PrefBlog

The BoC has released a Staff Working Paper by Carola Conces Binder, Rodrigo Sekkel titled Central Bank Forecasting: A Survey:

Central banks’ forecasts are important monetary policy inputs and tools for central bank communication. We survey the literature on forecasting at the Federal Reserve, European Central Bank, Bank of England and Bank of Canada, focusing especially on recent developments. After describing these central banks’ forecasting frameworks, we discuss the literature on central bank forecast evaluation and new tests of unbiasedness and efficiency. We also discuss evidence of central banks’ informational advantage over private sector forecasters—which appears to have weakened over time—and how central bank forecasts may affect private sector expectations even in the absence of an informational advantage. We discuss how the Great Recession led central banks to evaluate their forecasting frameworks and how the COVID-19 pandemic has further challenged central bank forecasting. Finally, we consider directions for future research.
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A seminal paper by Romer and Romer (2000) shows that Federal Reserve staff forecasts of inflation in the Greenbook are more accurate than private sector forecasts from Blue Chip, Data Resources, Inc., and the Survey of Professional Forecasters (SPF), and that access to Greenbook forecasts could have helped commercial forecasters improve forecasts. Indeed, “someone with access to both the Federal Reserve and commercial forecasts should not just put positive weight on the Federal Reserve forecast, but put little weight on the commercial one” (Romer and Romer, 2000, p. 438). Correspondingly, the mean squared errors of the Greenbook forecasts are around 25% lower than those of commercial forecasters at most horizons. For real GNP growth, the Fed’s informational advantage is most prominent at short horizons but varies at longer horizons.

To demonstrate the implications of the informational advantage they document, Romer and Romer (2000) show that the Fed’s monetary policy actions reveal some of their private information about the economic outlook. Thus, when the Fed raises the federal funds rate, forecasters revise their inflation expectations upward, which can help explain why interest rates at long horizons respond to monetary policy. Subsequent research has continued to probe the informational advantage of central banks and to examine how central bank expectations influence private sector expectations, even in the absence of a clear informational advantage.

And Central Bankers are examined again in an IMF article by RAGHURAM RAJAN titled More focused, less interventionist central banks would likely deliver better outcomes:

Central bankers of industrialized countries have fallen tremendously in the public’s estimation. Not long ago they were heroes, supporting feeble growth with unconventional monetary policies, promoting the hiring of minorities by allowing the labor market to run a little hot, and even trying to hold back climate change, all the while berating paralyzed legislatures for not doing more. Now they stand accused of botching their most basic task, keeping inflation low and stable. Politicians, sniffing blood and mistrustful of unelected power, want to reexamine central bank mandates.

Did central banks get it all wrong? If so, what should they do?
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Yet stopping the postmortem at this point is probably overly generous to central banks. After all, their past actions reduced their room to maneuver, and not only for the reasons just outlined. Take the emergence of both fiscal dominance (whereby the central bank acts to accommodate the government’s fiscal spending) and financial dominance (whereby the central bank acquiesces to the imperatives of the market). They clearly are not unrelated to central bank actions of the past few years.

Long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging. And both the government and the private sector leveraged up. Of course, the pandemic and Putin’s war pushed up government spending. But so did ultralow long-term interest rates and a bond market anesthetized by central bank actions such as quantitative easing. Indeed, there was a case for targeted government spending financed by issuing long-term debt. Yet sensible economists making the case for spending did not caveat their recommendations enough, and fractured politics ensured that the only spending that could be legislated had something for everyone. Politicians, as always, drew on unsound but convenient theories (think modern monetary theory) that gave them license for unbridled spending.

Central banks compounded the problem by buying government debt financed by overnight reserves, thus shortening the maturity of the financing of the government and central bank’s consolidated balance sheets. This means that as interest rates rise, government finances—especially for slow-growing countries with significant debt—are likely to become more problematic. Fiscal considerations already weigh on the policies of some central banks—for instance, the European Central Bank worries about the effect of its monetary actions on “fragmentation,” the yields of fiscally weaker countries’ debt blowing out relative to those of stronger countries. At the very least, perhaps central banks should have recognized the changing nature of politics that made unbridled spending more likely in response to shocks, even if they did not anticipate the shocks. This may have made them more concerned about suppressing long rates and espousing low-for-long policy rates.

