PrefBlog

Andrew Bailey, Governor of the Bank of England, gave a speech titled Getting inflation back to the 2% target:

Now, I’d like to push back strongly against one argument you sometimes hear, which is that inflation is high because monetary policy was too loose in the past. My colleagues Ben Broadbent and Silvana Tenreyro countered that assertion in detail in speeches last month.

The headline is that, even if we had had the benefit of full hindsight in the run-up to the war in Ukraine, and ample advanced warning – which for the record we did not, no one did – then in order to keep inflation at around 2%, we would have had to raise Bank Rate well into double digits, sending unemployment much higher than it is today, and we would have had to do so in the middle of the worst pandemic in more than a century. Ben and Silvana’s simulations show that, if we really could have followed this course on monetary policy, and then there had not actually been any subsequent increase in import prices, inflation would have fallen steeply, well into negative territory. And real incomes would have suffered through lower wages as well as much higher unemployment.

Monetary policy can’t make the impact on real incomes go away I’m afraid. What we have to do is to take action to ensure that inflation falls as the external shocks abate – that inflationary impulses from these external sources do
not cause persistent ‘secondround’ effects on domestic wage and price setting that could hold inflation up for longer.

That is why we have increased Bank Rate by nearly 4½ percentage points from December 2021, from 0.1% then to 4.5% now.
…
There are signs that the labour market is loosening a little. There has been some recovery in labour market participation, especially amongst younger workers, and the number of vacancies has come down from very high levels. The ratio of the number of vacancies to the number of unemployed, a key measure of labour market tightness, has fallen as a result.

Our Agents report that businesses face fewer recruitment difficulties, that employees are moving jobs less frequently, and employers are getting more applications for job vacancies.

But the easing of labour market tightness is happening at a slower pace than we expected in February, and the labour market remains very tight. The number of vacancies remains significantly higher, relative to the number of unemployed, than before the pandemic, and employment figures have been strong.
…
So while we expect CPI inflation to fall quite sharply as energy costs begin to ease, albeit at a somewhat slower pace than projected in February given the near-term outlook for food prices, the outlook for inflation further out is more uncertain and depends on the extent of persistence in wage and price setting.

In the MPC’s baseline modal projection from its May Report, which is conditional on a market-implied path for Bank Rate that peaks at 4¾% in the fourth quarter of this year, an increasing degree of economic slack, combined with declining external pressures, lead inflation to fall materially below the 2% target in the medium term.

Importantly, however, the Committee continues to judge that the risks to inflation are skewed significantly to the upside, primarily reflecting the possibility of more persistence in domestic wage and price setting. We think the unwinding of second-round effects may take longer than it did for them to emerge.

The Cleveland Fed has released a Working Paper by Pierlauro Lopez titled Welfare Implications of Asset Pricing Facts: Should Central Banks Fill Gaps or Remove Volatility?:

I find that removing consumption volatility is a priority over filling the gap between consumption and its flexible-price counterpart, or inflation targeting, in a model that matches empirical measures of the welfare costs of consumption fluctuations. Nearly 30 years of financial market data suggest sizable welfare costs of fluctuations that can be decomposed into a term structure that is downward-sloping on average, especially during downturns. This evidence offers guidance in selecting a model to study the benefits of macroeconomic stabilization from a structural perspective. The addition of nonlinear external habit formation to a textbook New Keynesian model can rationalize the evidence, and it offers a framework suitable for studying the desirability of removing fluctuations. The model is nearly observationally equivalent in its quantity implications to a standard New Keynesian model with CRRA utility, but the asset pricing and optimal policy implications are dramatically different. In the model, a central bank that minimizes consumption volatility generates welfare improvements relative to an inflation targeting regime that are equivalent to a 25 percent larger consumption stream.

Klaas Knot, President of the Netherlands Bank, gave a speech titled Mamma Mia, here we go again? Lessons from Silikon
Valley Bank and Credit Suisse:

Roughly a month ago, on the other side of the Atlantic, Silicon Valley Bank failed. The reason for this was a classic bank run. Similar to bank runs in the past. Different in that this bank run was a direct consequence of SVB’s specific business model. One that created a maturity mismatch: the interest rate on assets was fixed for longer than the interest rate on liabilities. On top of that, SVB made little use of interest rate derivatives to hedge this risk. The name of the game was serious risk mismanagement.
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SVB’s 2021 annual report shows that a 2 percent interest rate hike would have led to a 35.3 percent decrease in capital by the end of 2021. If the Basel interest rate risk standards had been in place, this would have set off a series of alarm bells. Because, according to these risk standards, this position should not exceed 15 percent of capital. And if it were to exceed 15 percent, the financial supervisor should intervene.

But the Basel interest rate risk standards were not in place. So, it’s not the case that the supervisor didn’t hear the alarm bells. It’s not that the alarm bells were quiet. It’s that the alarm bells simply weren’t ring, ring, ringing.
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What else can we learn from the SVB failure?

SVB was a relatively small bank in the US, working mainly with tech companies. But when it comes to buffers, the size of the institution is irrelevant. Every bank, whatever the size, whatever the scope, whatever the geographic location, should maintain strong buffers.

Because a second lesson we have now learned, is that even a bank that was not considered to be a systemic bank, could still cause a lot of stress in the financial markets. Stress that could possibly have been avoided with sufficient buffers. Stress that, knowing me, knowing you, surely got us thinking about what we can do to improve our current policies further.

And this brings me to my third reflection in the aftermath of SVB – or rather a few questions that might serve as food for thought.

For starters, we need to make sure that our policies are up to date – and I mean that quite literally. Are our policies in sync with today’s society? A society that, for a large part, is characterised by digitalisation and social media. A society in which, precisely because of this, liquidity risk seems to have become more acute.

Indeed, it cannot be denied that the speed at which deposits were withdrawn from SVB was much faster than expected – much faster than LCR calculations take into account. And so, should LCR be calibrated differently? And/or do we need to better stress test it?

Also – are there shortcomings in the way we look at interest rate risk? Should supervisors consider more frequently, and for each individual bank, whether additional Pillar 2 requirements are necessary, based on the bank’s risk profile?

And finally, should unrealised losses – that is the difference between market and book value for bonds which are held to maturity on banks’ balance sheets – should those unrealised losses be better reflected in the capitalisation
of banks? And should we look at how instruments, that are not marked to market daily, are reflected in liquidity buffers?

I don’t have an answer to these questions. But I do think they should be addressed. So that we can learn everything there is to learn from what happened at SVB.

PerpetualDiscounts now yield 6.34%, equivalent to 8.24% interest at the standard equivalency factor of 1.3x. Long corporates yielded 4.98% on 2023-5-5 and since then the closing price has changed from 15.21 to 15.17, a decline of 26bp in price, with a Duration of 12.32 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies an inccrease in yield of about 2bp since 5/5 to 5.00%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened to about 325bp from the 315bp reported May 10.

This entry was posted on Wednesday, May 17th, 2023 at 6:31 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.