1
What do we truly mean by a Monetary
Policy being behind the Curve?
(The Major Central Banks’ Strategies
on the Yield Curves)
Shumpei TAKEMORI
Professor,
Keio University
Regarding the current global crisis, the worst days may be
over even for Europe.
ECB’s role has been big not only in bringing this outcome but
also bringing other beneficial outcomes.
Consider the following facts:
(1) Because of the pivotal turnaround of the Irish
Referendum, the Lisbon treaty was now signed and
the European integration can move forward.
(2) Now some (small) countries outside the Euro Zone
(e.g. Iceland, Sweden) are seriously considering
joining Euro.
I claim:
It was the conducting of monetary policy by ECB which made
(1) and (2) possible.
Here is the reason:
As the consequence of the adoption of a growth strategy based on
the expansion of financial sector, many small countries in Europe
(both in and out of the Euro Zone) have been hardly hit by the
Crisis－The balance sheets of the financial sectors have been
over-extended relative to their GDPs so that by bailing out a
troubled financial sector a small country like Ireland has invited
a serious sovereign crisis.
In this context, the rescuing by ECB of a bank operated by a
small country is the same thing as the recuing of the small country
itself.
Although the statue prohibits ECB to bail out a country, ECB did
bail out Ireland.
It may be that Sweden and Iceland are dreaming of obtaining the
same favour from ECB!!
Despite the notoriety of a balance sheet inflation of FED, It is
the balance of ECB which is currently the biggest in the world
(about 50% larger than that of FED).
Also relative to GDP terms, it is the ECB’s balance sheet
which is bigger of the two (about 20% of the total GDP of the
Euro zone compared to the US number of 15%)
One might think that “Bailing Out” has become the main
business of the major central banks around the global
nowadays because of “the once in a century nature” of the
current crisis.
But there are signs that this way of conducting a central bank
business has always been important.
For instance, the recent shift in the BOJ policy, stop buying
CP despite the growing sign of the Japanese economy plunging
ever deeper into a deflation, might be a proof of the fact:
BOJ does not think anything but bailing out Japanese financial
companies as their job!
Many central bankers foresaw that the rescuing of banks will
become more and more important part of their jobs.
The comment by Stanley Fisher (currently the governor of the Bank of Israel) on
the paper presented by Raghu Rajan (University of Chicago) at the 2005 Jackson
Hole Conference organized by Kansas City Fed:
But what is the specific tool that the major central banks employ
to bail out banks?
Notice that even a boldest central banker cannot keep buying out
assets from banks forever.
In this context, the important point to notice is that financial
companies realize profits by borrowing short term and lending
long term.
If the Yield Curve is upward slowing, namely a high long term
rate combined with a low short term rate, the companies’ profits
will be increased.
The fact that Goldman Sachs and JPMorgan have realized
record profits this year benefitting from the upward sloping
yield curve suggests that the central bankers are trying to
create this situation.
This may be so in the US but things are different in
Japan:
The movements of the spreads are quite different
between Japan and US:
The spread between the interest rates of the 10-year Government bond and
the policy interest rates: The Japanese case (Red) versus the US case (Blue)
5.000
4.000
3.000
2.000
1.000
-2.000
-3.000
本本
本本
-4.000
-5.000
2009-01-01
2008-01-01
2007-01-01
2006-01-01
2005-01-01
2004-01-01
2003-01-01
2002-01-01
2001-01-01
2000-01-01
1999-01-01
1998-01-01
1997-01-01
1996-01-01
1995-01-01
1994-01-01
1993-01-01
1992-01-01
1991-01-01
-1.000
1990-01-01
0.000
It is mainly the conducting of the policy interest rates which
has resulted in creating this difference:
BOJ:
When they have to lower the interest rate, BOJ will lower it
like a cascade.
FED:
(1)When they have to lower the interest rate, FED will lower it
like a fall, rather than a cascade, so that the short term rate
quickly becomes lower than the long term rate.
(2) When they have to increase the interest rate, FED will
increase it like a (reverse) cascade, rather than a (reverse) fall
in order to prevent the long term rate becomes steeply lower
than the short term rate.