The Office of the Comptroller of the Currency released the OCC Mortgage Metrics Report for 22Q4:

• • As of December 31, 2022, the reporting banks serviced approximately 12 million first-lien residential mortgage loans with $2.7 trillion in unpaid principal balances (see figures 1 and 2). This $2.7 trillion was 22 percent of all residential mortgage debt outstanding in the United States.2
• • Overall mortgage performance this quarter improved from the fourth quarter of 2021. The percentage of mortgages that were current and performing at the end of the fourth quarter of 2022 was 97.1 percent compared with 96.4 percent at the end of the fourth quarter of 2021 (see figure 6). The CARES Act, signed into law on March 27, 2020, and extended on February 18, 2022, allows for loan forbearance that can extend up to 360 days and is reflected in the mortgage performance data.
• • Servicers initiated 9,166 new foreclosures in the fourth quarter of 2022, a decrease from the prior quarter, but a higher volume than a year earlier (see figure 7). The new foreclosure volume in the fourth quarter of 2022 is lower than pre-COVID-19 pandemic foreclosure volumes. Home forfeiture actions during the fourth quarter of 2022—completed foreclosure sales, short sales, and deed-in-lieu-of-foreclosure actions—increased 42.8 percent from a year earlier to 2,525 (see figure 8). Events associated with the COVID-19 pandemic, including foreclosure moratoriums that began March 18, 2020, and were extended to July 31, 2021, have significantly affected these metrics.

It doesn’t look like we’re in a recession. Not yet, anyway!

The Canadian economy has picked up momentum in the early stages of 2023 and avoided slipping into a recession, despite the highest interest rates in more than 15 years.

Real gross domestic product rose 0.5 per cent in January from the previous month, Statistics Canada reported on Friday. In a preliminary estimate, the agency said the economy grew by a further 0.3 per cent in February.

On an annualized basis, growth is trending toward 2.5 per cent in the first quarter – far stronger than the 0.5 per cent pace that the Bank of Canada had projected. This also marked a rebound from no growth in the fourth quarter, a result that was largely owing to a sharp pullback in inventory investments.

The BoC has released a Staff Working Paper by Serdar Kabaca and Kerem Tuzcuoglu titled Supply Drivers of the US Inflation Since the Pandemic:

This paper examines the contribution of several supply factors to US headline inflation since the start of the COVID-19 pandemic. We identify six supply shocks using a structural VAR model: labor supply, labor productivity, global supply chain, oil price, price mark-up and wage mark-up shocks. Our shock identification relies mainly on sign restrictions. But for the global supply chain shock, we propose a new identification scheme combining sign, narrative and variance decomposition restrictions. Historical decomposition results suggest that global supply chain and oil price shocks are the biggest supply contributors to the US inflation during the pandemic. In contrast, labor shortages only mildly contribute to inflation, but their impact on output is larger in that period. Additionally, price and wage mark-up shocks start to significantly contribute to inflation only towards the middle of 2022. Finally, our analysis, which also allows the identification of monetary policy and aggregate demand shocks, suggests that demand and supply factors are almost equally responsible for the movements in the inflation rate during the pandemic.
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On the demand side, some scholars attribute a considerable portion of the rise in inflation to monetary and fiscal policy mistakes. Reis (2022) and Summers (2022) emphasize the cost of a delayed monetary policy response to increases in inflation. Jord`a et al. (2022), Jord`a and Nechio (2022) and Summers (2021) underline the role of fiscal expansions in the sharp increase in inflation. Our results highlight that monetary policy significantly contributes to inflation, especially in 2021 during which authorities use the “transitory” language in their guidance. We also find the aggregate demand increasingly contributes to the rise in inflation following the month when the second fiscal stimulus is announced under the Biden administration in 2021. Overall, in our framework, demand factors including monetary policy shocks are found to contribute to half of the rise in US inflation

The BoC has released a Staff Discussion Paper by Sarah Miller and Patrick Sabourin titled What consistent responses on future inflation by consumers can reveal:

