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December 16, 2014

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Latest Posts from Economist's View


Fed Watch: IP, Russia

Posted: 16 Dec 2014 12:15 AM PST

Tim Duy:

IP, Russia, by Tim Duy: The string of solid US economic news continued with industrial production advancing 1.3% in November. Year-over-year growth (5.2%) is now comparable to the late-90's:

IP121514

Meanwhile, the international fallout from the oil price drop continues. Russia is a classic emerging market crisis story. The decline in energy prices reveals a currency mismatch between assets and liabilities. The decline in oil dries up the dollars needed to support those liabilities, so the value of the ruble is bid down as market participants scramble for dollars. One suspects that capital flight from Russia only aggravates the problem; those oligarchs are seeing their fortunes whither. Currency plummets, aggravating the cycle. The sanctions were the beginning of this crisis, the oil price shock the culmination.
The Central Bank of Russia is forced into defending its currency via either depleting reserves or hiking interest rates. Both are losing games in a full blown crisis. The Central Bank of Russia has tried both, upping the ante by jacking up rates to 17% this afternoon, a hike of 650bp. That, however, is no guarantee of stability. Tight policy will crush the financial sector and the economy with it, triggering further net capital outflows that my guess will swamp the net inflows the rate hike was intended to create. Everything heads into free-fall until a new, lower equilibrium is established.
It is all appears really quite textbook. At this point, an IMF program would be on the horizon. But that's where the textbook changes. Hard to see the IMF just handing out a lifeline to an economy probably viewed by most as currently invading its neighbor (that's the point of the sanctions after all). And I am guessing that Russian Premier Vladimir Putin is not going to easily acquiesce to an IMF program in any event. At the moment, looks like Russia is toast. (Update: Arguably I am being a little pessimistic here. Joseph Cotterill points out that the rate hike falls well short of 1998.)
Venezuela is heading down the tubes as well, but that was always a given. Just a matter of time on that one.
Back at the Federal Reserve ranch, a fascinating experiment is underway. Have policymakers been successful in insulating the financial sector from these kinds of shocks? There will be losses, but will those losses cascade throughout the financial sector and into the real economy, or will they be contained? If the answer is containment, then interestingly Russia will lose a bargaining chip and the Fed's willingness to counter the potential risks of low interest rates with macroprudential policy will look like a sustainable policy mix.
If, however, contagion takes hold, we will once again be revisiting regulatory policy. And if the proximate cause of the contagion is deemed high-yield energy sector debt, and the excessively low rates in high-yield in general is deemed a consequence of ZIRP, then the Fed will be pushed to rethink its faith in macroprudential policy. The Austrians would have plenty of grist to chew on.
Bottom Line: All of this will be on the table at tomorrow's two-day FOMC meeting. The Fed will be forced to balance the US picture against the global shock. The primary argument to pull "considerable time" is the current US economic momentum. Furthermore, changing the language is not a policy change in any event; arguably, the language itself is already meaningless if the Fed is truly data dependent. In addition, policymakers may be wary to appear overly sensitive to financial markets. They may also be concerned that not eliminating the language will make the Fed appear less hawkish and more pessimistic than it is, thus risking disrupting financial markets at a later time if data suggests a rate hike is appropriate. The issue of "considerable time" however, is in my opinion, no longer of much interest. The macroprudential/regulatory experiment is far more important now.

Links for 12-16-14

Posted: 16 Dec 2014 12:06 AM PST

'Higher Capital Requirements Didn't Slow the Economy'

Posted: 15 Dec 2014 09:42 AM PST

Cecchetti & Schoenholtz:

Higher capital requirements didn't slow the economy: During the debate over the 2010 Basel III regulatory reform, one of the biggest concerns was that higher capital requirements would damage economic growth. Pessimists argued that forcing banks to increase their capitalization would lower long-run growth permanently and that the transitional adjustment would impose an extra drag on the recovery from the Great Recession. Unsurprisingly, the private sector saw catastrophe, while the official sector was more positive.
The Institute of International Finance's (IIF) 2010 report is the most sensational example of the former and the Macroeconomic Assessment Group (MAG) one of the most staid cases of the latter. The IIF concluded that banks would need to increase capital levels dramatically and that this would drive lending rates up, loan volumes down and result in an annual 0.6-percentage-point hit to GDP growth in the United States, the euro area and Japan. By contrast, the MAG reported that the implied increase in capital would drive lending rates up only modestly, loan volumes down a bit, and result in a decline in growth of only 0.05 percentage point per year for five years – one-twelfth the IIF's estimate.
Four years on we can start to take stock, and our reading of the evidence is that the optimistic view was correct. Since the crisis, capital requirements and capital levels have both gone up substantially. Yet, outside the still-fragile euro area, lending spreads have barely moved, bank interest margins have fallen and loan volumes are up. To the extent that more demanding capital regulations had any macroeconomic impact, it would appear to have been offset by accommodative monetary policy. ...

[There is much, much more in the post.]

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