacity standard and effective cross-border resolution regimes. Members will “continue to address systemic risk within the insurance sector,” along with “emerging risks and vulnerabilities in the financial system, including those associated with shadow banking, asset management and other market-based finance.”
  • The G20 recognizes “recent progress made on effective and widespread implementation of the internationally agreed standards on tax transparency.” The G20 recognizes the effectiveness of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” The G20 will continue working on issues surrounding pro-growth tax policies and tax certainty.
  • G20 countries should participate in a “voluntary peer review of inefficient fossil fuel subsidies that encourage wasteful consumption.” Further, green financing must be increased if environmentally sustainable growth on a global scale is to be supported.

Lofchie Comment: Although the G20 Communiqué has no actual legal effect, the intellectual bent is clear: it supports globalism and government intervention while remaining either indifferent or hostile to private enterprise. The Communiqué begins with a recognition that the global economy is weak. It then pivots toward questions of infrastructure spending which inherently means either government spending or spending through international government agencies and “multilateral development banks.” The G20 seems to view private financing sources with suspicion and perhaps even hostility in its assessment of “vulnerabilities . . . associated with shadow banking, asset management and other market-based finance.”

The G20 stance on energy is that “green financing must be increased,” presumably, through additional government financing. At the same time, the G20 advocates for the reduction of “fossil fuel subsidies that encourage wasteful consumption.” It is difficult to understand the policy implications of these statements. Wouldn’t governmental subsidies of green financing also encourage wasteful energy consumption? If, for example, you wanted to reduce energy consumption, wouldn’t you have to raise the cost of energy, instead of subsidizing its production?

According to the G20, tax collection must be improved while “pro-growth tax policies” are implemented. Again, it is difficult to understand what is being advocated here. Is this an argument for reduced taxes? The G20 says that it favors the use of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” What does this mean? Who possibly could be against “innovation-driven, inclusive growth”? Or better yet, how about this incomprehensible line: “We launch the Global Infrastructure Connectivity Alliance to enhance the synergy and cooperation among various infrastructure connectivity programs in a holistic way.”

In a passage from the Communiqué that seems particularly problematic, the G20 observes that “fluctuating commodity prices and low inflation . . . could be prevented by sharing benefits of growth within and among countries to promote inclusiveness.” Perhaps this is true, but since the Democratic and Republican parties both seem to oppose further trade agreements, and likely are in favor of reevaluating established ones, it is unclear what part or political faction of the U.S. government would endorse the G20’s position.

Why CFS Divisia Money Matters, Now!

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My remarks at the Society for Economic Measurement illustrate how the world may have been different had CFS Divisia money been on the Fed’s dashboard.

Even today, CFS Divisia M4 suggests that growth may be better than expected.

Takeaways for investors and officials from our experience producing monetary aggregates and measuring money in the U.S. since 2012 include: 1) private sector versus state money, 2) deflation and inflation scares, 3) a damaged monetary transmission mechanism, 4) collapse in shadow banking, 5) shortage of financial market liquidity, and 6) ideas for the future.

Whether you are a Keynesian, Monetarist, or simply agnostic, monetary and financial measurement and its integration into policy is essential for the future.

For full remarks:
http://centerforfinancialstability.org/research/why_cfs_divisia_071316.pdf

Financial Markets are More Forward-looking Than We Thought: Fed Funds Futures Prices Ahead of FOMC Decisions

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Much of the literature related to Federal Open Market Committee (FOMC) decisions focuses on their post-announcement effects. There is ample evidence that asset prices and volatilities only respond to ‘surprises’ – that is, when the actual target decision differs from the market’s expectation (e.g. Bomfim 2003, Bernanke and Kuttner 2005, Gürkaynak et al. 2005), mirroring the findings of a substantial body of work considering the effects of macroeconomic announcements (e.g. Ederington and Lee 1993, Jones et al. 1998).

In addition, there is an equally large literature that investigates whether FOMC target rate decisions are predictable via macroeconomic announcements, Fed funds futures, or the yield curve (e.g. Lange et al. 2003 Hamilton 2008) or a combination of these, and literature on anticipation of Federal Reserve actions (e.g. Lucca and Moench 2015). Within this literature, there is some evidence that anticipatory effects develop gradually and that Fed funds futures may not fully capture the effects of FOMC decisions on this market.

For the most part, both sets of literature focus on the days immediately surrounding an FOMC decision. There is good reason for this, as is evident when considering extreme examples: first, the instant before the decision reflects all available information, hence providing the most accurate pre-announcement expectation; and second, the instant immediately after the decision is the point of fullest response, before the reaction begins to dissipate or is marred by reactions to other information. Such instant before versus instant after comparisons are the motivation behind much of the event study literature.