Inflation expectations play a vital role in determining inflation. Central bankers need to understand their intricacies and the information they can reveal. We look at the consistency of consumers’ answers to questions on inflation expectations in the Bank of Canada’s Canadian Survey of Consumer Expectations. We analyze factors that may explain consistencies among individuals and overall. We also compare the inflation forecasts of consumers with consistent responses with those of professional forecasters and consumers with varying responses.
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Consumers aged 30 years and over with income above $100,000 and a post-secondary degree are more likely to provide consistent answers. The most important characteristic for consistency is age. For instance, respondents aged 55 years and over are almost twice as likely to provide consistent answers than respondents under 30 years old. We also find that women are less likely to be consistent than men—their point predictions exceed their subjective distributions more often. Indigenous people are less likely than non-Indigenous people to respond consistently. Similar to the gap between consumers’ perceptions of inflation and actual inflation, the likelihood that consumers provide consistent responses may also vary by their shopping patterns.5 For instance, they may be influenced by the prices of goods they purchase frequently, such as food and gasoline. Several factors may influence why certain demographic groups are more likely than others to provide consistent responses. These factors include:

•  a propensity for overpredicting because it is less costly than underpredicting (or vice versa). This is known as asymmetric loss and may cause a consumer to report a point forecast that is outside the interval from their subjective probabilities (for more details, see Patton and Timmermann 2007).
•  a tendency to round probabilities, although Engelberg, Manski and Williams (2009) tested and rejected this hypothesis
•  the possibility that youth, with less experience of high inflation, update their inflation expectations more strongly in response to surprise inflation than older people do (proposed by Malmendier and Nagel 2016)
•  other unobserved personal characteristics such as patience and maturity

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To determine whether the inflation expectations of consumers with consistent responses are more informative of actual CPI inflation than those of other consumers, we look at perceived inflation (i.e., inflation over the past 12 months) separately for these two groups. Chart 7 reveals striking differences. Perceived inflation averaged across consumers with consistent responses is close to actual CPI, but well above actual CPI for consumers with inconsistent responses. Instead, the pattern of perceived inflation averaged across the inconsistent group is closer to CPI inflation for gasoline.
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We know that consumers with consistent views are better than other consumers at forecasting inflation. But how does their forecasting compare with that of professional forecasters? Before the pandemic, the one-year-ahead inflation expectations of consumers with consistent views were systematically above actual inflation four quarters later (Chart 8). Forecasting errors for these consumers were larger than those of professional forecasters in Canada surveyed by Consensus Economics.10 Since the pandemic started, forecasting performance has deteriorated for both groups. However, the one-year-ahead inflation expectations of consistent consumers have been closer to actual inflation than those of professional forecasters. This suggests that, when assessing risks around inflation, we should seriously consider the survey results from these consumers. Their expectations represent an upside risk to the inflation outlook presented in the January 2023 Monetary Policy Report.
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However, like Braitsch and Mitchell (2022), we think targeted and additional forms of communication may be needed to reach consumers with inconsistent responses to encourage them to moderate their inflation expectations. The Bank’s The Economy, Plain and Simple series and the Bank of Canada Museum’s education programs are steps in that direction.

And the BoC has released (boy, they were busy today!) a Staff Discussion Paper by Lin Chen and Stephanie Houle titled Turning Words into Numbers: Measuring News Media Coverage of Shortages:

We generate high-frequency and up-to-date indicators to monitor news media coverage of supply (raw, intermediate and final goods) and labour shortages in Canada. We use natural language processing to construct two news-based indicators and time-varying topic narratives to track Canadian media coverage of these shortages from 2000 to 2022. This makes our indicators an insightful alternative monitoring tool for policy. Notably, our indicators track well with monthly price indexes and measures from the Bank of Canada’s Business Outlook Survey, and they are highly correlated with commonly tracked indicators of supply constraint. Moreover, the news-based indicators reflect the attention of the public on pressing issues.
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We use the Cision news media database to build a corpus (a collection of written texts) of Canadian English economic and management news articles published between January 1, 2000, and July 4, 2022. We extract sentences containing the keyword “shortage” and collect them into daily documents. Then, we use unsupervised natural language processing (NLP) to decompose the news corpus into different shortage topics. These topics reflect media attention on, among others, the supply and labour shortages that affected Canada’s economy from the early 2000s to the 2020–22 period of the COVID-19 pandemic.