2009-01-01
9.0
2008-01-01
2007-01-01
2006-01-01
2005-01-01
2004-01-01
2003-01-01
2002-01-01
2001-01-01
2000-01-01
1999-01-01
1998-01-01
1997-01-01
1996-01-01
1995-01-01
1994-01-01
1993-01-01
1992-01-01
1991-01-01
1990-01-01
The interest rates of the 10-year government bonds: the Japanese Bond (Red)
versus the US Bond (Blue)
10.0
本本
本本
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
2 0 0 9 - 0 1 -0 1
2 0 0 8 - 0 1 -0 1
8.000
2 0 0 7 - 0 1 -0 1
2 0 0 6 - 0 1 -0 1
2 0 0 5 - 0 1 -0 1
2 0 0 4 - 0 1 -0 1
2 0 0 3 - 0 1 -0 1
2 0 0 2 - 0 1 -0 1
2 0 0 1 - 0 1 -0 1
2 0 0 0 - 0 1 -0 1
1 9 9 9 - 0 1 -0 1
1 9 9 8 - 0 1 -0 1
1 9 9 7 - 0 1 -0 1
1 9 9 6 - 0 1 -0 1
1 9 9 5 - 0 1 -0 1
1 9 9 4 - 0 1 -0 1
1 9 9 3 - 0 1 -0 1
1 9 9 2 - 0 1 -0 1
1 9 9 1 - 0 1 -0 1
1 9 9 0 - 0 1 -0 1
The Bank of Japan policy interest rate (Red) versus the FRB policy interest rate
(Blue)
9.000
本本本BOJ）
本本本FRB）
7.000
6.000
5.000
4.000
3.000
2.000
1.000
0.000
(1) The problem with the BOJ strategy is that it can easily become
“behind the curve”, namely both the long term rate and the
short term rate falling almost with the same speed so that a
condition favorable for banks, namely an upward sloping yield
curve, may not materialize.
(2) On the other hand the FED strategy is more effective in creating
a condition favorable for banks, an upward sloping yield curve.
(3) But the FED strategy is also risky: when it wants to tighten the
monetary policy, it can only do so at a cost of creating a
downward sloping yield curve, the long term rate placed at a
lower level than the short term rate, which will damage banks.
The former chairman of FED, Alan Greenspan called the fact that
the long term rate did not rise significantly after 2005 despite the
monetary policy tightening a conundrum.
But why was he tormented by the conundrum?
The standard interpretation: He wanted to avoid generating inflation
or an asset price bubble but he could not.
My interpretation: He wanted to avoid a steeply downward sloping
yield curve to emerge but he could not.
In fact the previous diagram shows that from 2006 and 2007 the
yield curve became steeply downward sloped and it was the
period when US financial institutions have produced massive
volume of mortgage bonds apparently for their survival.
It is now often argued that Greenspan should have raised the policy
interest rate much more quickly.
He could not because that will hit the financial sector harshly by
creating a still more steeply downward sloped yield curve.
The important point to notice is that now in the Euro Zone the
ECB is adopting an yield curve strategy perfectly similar to the
FED’s.
-0.5
-1
01/07/2009
01/01/2009
01/07/2008
01/01/2008
01/07/2007
01/01/2007
01/07/2006
01/01/2006
01/07/2005
01/01/2005
01/07/2004
01/01/2004
01/07/2003
01/01/2003
01/07/2002
01/01/2002
01/07/2001
01/01/2001
01/07/2000
01/01/2000
01/07/1999
01/01/1999
The spread between the interest rate of the 10-year German Government bond
and the ECB policy interest rate
3.5
3
2.5
2
1.5
1
0.5
0
The Conclusion and the Policy Recommendation:
There are currently many proposals for financial regulation.
But the most urgent one will be the regulation on funding:
The authority must force banks to fund their liabilities with longer
term securities.
Moreover, this regulation must be enforced before central banks
embark on the exit strategy.
It must be in place before the major central banks start the
tightening cycle.
Otherwise, banks around the globe will be hit by the
downwardly sloped yield curve which can trigger another
financial crisis.
But if banks must fund their investment in long term securities
with long term securities, the banking business may never
return to be profitable as before.