The view from the trading floor

Anyone who has been near the Treasury desk on a trading floor on the day of an FOMC decision knows the typical pattern surrounding such announcements. The minutes leading up to the announcement give meaning to the phrase “the calm before the storm”. And as soon as the statement is made, a frenzy of activity ensues – reflecting both the surprise reaction of some market participants and the position adjustment of those for whom the “future path of policy” (Gürkaynak et al. 2005) has suddenly been revealed.

Having been on a trading floor in 2004 when the Fed began a steady programme of tightening following a protracted period of being on hold at historically low levels, I know anecdotally that traders generally don’t wait until 2:14pm to adjust their positions in anticipation of a 2:15pm announcement. They ‘set up’ much farther in advance, both to handle any last-minute orders that customers might have and to be ready to respond to trade requests in the aftermath of an announcement.

It is for this reason that I and my co-authors, Dick van Dijk and Michel van der Wel, decided to investigate the extent to which financial market participants set up for Federal Reserve decisions (van Dijk et al. 2016). Our focus on anticipatory effects blends the future path of policy idea of Gürkaynak et al. (2005) with the foresight model specified in Leeper et al. (2013).

To consider this possibility of early anticipatory set-up, we design a comprehensive regression framework that enables us to investigate how the Fed funds futures market is shaped by scheduled FOMC announcements, as well as Federal Reserve communications in the form of speeches and testimony of members of the Board of Governors of the Federal Reserve System, and how those effects interact with announcements of macroeconomic variables during the six months preceding a scheduled target rate decision.

Quantifying the respective contributions of macroeconomic announcements and Federal Reserve officials’ communications to the evolution of daily changes in Fed funds futures prices is the main focus of our study.

We find that the anticipation (or ‘set-up’) occurs over a much longer horizon than previously thought. Furthermore, these effects decline as the FOMC meeting nears: earlier FOMC decisions and surprises in macroeconomic announcements affect Fed funds futures prices more strongly than more recent ones; and Fed funds futures volatility tends to be lower in the days leading up to an FOMC meeting than in the weeks or months preceding it. We argue therefore, that in order to identify fully how information shapes financial market expectations, it is necessary to look much farther back in time.

In contrast to the conventional wisdom that financial markets are reactionary and instantaneous, our work suggests a more methodical approach to digesting central bank communications and macroeconomic announcements, one that considers not only the latest news but how that in turn shapes the path of future policy decisions. In short, financial markets are more forward-looking than we had thought.

One of the challenges in quantifying how the financial markets are affected by Federal Reserve communications over longer periods of time is that other news, such as the release of major economic indicators, also plays a role. By looking at both items together, we find that macroeconomic indicators and central bank officials’ congressional testimony are of comparable importance.

We document that macroeconomic releases have stronger effects on days when Federal Reserve officials are silent (for example, during the ‘blackout period’ – that is, the 7-10 days preceding an FOMC announcement). In contrast, we find that congressional testimony is more important when it coincides with days when important macroeconomic information is released.

Our finding of large anticipatory set-up emphasizes the importance of clarity in central bank communications. The potential importance of these communications has been recognized by the Federal Reserve itself, through a series of decisions since 1994 designed to increase transparency.

An implication of our results, showing that Fed funds futures volatility declines as the FOMC announcement draws near, is that the Fed’s policy rate intentions have been well-understood by the financial markets.

In the paper, we also demonstrate that failure to look back far enough results in inferences that attribute much less significance to both Fed communications and macro announcements in shaping Fed funds futures prices, suggesting that previous studies’ effects may have been understated.

References

Bernanke, BS, and KN Kuttner (2005), “What Explains the Stock Market’s Reaction to Federal Reserve policy?”, Journal of Finance 60(3): 1221-57.

Bomfim, AN (2003), “Pre-announcement Effects, News Effects, and Volatility: Monetary Policy and the Stock Market”, Journal of Banking and Finance 27(1): 133-51.

van Dijk, D, RL Lumsdaine, and M van der Wel (2016), “Market Set-up in Advance of Federal Reserve Policy Rate Decisions”, Economic Journal 126 (May): 618-53; earlier version of available as National Bureau of Economic Research (NBER) Working Paper No. 19814.

Ederington, L, and J Lee (1993), “The Short-run Dynamics of the Price Adjustment to New Information”, Journal of Financial and Quantitative Analysis 30(1): 117-34.

Gürkaynak, RS, BP Sack, and ET Swanson (2005), “Do Actions Speak Louder than Words? The Response of Asset Prices to Monetary Policy Actions and Statements”, International Journal of Central Banking 1 (May): 55-93.