SEC Commissioner Caroline A. Crenshaw gave a speech titled Fixed Income and Options: The Other Market Structures:

The corporate bond and municipal securities markets are relied upon by both retail and institutional investors, including Americans who are approaching retirement or are already there. In the corporate bond market, trades under $100,000 account for between 60% and 70% of reported customer transactions.[17] In the municipal securities market, transactions of less than $25,000 account for more than half of the trades, and those less than $100,000 account for 87% of trades, reflecting that individual investors hold the majority of outstanding municipal bonds.[18]

Investors in these markets are incurring trading costs that far outstrip the costs of transacting in the equity markets. While estimates of trading costs can be a challenge in part due to the relative lack of transparency, academics have estimated corporate bond trading costs at around 84 basis points[19] and municipal bond trading costs as high as 90 basis points for retail-size trades.[20] Surprisingly, smaller bond transactions, which are more likely to originate from retail investors, are more expensive to complete than larger transactions – the opposite of the pattern typically observed in equity markets.[21]

One way to reduce transaction costs and improve investor outcomes would be to improve price transparency. Post-trade price transparency, via TRACE and EMMA, has been a feature of the U.S. fixed income markets, to varying degrees, since the 1990s, and there have been significant improvements over the last several years. However, fixed income markets still largely lack the pre-trade price transparency that has been a feature of the equity markets for decades. While there are some quotation data available from dealers and electronic venues, smaller dealers are less likely to have access to these data or the ability to consolidate them effectively, and they are generally not visible to the retail customer and therefore cannot be used to help the customer negotiate a better price with its dealer.[22] And post-trade information for infrequently traded bonds can be stale or even unavailable.[23] Consistent with this, research on municipal bond markets from the SEC’s Division of Economic and Risk Analysis showed that the majority of customer trades execute at worse prices than best available dealer quotes.[24]

The Corporate Bond Market Distress Index was updated:

• Corporate bond market functioning appears healthy, with the overall market-level CMDI remaining stable around its historical 25th percentile.
• Market functioning in the investment-grade segment has continued to improve in March. The high-yield segment is slightly up, but still at low historical levels.

BIS has released a working paper by Ernest Dautović, Leonardo Gambacorta and Alessio Reghezza titled Supervisory policy stimulus: evidence from the euro area dividend recommendation:

Focus
In March 2020, the European Central Bank made the recommendation that, at least until October 2020, no “significant institution” should pay out dividends. We investigate the recommendation’s impact on the credit supply to non-financial corporations amid the Covid-19 economic shock. Bank managements effectively faced a choice of how to allocate their capital when deciding whether to follow the ECB recommendation, with differing implications for the credit supply. On the one hand, given constant demand and price effects, they might have opted to use the surplus capital to increase lending supply, thus responding countercyclically to support the economy. On the other hand, they might have decided to increase their resilience to future shocks by saving capital, and/or strengthening their loss-absorption capacity by making additional provisions. The paper asks whether the ECB’s dividend recommendation led to an increase or a decrease in the credit supply to non-financial corporations, and whether this effect varied for different types of firm and sector.

Contribution
The study compares the credit supply of banks affected by the ECB recommendation with a group of unaffected banks, and controls for other pandemic-related support measures. To address identification issues, we rely on credit registry data and a direct measure that captures differences in compliance with the dividend recommendation across banks in the euro area. The analysis disentangles the confounding effects stemming from the wide range of monetary and fiscal policies that supported credit during the Covid-19 downturn and investigates their interaction with the dividend recommendation.

Findings
We find that dividend restrictions have been an effective policy in supporting financially constrained firms, adding capital space to banks, and restricting some forms of procyclical behaviour. In particular, the study finds that the dividend recommendation added 4.4 percentage points to the growth rate of euro area credit supply to non-financial corporations. The effects on lending are larger for small and medium enterprises and for firms operating in sectors that were exposed to the effects of Covid-19. We also find evidence that the dividend recommendation has sustained bank lending even in the absence of government guarantees. At the same time, we do not find evidence of a significant increase in lending to riskier borrowers and “zombie” firms.

Abstract
At the onset of the Covid-19 outbreak, central banks and supervisors introduced dividend restrictions as a new policy instrument aimed at supporting lending to the real economy and strengthening banks’ capacity to absorb losses. In this paper we estimate the impact of the ECB’s dividend recommendation on bank lending and risk-taking. To address identification issues, we rely on credit registry data and a direct measure that captures variation in compliance with the recommendation across banks in the euro area. The analysis disentangles the confounding effects stemming from the wide range of monetary and fiscal policies that supported credit during the Covid-19 downturn and investigates their interaction with the dividend recommendation. We find that dividend restrictions have been an effective policy in supporting financially constrained firms, adding capital space to banks, and limiting some forms of procyclical behaviour. The effects on lending are larger for small and medium enterprises and for firms operating in Covid-19 vulnerable sectors. At the same time, we do not find evidence of a significant increase in lending to riskier borrowers and “zombie” firms.

