Limits to Monetary Policy under Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The major advanced economies are maintaining extraordinarily accommodative monetary conditions, through low policy rates and the continued expansion of their balance sheets through new rounds of unconventional policy measures.  These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies (EMEs) in the form of undesirable exchange rate and capital flow volatility. As a consequence of EME efforts to manage these spillovers, the stance of monetary policy is highly accommodative globally.  The limits to monetary policy, in the current environment, are addressed in the latest 2011 BIS Annual Report.

 

There is widespread agreement that, during the crisis, decisive central bank action was essential to prevent a financial meltdown and that in the aftermath it has been supporting faltering economies. Central banks have had little choice but to maintain monetary ease because governments have failed to quickly and comprehensively address structural impediments to growth.

 

However, there are limits to what monetary policy can do; such as provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks with conflicting objectives, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally as actual achievements fall short of expectations.

 

The global monetary policy stance taken by central banks is unusually accommodative. Policy rates are well below benchmark measures while central bank balance sheets continue to expand.  Against the background of weak growth and high unemployment, sustained monetary easing is natural and compelling.  However, there is a growing risk that monetary policy, by itself, cannot solve all issues such as solvency or deeper structural problems. It can buy time, but conversely may delay the return to a self-sustaining recovery. Central banks need to recognize and communicate the limits of monetary policy, making clear that it may not address the root causes of financial fragility and economic weakness.

 

The combination of weak growth and low rates, and efforts to manage the spillovers in emerging market economies, has helped to spread monetary accommodation globally.  This has resulted in a build-up of financial imbalances and increasing inflationary expectations could have negative repercussions on the global economy. Central banks need to account for global spillovers from domestic monetary policies on financial and price stability.

 

Finally, central banks need to beware of longer-term risks to their credibility and operational independence. There can be a gap between expectations and the actual results delivered by monetary policy. This could complicate the eventual exit from monetary accommodation and threaten central banks’ credibility and operational autonomy. It is reinforced by political economy risks arising from the combination of balance sheet policies that have blurred the line between monetary and fiscal policies, on the one hand, and the risk of unsustainable fiscal positions, on the other.

 

The lesson for risk management is that monetary policy will not solve all the problems and some hard decisions are required.

 

For more on this, follow the link:  www.bis.org/publ/arpdf/ar2012e4.htm

Breaking the Vicious Cycles

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutioins.com

 

The global economy, after five years, has yet to overcome the legacies of the financial crisis to achieve balanced, self-sustaining growth. In different ways, vicious cycles are hindering the transition for both the advanced and emerging market economies as noted in the first chapter of the 2011 BIS Annual Report.

 

Moving the global economy to a path of balanced, self-sustaining growth remains a difficult and unfinished task.   However, a number of interacting structural weaknesses are hindering the reforms required.   Investors and politicians hoping for quick fixes will continue to be disappointed – there are none.   Central banks, already overburdened, cannot repair all these weaknesses – consumer debt reduction, stimulate investment and job creation while creating an attractive investment environment.

 

A look at the global economy suggest that there are three areas for adjustment: the financial sector needs to recognize losses and recapitalize; governments must put fiscal trajectories on a sustainable path; and households and firms need to deleverage. As things stand, each sector’s burdens and efforts to adjust are worsening the position of the other two.   All of these linkages are creating a variety of vicious cycles.

 

Central banks find themselves in the epicenter, pushed to contain the damage: expected to fund the financial sector while maintaining low interest rates to ease the strains on fiscal authorities, households and firms. This pressure puts the central banks’ price stability objective, their credibility and, ultimately, their independence at risk.

 

Taming the vicious cycles, and reducing pressure on central banks, is critical.  This goal requires cleaning up and strengthening banks at the same time as containing the riskiness of the financial sector.  Bank balance sheets must accurately reflect the value of assets; while making progress on this score more rapid movement is required.   As they do, policymakers must ensure speedy recapitalization, see that banks build capital buffers as conditions improve, authorities must implement agreed financial reforms, and extend them to shadow banking activities.

 

In the euro area, the effects of the vicious cycles have reached an advanced stage that reflects not only weaknesses seen elsewhere but also the incomplete nature of financial integration in the currency union. Europe can overcome this crisis if it can address certain issues: structural adjustment, fiscal consolidation and bank recapitalization; and unify the framework for bank regulation, supervision, deposit insurance and resolution. That approach will decisively break the damaging feedback between weak sovereigns and weak banks, delivering the financial stability required that will allow time for further development of the euro area’s institutional framework.

 

Overall, in Europe and elsewhere, the revitalization of banks and the moderation of the financial industry will end their destructive interaction with the other sectors and clear the way for the next steps – fiscal consolidation and the deleveraging of the private non-financial parts of the economy. Only then, when balance sheets across all sectors are repaired, can we hope to move back to a balanced growth path? Only then will virtuous cycles replace the vicious ones now gripping the global economy.

 

Otherwise, the job of the risk manager will prove very difficult.

 

For more on this, follow the link:  http://www.bis.org/press/p120624.htm

Twelve Signs of the Europocalypse

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

What was unthinkable two years ago – the consideration of pan-European bank regulation, cross-border deposit guarantees, joint and several Eurobonds, and the very survival of the common currency – appear to be verging on the inevitable now.  The staid European Union we knew for its first two decades is a thing of the past. 

 

Douglas Rediker and David Gordon, look at some of these issues in the Jun. 12^th issue of Foreign Policy.  The authors offer 12 key trends to watch over the next few weeks for help in projecting what the new Europe will look like if it finally emerges from the mire.  There are interesting signposts for risk management and serve as tipping points. 

 

Some of these trends such as, Greek dysfunction and Spanish banks, are already well in process.  None of them are very encouraging for a benign solution to the euro zone crisis.  Several are scarier than others.  Greece and its European partners are in for an almost unimaginable set of politically unpalatable choices, and the likelihood of Greece remaining in the Eurozone is very low. 

 

German domestic politics, with federal elections scheduled for this autumn of next year, may be the single-most crucial factor in shaping the final German response to the crisis, with German politicians gauging every move and its impact on that vote.  The United States doesn’t possess the inclination, the ideas, or the financial capacity to materially influence the endgame in Europe.

 

For the so-called Troika, ECB-EC-IMF, tensions revolve around something quite simple: who pays.  Neither of the funding programs the EU governments has set up — the EFSF and the ESM — has any significant capital, relying instead on capital markets, leverage, and to some extent “alchemy” to reach its headline funding capacity. 

 

China is not coming to Europe’s financial rescue, but will instead look for potential European investment bargains once forced sellers of distressed assets find themselves without other options.

 

The European Union remains one of the great experiments of the 20^th century.  It was a major effort by countries to give up major elements of their sovereignty, acting collectively through a set of agreed-upon rules and coordinated through supranational agencies.  The whole process was organized by great strategists and visionaries, but the next stage could be organized by anonymous and impatient financial markets dominated by responses from unknown bureaucrats and politicians. 

 

The lesson for risk management is to look at potential tipping points before the accident occurs.

 

For more on this follow the link:  http://tinyurl.com/6s6dyv9