Hamilton, JD (2008), “Assessing Monetary Policy Effects Using Daily Federal Funds Futures Contracts”, Federal Reserve Bank of St. Louis Review 90(4): 377-93.

Jones, CM, O Lamont, and RL Lumsdaine (1998), “Macroeconomic News and Bond Market Volatility”, Journal of Financial Economics 47(3): 315-37.

Lange, J, B Sack, and W Whitesell (2003), “Anticipations of Monetary Policy in Financial Markets”, Journal of Money, Credit, and Banking 35(6): 889=909.

Leeper, EM, TB Walker, and SCS Yang (2013), “Fiscal Foresight and Information Flows”, Econometrica 81(3): 1115-45.

Lucca, DO, and E Moench (2015), “The Pre-FOMC Announcement Drift”, Journal of Finance 70(1): 329-71.

 

Future and History of Global Capital Markets

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CFS partner, Jack Malvey from BNY Mellon, created a wonderful guide to financial market history and factors driving change into the 21st Century.

We are grateful to Jack for allowing us to share his presentation with CFS friends.

Although we rarely distribute outside research, today, markets confront challenges of epic proportion. Simply put, a glance back at the last thirty years is insufficient.

Analytics, data, and an appreciation of history are in our DNA. Hence, CFS hosted “Bretton Woods: The Founders and the Future” with long-term takeaways for markets and economies. Similarly, Senior Fellow Kurt Schuler’s Historical Financial Statistics (HFS) database – with contributions from over 80 academics – is a treasure trove of information and a popular part of our website.

Most importantly, thanks again to Jack for sharing his outstanding work integrating the past with the future. It is no wonder that a recent Bloomberg story referenced him as “one of the most-respected figures in the bond market.”

Given the enormous scope of coverage, Jack would be grateful for any thoughtful commentary.

The full presentation is:
www.CenterforFinancialStability.org/research/Global_Capital_Market_History.pdf

NY Federal Reserve V.P. Discusses the Role of Bank Supervision

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Executive Vice President of the Federal Reserve Bank of New York (“FRBNY”) Kevin Stiroh discussed the necessity of governmental supervision of the financial industry (oversight of firms’ governance, internal controls and financial condition) as opposed to mere regulation (rulemaking).

Mr. Stiroh, who is head of the FRBNY’s Supervision Group, discussed the theory and practice of bank supervision – considering the need for supervision, the FRBNY’s role in supervising banks, and some of the practical realities of conducting such supervision.

Mr. Stiroh stressed three developments which will be relevant to the FRBNY in executing its supervisory responsibilities.

  • Cybersecurity. Because the state of cybersecurity readiness varies across firms, Mr. Stiroh explained, supervisors must develop common principles for addressing cybersecurity risks and defending operations that are critical to the financial services sector.
  • FinTech. Mr. Stiroh questioned whether FinTech will “enhance or fundamentally disrupt” the financial service and payment industries. In that regard, he noted, investment in FinTech companies rose 10% between 2010 and 2015. Mr. Stiroh noted that firms and supervisors should be mindful of how technological change impacts bank risk and the supervisory framework.
  • Reputational Risk. Mr. Stiroh encouraged financial institutions to “consider the many factors that have contributed to recent, widespread misconduct and the perceived lack of trust in the financial sector.” He argued that firms should have strong incentives to manage their reputations, and that supervisors should support that goal.

Mr. Stiroh also cited two recent Federal Reserve Supervisory letters on capital planning (see Premium Content links on the right) as “specific examples” of how regulators approach firms that are more or less complex.

Mr. Stiroh delivered his remarks at the SIFMA Internal Auditors Society Education Luncheon at the Harvard Club in New York City.

Lofchie Comment: One of the reasons that the financial services industry is under pressure is because the government attacks its reputation constantly, and not always for good reasons. (To be fair, Mr. Stiroh noted both actual misconduct and a perception of a lack of trust.) With that in mind, consider the following observations: (i) most persons (including the government) tend to be less critical of themselves than of others, (ii) misconduct by government officials and a perceived lack of trust seems at least as common in government as in the financial services, and (iii) mistakes by those in government seem as frequent as mistakes by those in the financial sector. It is not true that the only so-called mistake made by government is insufficient regulation; many regulations are either unnecessary or spur conduct that undermines monetary growth. When the government becomes as critical of itself as it is of the financial industry, then both will improve together.