I must admit, this kind of research makes me nervous. Look at the abstract! “… central banks and supervisors introduced dividend restrictions as a new policy instrument aimed at supporting lending to the real economy and strengthening banks’ capacity to absorb losses.” OK, the second objective is well within the aegis of the supervisory class, but the first? That’s just mission creep. If the authorities want to boost lending, they have lots of less invasive tools in the box already.

And in Canada, thirty year mortgages will become more common:

Proposals from the Financial Consumer Agency of Canada are aimed at ensuring fairness and consistency in terms of relief offered for struggling borrowers. The plan was highlighted in the federal budget this week in a clear sign that Ottawa endorses the idea of allowing mortgages to grow to keep payments down.
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The FCAC said it developed the guidelines for mortgage borrowers at risk of missing monthly payments because of what it called “exceptional circumstances.” The FCAC did not provide a measurable definition of “exceptional circumstances” except to say it could be the combined effects of high household debt, rapid interest-rate hikes and higher cost of living.

Under the proposal, banks could lengthen their troubled borrowers’ amortization periods either temporarily or permanently. The guideline would apply to all types of mortgages, including those with a fixed interest rate.

If it is temporary, the watchdog said banks should take into account the borrower’s ability to restore the amortization to the original period within what it said was a “reasonable time frame.” If it is a permanent solution, the bank must ensure the amortization period is “reasonable.” FCAC would not comment on what it considered reasonable.

PerpetualDiscounts now yield 6.25%, equivalent to 8.12% interest at the standard equivalency factor of 1.3x. Long corporates yielded 4.95% on 2023-3-24 and since then the closing price has changed from 15.18 to 14.98, a decrease of 132bp in price, with a Duration of 12.41 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies an increase in yield of about 11bp since 3/24 to 5.06%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed substantially to about 305bp from the 330bp reported March 22.

Dr Joachim Nagel, President of the Deutsche Bundesbank, gave a speech:

The unemployment rates in the European Union and the euro area, at currently (January) 6.1% and 6.7%, respectively, are around their lowest levels since the start of this data series in 1998. Employment in the EU (European Union) and the euro area fell only slightly during the pandemic and was, in the final quarter of 2022, well above the 2019 level. In Germany at the end of last year, more people (45.9 million) were in paid employment than ever before.

The labour market has also proven very robust in the United Kingdom and especially in Scotland. At 3.7% the UK (United Kingdom) unemployment rate for November to January was clearly lower than in the euro area. The Scottish unemployment rate even stands at 3.1%. Employment in the UK (United Kingdom) has recovered swiftly from the pandemic. And from November to January, the number of vacancies was still at high levels despite continuing its downward trend. Furthermore, the Scottish employment rate has reached its highest figure on record, at over 76%.
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Let me quote the chief economist of the Bank of England in this context. Huw Pill recently said in a speech: “In an attempt to protect their own real income from the unavoidable impact of higher external prices, the longer that firms try to maintain real profit margins and employees try to maintain real wages at pre-energy price shock levels, the more likely it is that domestically-generated inflation will achieve its own selfsustaining momentum even as the external impulse to UK (United Kingdom) inflation recedes.”

To illustrate what Pill said with German data: In Germany in 2022, the price index of gross value added rose more strongly than unit labour costs. This is an indicator that profit margins increased. The German ifo (Information und Forschung) Institute noted recently: “In the fourth quarter of 2022, some German companies continued to increase their sales prices more than was indicated by the development of purchase prices.” It seems plausible that pent-up demand due to the pandemic enabled such price-setting behaviour in some sectors. Nevertheless, firms’ pricing power is likely to diminish, as inflation has been increasingly eroding consumers’ purchasing power.

Last year, nominal wages and salaries per employee climbed in the EU (European Union) by 5½%, in the euro area and in Germany by more than 4½%. For Germany, it was the largest increase in 30 years, which came on the heels of German reunification. However, due to high inflation, employees suffered the largest loss in real wages since the beginning of monetary union: a decrease of more than 3½% from the previous year.

