Abort, Retry, Fail?

Well, golllllly.  Who knew that a judiciously-leaked story that DB was considering buying back a few billion euros' worth of senior debt (i.e., not the Cocos that everyone's suddenly an expert in) would single-handedly turn the tide of bearish sentiment engulfing global markets yesterday?  It's hard to believe that this solution didn't occur to them earlier; they can just dig under the sofa cushions for the money, or just spend last year's retained earnings....er, never mind.  Anyhow, huzzah for John Cryan!

Regardless of the merits of either Deutsche Bank or this story, yesterday's immediately enthusiastic reaction to it was more than a little redolent of 2008 or 2011, when hopeful tape bombs would push markets from the brink for a few hours at least, sucking the foolish into a sense of complacency and giving the wise an opportunity to do some selling.   Macro Man half expected to see a red headline that a Korean bank is this close to bidding for Lehman Brothers....

While today's price action in European financials will be a tasty opening act, the main event today is of course Janet Yellen's testimony before Congress.   Given the evident deceleration in US growth, the tumult gripping global markets, and the absence of any visible inflationary pressures, she has the opportunity to inject a further degree of confidence into markets, if only temporarily, by signalling the Fed's willingness to climb down from its policy of slowly removing accommodation.   That doesn't mean that she will, or even that she should, of course; the most likely (and most sensible) approach would be to keep her options open while acknowledging that March is probably off the table.

In a very real sense, the Fed faces the same difficult choice as the ECB and BOJ, and indeed must feel the same level of frustration that two generations of computer users encountered when confronted with the MS DOS query of what do you wanna do: Abort, Retry, Fail?

Consider the options, with a little help from Wikipedia:

Abort: Terminate the current policy operation and return to a flat policy setting.    This might be an option for the Fed (sitting tight at current rates), though given rhetoric and the clear disequilibrium of current policy settings it might be a little trickier for Japan and especially Europe.

Retry:  CBs could attempt the operation again.   Retry makes sense if the policymaker can rectify the problem that has caused the current reflation to crash.   Easier said than done, obviously, but clearly on the table for all three central banks in one form or another.

Fail: Return policy status to the earlier program/routine.   The economy could then gracefully recover from the problem.  The recommended policy for the Fed if you happen to own a few hundred billion dollars' worth of bonds, and for the ECB and BOJ if you happen to own a few hundred thousand bank shares.

The more that Macro Man looks at the NIRP issue, the more convinced he becomes that it was ill-conceived with little appreciation of the negative externalities.   Unfortunately, we're all operating under the jurisdiction of the law of unintended consequences,  and the judge is a stern task-master.  At this juncture the impact upon banks should be fairly clear, but what about pension funds with liabilities discounted by long-term rates?

Consider the stylized example below of a pension fund with an obligation to pay out 5 nominal units per year for the next 30 years.  (Real-life liability calculations are much more complicated.)  For the sake of simplicity we'll assume an asset base that has a net present value of 100 units, based on current nominal asset size and a constant real return assumption.   Note that this is in some ways a flattering assumption; periods with extremely low discount rates can probably be expected to sustain a compression in real returns as well, but we'll forego that for this example.

Using 30 year euro swap rates as our discount rates, we can see how the pension fund's status changes as the discount rate declines.  At 3% swap rates, it is more than fully-funded and has a liability duration of 18.25 years; at 2%, it is 7% in deficit and has seen duration extend by a year; a 1%, it's now 24% in deficit and has its liability duration yet another year.

Again, this is a very simple example and the real world is much more complicated.   Nevertheless, the impact of policy driven low rates can be seen quite starkly, even if actual discount rates move more slowly than markets. Lest we forget, here's what long dated euro swaps have done over the past few years:

Grazie, Mario!   And how are those pension return assumptions panning out with so much of the low-risk euro-denominated asset base delivering negative nominal and real yields?   What will happen if, in extremis, a lower deposit rate combined with negative convexity drives long-dated swap rates into negative territory for an extended period?   In such a case, the NPV of future liabilities could exceed the nominal value of said liabilities!  It sounds crazy, sure....but no more crazy than negative rates would have sounded a decade ago.

At the same time, Macro Man had to laugh when he saw the headline that European regulators are probing a "suspected rigging of $1.5 trillion debt market" for government-sponsored bonds.  Let's take a step back, shall we, and examine what real manipulation looks like?

* From 2002-2013 or so, China actively maintained an artificially weak exchange rate and accrued FX reserves of $3.6 trillion.  This policy distorted market pricing at home and abroad, leading to significant misallocations of capital.   Since then, they have maintained an artificially strong exchange rate.  Commodity producers and other mercantilist countries have pursued similar policies, leading to very substantial flows into and out of asset markets.   How's that worked out?

* Many central banks, including the Fed, ECB, BOJ, and BOE have been active participants in government bond markets, driving yields to levels that they likely would not have reached otherwise.  This is turn has impacted not only pension funding as described above, but also the pricing and allocation of capital into such worthy endeavours as...oh...share buybacks and oil ventures requiring $60 crude to turn a profit.   How's that working out?

* Even latterly, in the name of macroprudential policy and financial stability, regulators have encouraged banks to raise capital and, in Europe, blessed the issuance of some $450 billion of hard-to-value Coco bonds that at least one national central bank studied and decided would...wait for it...threaten financial stability!

If Macro Man had his druthers, we would declare modern central banking (un)orthodoxy a giant Fail, decide to Abort it, and then Retry with another policy mix.  Given that the downside of going batshit-crazy in monetary terms has become increasingly evident, why not try something different and go crazy in fiscal terms?

Two of the major problems in the world at the moment are government balance sheets that require some measure of austerity and the lack of inflation.   Japan has faced similar issues for nearly two decades, and Macro Man is mindful of a suggestion he raised a dozen years ago, well before the advent of this blog.

The US, Eurozone,  UK, and Japan all have 2% inflation targets that they're nowhere close to meeting.   Why not implement a periodic VAT increase of 0.5% per quarter, ad infinitum- in other words, legislate quasi-2% inflation?  The usual VAT issue of simply pulling consumption forward would be resolved because the tax would continue to rise rather than  being a one-shot deal, and would presumably inform inflation expectations as well.   Crucially, the revenue would then be spent back into the real economy to achieve some sort of positive growth impact- upgrading infrastructure in the US, public services in the UK and parts of Europe, etc.  The policy probably wouldn't work in Japan, given the long-term failure of infrastructure projects there, but they're kind of screwed anyway by demographics so why not give it the old college try?

To be sure, there are problems with such a policy, most notably the implementation issues of high-frequency tax rate changes.  Moreover, legislated inflation is not "real" inflation, and would not necessarily impact wages and incomes, particularly at the beginning.   This would lead to a loss of real purchasing power, which would apparently negate any impact of fiscal impulse from the government.  Then again, consumers are enjoying a historically positive "personal terms of trade" shock via commodity and manufactured goods deflation, so if there were ever a time to try such a policy now would be it.

At the end of the day, how bad could it be, particularly if central banks allowed consumers, pensions, etc to actually a generate a positive return on their savings instead of confiscating it through ZIRP and NIRP?  At the very least, you could say that this type of policy would avoid an officially-sponsored sanction to buy crappy assets at dubious prices, which has been a central plank of modern monetary policy since the crisis (and well before, in places like the US.)

And hey- if it didn't work after a few years, you could just abort it, retry it in a slightly different form, or declare all modern policies a failure and just add a zero to everyone's bank balance....