Federal Reserve Bank President Evaluates Federal Reserve Board Actions Post-Crisis

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President of the Federal Reserve Bank of New York William Dudley praised the Federal Reserve Board for providing support to firms during the financial crisis and criticized efforts either to make the Board’s monetary policy more formulaic or to subject the Board to greater political control. At the Annual Meeting of the Virginia Association of Economists, President Dudley emphasized historical lessons and that the United States should maintain a strong central bank “insulated from short-term political pressures in [its] conduct of monetary policy.”

Drawing conclusions from the 2008 crisis, President Dudley asserted that:

  • The regulatory community did not fully grasp the vulnerability of the financial system. Accordingly, the Federal Reserve took actions to: (i) raise capital and liquidity requirements, (ii) put banks through annual stress tests, (iii) establish the Large Institution Supervision Coordination Committee to evaluate large firms, and (iv) set up the Office of Financial Stability.
  • The financial system needs to explain its actions with greater transparency. To increase transparency, Mr. Dudley stated, the Federal Reserve now (i) issues statements after each Federal Open Market Committee meeting, and (ii) holds a press conference four times per year to explain the Committee’s releases and its economic projections.
  • Some large financial institutions had become too-big-to-fail. Title II of the Dodd-Frank Act presently establishes a process to ensure that any financial firm can be resolved without threatening the viability of the financial system and without putting taxpayer funds at risk.

Lofchie Comment: President Dudley asserts that when the Board extended credit in the financial crisis, “it intervened to prevent the failure of several systemically important institutions, including firms it did not supervise – namely Bear Stearns and AIG.” The gist of Mr. Dudley’s remarks seems to be: if the Board made any mistakes leading to the crisis, it was not realizing that others would screw up. Wouldn’t it have been fairer to say that if the Board had not existed as a lender of last resort, the entire financial system might have collapsed, including institutions that were supervised by the Board? Isn’t it the case that a large number of banks would have failed without access to the Fed’s Discount Window?

There is no disagreement with the fact that the Board did step in as a lender of last resort. But there is an inconsistency between simultaneously claiming the need to learn from mistakes and the claim to have succeeded brilliantly. According to Mr. Dudley, whatever mistakes the Board might have made leading up to the financial crisis, without the Board’s wise conduct since that event, “the recovery would have been slower, the unemployment rate would have been higher, and there would have been a greater risk of deflation.” To those who worry that the Board’s policies have unduly distorted market forces, Mr. Dudley “simply responds” that “monetary policy always affects financial markets.” Shouldn’t a response be a little less simple? Like by how much and for how long

Today’s WSJ: ‘Focusing on Bank Size, Missing the Real Problem’…

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Today, The Wall Street Journal published an op-ed titled “Focusing on Bank Size, Missing the Real Problem.”

CFS Board Member and former Treasury Under Secretary Randal Quarles and I note how:

The new president of the Minneapolis Federal Reserve Bank, Neel Kashkari, along with Bernie Sanders, Elizabeth Warren, and Sherrod Brown believe that breaking up “too big to fail” institutions or turning them into regulated utilities is the only way the country can be confident that the 2008 bailouts won’t be repeated.

This proposal is misguided.

We offer three solutions:

– Facilitate orderly liquidation of failing or failed banks.
– Adopt a monetary policy rule to reduce the incentive for banks to take dangerous risks.
– Fully measure and evaluate the impact of Dodd-Frank before arbitrarily taking an ax to big banks and irreparably damaging the economy.

View the full article.

Economic Policy Uncertainty and the Credit Channel…

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I am grateful to John Duca at the Federal Reserve Bank of Dallas for highlighting a recent NBER paper that he co-authored with Michael Bordo and Christoffer Koch.

The authors find that “policy uncertainty significantly slows U.S. bank credit growth, consistent with it having an effect on broad loan supply and demand.”

These results corroborate our findings in recent years evaluating the performance of CFS Divisia monetary aggregates.

Bordo, Duca, and Koch also did fine work quantifying the regulatory and reporting burden on banks since Dodd-Frank (see Figure 2 on page 26). In fact, their data stretch back to 1960. For instance, the number of pages per regulatory filing for banks was less than 10 from 1960 into the early 1980s, gradually advancing to roughly 50 prior to the financial crisis. Since the crisis, the pages per filing are near 90 and advancing at a seemingly geometric rate.

The paper is available at http://www.nber.org/papers/w22021.

Crisis Detection: Implications for Investors and Officials…

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At the Boston Economic Club, I discussed crisis detection and prevention based on experiences chairing an inter-agency crisis prevention group — while at the U.S. Treasury — and working as a strategist on Wall Street.

I concluded with eight actionable ideas to improve crises detection for investors and officials.

For full remarks:
http://centerforfinancialstability.org/speeches/Boston_032316.pdf