It is now understandable that workers and trade unions are trying to compensate for the loss of purchasing power in wage negotiations. These wage negotiations are entirely up to the social partners. Having said that, the wage deals currently reached in Germany are, overall, not compatible with price stability for the euro area in the medium term. There are signs of second-round effects from inflation-induced higher wage increases back to prices.

Wage growth constitutes an important component of “homemade” inflation. In particular, elevated services inflation is likely to partly counterbalance abating upstream price pressures on goods inflation. On the one hand, stronger wage growth is necessary for burden sharing. It prevents employees from bearing too much of the high inflation. On the other hand, wage developments are likely to prolong the prevailing period of high inflation rates. In other words: Inflation will become more persistent.

To be clear: Preventing inflation to become persistent via the labour market requires that employees accept sensible wage gains and that firms accept sensible profit margins. Despite signs of second-round effects, we have not observed a destabilising price-wage spiral in Germany so far. From the Bundesbank’s view, it is necessary to avoid such a price-wage spiral.

Ms Isabel Schnabel, Member of the Executive Board of the European Central Bank, also gave a speech:

On 1 March, the ECB started quantitative tightening (QT) after eight years of balance sheet expansion. At the peak in 2022, the Eurosystem held monetary policy assets corresponding to around 56% of euro area GDP. This was substantial both from a historical perspective and in international comparison (Slide 2, left-hand side).

The first wave of balance sheet expansion was a response to the low-inflation environment prevailing in the aftermath of the euro area sovereign debt crisis. Between 2014 and 2016 headline inflation ran persistently below our target of 2%, averaging just 0.3% (Slide 2, right-hand side).
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The second wave of balance sheet expansion came with the ECB’s response to the pandemic. The launch of the pandemic emergency purchase programme (PEPP) and adjustments to the third series of TLTROs resulted in a further large increase of our monetary policy assets. These measures were necessary to protect the euro area economy from falling into a full-blown financial crisis and economic depression.
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Last July, balance sheet growth came to a halt when we ended net asset purchases under the asset purchase programme (APP). Since autumn, the size of the balance sheet has been declining as banks began repaying their outstanding TLTRO loans. The balance sheet has declined further since the beginning of March, when we stopped fully reinvesting maturing securities bought under the APP.

Further TLTRO repayments and a gradual run-down of our monetary policy bond portfolio imply that our balance sheet is expected to decline meaningfully over the coming years, thereby reducing excess liquidity.
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When we launched the APP in 2015 and excess liquidity started to grow rapidly, we effectively
moved from a “corridor” towards a “floor” system.

Conceptually, the supply curve shifted further and further to the right, now crossing the demand curve at its flat, highly elastic part, where discrete changes in liquidity have very little effect on the level of shortterm interest rates (Slide 6).

Balance sheet run-down will reverse this shift, progressively moving the supply curve back towards the steep part of the demand curve. In the current situation, the large volume of excess reserves means that we should still be at a significant distance from that point. Yet, uncertainty about the exact location of the “kink” is very high.

One reason for this is that years of large excess reserves have blurred our understanding of banks’ underlying demand for liquidity. The aggregate level of reserves has been largely determined by thequantity of asset purchases rather than by banks’ liquidity choices.

Should the demand for reserves have shifted more fundamentally, then upward pressure on interest rates may well start earlier than estimates of the historical relationship between the level of excess reserves and market rates would suggest (Slide 7).

This is broadly what happened in the United States in the autumn of 2019, when interest rate volatility spiked unexpectedly although the supply of reserves was still considerably above what banks had indicated in surveys as their lowest comfortable level.
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The ability to effectively steer overnight rates in the pre-2008 corridor framework relied heavily on two features.

The first was our ability to accurately predict the reserves needed to steer the operational target towards the middle of the corridor. In the steep part of the demand curve, even small changes in the supply of, or demand for, reserves can lead to large swings in interest rates.

The second feature was a well-functioning interbank market that distributed central bank reserves efficiently across the euro area banking system. The standing facilities were not designed to be used on a regular basis but were supposed to accommodate unforeseen liquidity shocks.

Over the past decade, however, the environment in which central banks operate has changed fundamentally.

In the aftermath of the global financial crisis, large excess reserves and prevailing fragmentation have considerably reduced the volume of reserves intermediated through the unsecured interbank market (Slide 8).

It is not clear whether the interbank market will recover once excess reserves become scarcer.

A structural decline in banks’ risk tolerance may have permanently reduced the capacity of the euro area interbank market to efficiently distribute reserves across banks all over the euro area. And while tighter financial regulation has made our financial system safer and more resilient, it has made interbank lending more costly.

Banks might also want to hold much higher liquidity buffers than in the past. The recent experience of Sveriges Riksbank is a case in point.

In recent weeks, it regularly issued certificates amounting to the estimated liquidity surplus of the banking system to steer the Swedish Krona short-term rate to the middle of the interest rate corridor.

However, banks often decided to hold on to about one fifth of excess reserves which they placed in the deposit facility that pays a lower rate of remuneration, so that the short-term rate remained stuck to the floor of the corridor (Slide 9).

This points to banks’ strong preference for reserves, which may affect the ability of central banks toeffectively steer short-term rates in a large corridor system, such as the one we had before 2008.

There are two main reasons as to why banks may today wish to hold a higher level of excess reserves.

One relates to regulatory changes. The introduction of Basel III has resulted in a measurable increase in the demand for high-quality liquid assets (HQLA) that banks need to hold to comply with the liquidity coverage ratio (LCR).

Many euro area banks currently use excess reserves to meet regulatory requirements, especially in those countries with high excess liquidity. For the euro area as a whole, excess reserves currently account for 60% of HQLA holdings (Slide 10).

The second factor relates to banks’ precautionary behaviour in guarding against liquidity risks, as the turbulent events in the past few weeks forcefully underline.

Overnight deposits at euro area banks have shown an upward trend in relation to banks’ total deposits until about mid-2022 (Slide 11, left-hand side).

As a result, the risk of withdrawals or portfolio rebalancing has increased.

And here’s part of a speech by Mr Andrew Bailey, Governor of the Bank of England:

UK Consumer price inflation is currently at 10.4%. This is much too high, and we need to, and will, bring it back down to the 2% target. That is why last Thursday the Monetary Policy Committee increased Bank Rate at the eleventh meeting in a row, to 4.25%. We have increased Bank Rate by more than 4 percentage points since December 2021. These increases are being felt by households and businesses across the country.
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In the New Keynesian models that have dominated monetary macroeconomics over the past three decades, monetary policy has real effects because market prices are sticky. So when nominal interest rates change, the real interest rates that determine real consumption and investment decisions change with them. And markets may operate with ‘excess supply’ or ‘excess demand’ for as long as it takes wages and prices to adjust to shifts in either demand or supply.
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Chart 4, reproduced from our latest Monetary Policy Report, shows that there has been a marked and sustained fall in productivity growth in the United Kingdom following the global financial crisis in particular.
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Whatever the reason, when productivity growth is weak, companies gain less from installing new capital. So weaker productivity growth has meant that firms have sought to borrow less to finance investments at a given interest rate. This reduction in the demand for capital has lowered the equilibrium rate.

The second important factor is population ageing.
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As people accumulate savings over their working life to fund their retirement, wealth in the economy increases as the age distribution shifts towards older cohorts (indicated in this chart by bars in different colours).

So ageing households have sought to lend more at a time when less productive firms have sought to borrow less. The only way to establish an equilibrium between the supply and demand in the market for investable funds – that is, to incentivise firms to invest this additional wealth into productive capital – has been for the price of those funds, the real interest rate, to fall.

The trend equilibrium rate, R*, is like a long-term anchor for monetary policy. As R* has fallen, monetary policy has moved with it. This is an important point. The low level of interest rates over the past few decades reflects deep underlying factors on the supply side of the economy. As these underlying factors – trends in technology and demographics – only move slowly, it is not unreasonable to expect that R* will remain low.

This means that, even as we now respond to rising inflation by raising Bank Rate, interest rates will not necessarily have to return fully to, and remain around, the higher levels they once had.

The New York Fed has released the 2023 SCE Housing Survey:

• Households expect home price growth to decline to 2.6 percent over the next twelve months, down sharply from 7.0 percent a year ago. This marks the lowest such reading since the series’ inception in 2014. Expectations over the five-year horizon rose, with households anticipating average annualized price growth of 2.8 percent from 2.2 percent.
• Households expect rents to increase by 8.2 percent over the next twelve months, compared with 11.5 percent in February 2022.
• Renters put the probability of owning a home in the future at 44.4 percent, up slightly from 43.3 percent a year ago.
• Households expect mortgage rates to rise to 8.4 percent a year from now and 8.8 percent in three years’ time.

… as well as the more general and more frequent SURVEY OF CONSUMER EXPECTATIONS:

Sharp Fall in Short-Term Inflation Expectations; Labor Market Expectations Improve
Median one-year-ahead inflation expectations declined by 0.8 percentage point to 4.2 percent, according to the February Survey of Consumer Expectations. Three-year-ahead expectations remained at 2.7 percent, while the five-year-ahead measure increased by 0.1 percentage point to 2.6 percent. Labor market expectations improved, with unemployment expectations and perceived job loss risk decreasing and job finding expectations increasing. Expectations for voluntary job quits reached the highest level since the start of the pandemic.

And there’s more scandal from the Bankman-Fried investigation:

Federal prosecutors added a foreign bribery charge to the growing list of crimes already pending against the FTX founder Sam Bankman-Fried, according to a new indictment filed in federal court in Manhattan on Tuesday.

Federal prosecutors said that in 2021 Mr. Bankman-Fried instructed those working for him to pay a bribe of $40 million to one or more Chinese officials to help unfreeze trading accounts maintained by Alameda Research, FTX’s sister company, that held about $1 billion in cryptocurrencies.

The bribe money was paid to the Chinese officials in cryptocurrency, the document said. The indictment said the effort to pay off the unnamed Chinese officials was successful in getting the trading accounts unfrozen.

And what should we think of central bankers?

Central bankers of industrialized countries have fallen tremendously in the public’s estimation. Not long ago they were heroes, supporting feeble growth with unconventional monetary policies, promoting the hiring of minorities by allowing the labor market to run a little hot, and even trying to hold back climate change, all the while berating paralyzed legislatures for not doing more. Now they stand accused of botching their most basic task, keeping inflation low and stable. Politicians, sniffing blood and mistrustful of unelected power, want to reexamine central bank mandates.
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Long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging. And both the government and the private sector leveraged up. Of course, the pandemic and Putin’s war pushed up government spending. But so did ultralow long-term interest rates and a bond market anesthetized by central bank actions such as quantitative easing. Indeed, there was a case for targeted government spending financed by issuing long-term debt. Yet sensible economists making the case for spending did not caveat their recommendations enough, and fractured politics ensured that the only spending that could be legislated had something for everyone. Politicians, as always, drew on unsound but convenient theories (think modern monetary theory) that gave them license for unbridled spending.

Central banks compounded the problem by buying government debt financed by overnight reserves, thus shortening the maturity of the financing of the government and central bank’s consolidated balance sheets. This means that as interest rates rise, government finances—especially for slow-growing countries with significant debt—are likely to become more problematic.
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The private sector also leveraged up, both at the household level (think Australia, Canada, and Sweden) and at the corporate level. But there is another new, largely overlooked, concern—liquidity dependence. As the Fed pumped out reserves during quantitative easing, commercial banks financed the reserves largely with wholesale demand deposits, effectively shortening the maturity of their liabilities. In addition, in order to generate fees from the large volume of low-return reserves sitting on their balance sheets, they wrote all sorts of liquidity promises to the private sector—committed lines of credit, margin support for speculative positions, and so on.

The problem is that as the central bank shrinks its balance sheet, it is hard for commercial banks to unwind these promises quickly. The private sector becomes much more dependent on the central bank for continued liquidity. We had a first glimpse of this in the UK pension turmoil in October 2022, which was defused by a mix of central bank intervention and government backtracking on its extravagant spending plans. The episode did suggest, however, a liquidity-dependent private sector that could potentially affect the central bank’s plans to shrink its balance sheet to reduce monetary accommodation.
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High asset prices, high private leverage, and liquidity dependence suggest that the central bank could face financial dominance—monetary policy that responds to financial developments in the private sector rather than to inflation. Regardless of whether the Fed intends to be dominated, current private sector forecasts that it will be forced to cut policy rates quickly have made its task of removing monetary accommodation more difficult. It will have to be harsher for longer than it would want to be, absent these private sector expectations. And that means worse consequences for global activity. It also means that when asset prices reach their new equilibrium, households, pension funds, and insurance companies will all have experienced significant losses—and these are often not the entities that benefited from the rise. Bureaucrat-managed state pension funds, the unsophisticated, and the relatively poor get drawn in at the tail end of an asset price boom, with problematic distributional consequences for which the central bank bears some responsibility.