Is monetary policy less effective when interest rates are persistently low?

Interesting BIS working paper which says that at low interest rates,  monetary policy transmission becomes less effective.

Interest rates in the core advanced economies have been persistently low for about eight years now. Short-term nominal rates have on average remained near zero since early 2009 and have been even negative in the euro area and Japan, respectively, since 2014 and 2016. The drop in short-term nominal rates has gone along with a fall in real (inflation-adjusted) rates to persistently negative levels. Long-term rates have also trended down, albeit more gradually, over this period: in nominal terms, they fell from between 3–4% in 2009 to below 1% in 2016.

From a historical perspective, this persistently low level of short- and long-term nominal rates is unprecedented. Since 1870, nominal interest rates in the core advanced economies have never been so low for so long, not even in the wake of the Great Depression of the 1930s (Graph 2, top panels). Elsewhere, too, including in Australia, short- and long-term interest rates have fallen to new troughs, reflecting in part global interest rate spillovers especially at the long end.

The persistently low rates of the recent past have reflected central banks’ unprecedented monetary easing to cushion the fallout of the Great Financial Crisis (GFC), spur economic recovery and push inflation back up towards objectives. However, despite such efforts, the recovery has been lacklustre. In the core economies, for instance, output has not returned to its pre-recession path, evolving along a lower, if anything flatter, trajectory, as growth has disappointed. At the same time, in many countries inflation has remained persistently below target over the past three years or so.

Against this background, there have been questions about the effectiveness of monetary policy in boosting the economy in a low interest rate environment. This paper assesses this issue by taking stock of the existing literature. Specifically, the focus is on whether the positive effect of lower interest rates on aggregate demand diminishes when policy rates are in the proximity of what used to be called the zero lower bound. Moreover, to keep the paper’s scope manageable, we take as given the first link in the transmission mechanism: from the central bank’s instruments, including the policy rate, to other rates.

The review suggests that both conceptually and empirically there is support for the notion that monetary transmission is less effective when interest rates are persistently low. Reduced effectiveness can arise for two main reasons: (i) headwinds that typically blow in the wake of balance sheet recessions, when interest rates are low (eg debt overhang, an impaired banking system, high uncertainty, resource misallocation); and (ii) inherent nonlinearities linked to the level of interest rates (eg impact of low rates on banks’ profits and credit supply, on consumption and saving behaviour – including through possible adverse confidence effects – and on resource misallocation). Our review of the existing empirical literature suggests that the headwinds experienced during the recovery from balance-sheet recessions can significantly reduce monetary policy effectiveness. There is also evidence that lower rates have a diminishing impact on consumption and the supply of credit. Importantly, these results point to an independent role for nominal rates, regardless of the level of real (inflation-adjusted) rates.

The review reveals that the relevant theoretical and empirical literature is much scanter than one would have hoped for, in particular given that periods of persistently low interest rates have become more frequent and longer-lasting. While there are appealing conceptual arguments suggesting that monetary transmission may be impaired when rates are low, many of these have not been formalised by means of rigorous theoretical modelling. And the extant empirical work is limited, both geographically and in scope. For instance, most studies assessing changes in monetary transmission in low rate environments focus on the United States. Similarly, there is hardly any work assessing specific mechanisms. The field is wide open and deserves further exploration, not least given the first-order policy implications.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Enhancements to the Basel Pillar 3 Disclosure Framework Released

The Basel Committee on Banking Supervision has issued Pillar 3 disclosure requirements – consolidated and enhanced framework. This standard represents the second phase of the Committee’s review of the Pillar 3 disclosure framework and builds on the revisions to the Pillar 3 disclosure published by the Committee in January 2015.

The Pillar 3 disclosure framework seeks to promote market discipline through regulatory disclosure requirements. The enhancements in the standard contain three main elements:

  • Consolidation of all existing BCBS disclosure requirements into the Pillar 3 framework – These disclosure requirements cover the composition of capital, the leverage ratio, the Liquidity Coverage Ratio (LCR), the Net Stable Funding Ratio (NSFR), the indicators for determining globally systemically important banks (G-SIBs), the countercyclical capital buffer, interest rate risk in the banking book and remuneration.
  • Two enhancements to the Pillar 3 framework – This standard introduces a “dashboard” of a bank’s key prudential metrics which will provide users of Pillar 3 data with an overview of a bank’s prudential position, and a new disclosure requirement for those banks which record prudent valuation adjustments (PVAs) to provide users with a granular breakdown of how a bank’s PVAs are calculated.
  • Revisions and additions to the Pillar 3 standard arising from ongoing reforms to the regulatory policy framework – This standard includes new disclosure requirements in respect of the total loss-absorbing capacity (TLAC) regime for G-SIBs issued in November 2015, and revised disclosure requirements for market risk arising from the revised market risk framework published by the Committee in January 2016.

Note that this standard does not include disclosure requirements arising from the Committee’s ongoing finalisation of the Basel III reforms. Disclosure requirements agreed by the Committee following the issuance of this standard will be included within the scope of the third phase of the review of the Pillar 3 framework.

The standard incorporates feedback from Pillar 3 preparers and users collected during the public consultation conducted in March 2016. Clarifications have been made relating to the disclosure requirements, in particular those pertaining to TLAC.

The implementation date for each of the disclosure requirements is set out in the standard. In general, the implementation date for existing disclosure requirements consolidated under the standard will be end-2017. For disclosure requirements which are new and/or depend on the implementation of another policy framework, the implementation date has been aligned with the implementation date of that framework

Debt Servicing Ratio Update Highlights Risks

The BIS has released the latest DSR data for major economies. Australia sits firmly near the top, alongside Norway, Netherlands, Canada and Hong Kong. USA and UK are significantly lower.

The DSR reflects the share of income used to service debt and has been found to provide important information about financial-real interactions. For one, the DSR is a reliable early warning indicator for systemic banking crises. Furthermore, a high DSR has a strong negative impact on consumption and investment. The DSRs are constructed based primarily on data from the national accounts. You can read more about the index here.

Here are comparative charts to September 2016.

The trends over time are also interesting, as interest rates and debt levels change. I have removed a few countries to make the chart easier to read.

The BIS says:

Debt forms a central part of the narrative of financial crises and financial cycles more generally. Leverage, often proxied at the aggregate level by the ratio of the stock of liabilities (ie debt) to income, has received much attention as an indicator of financial excesses and vulnerabilities. Less discussed, but equally important, is the debt service ratio (DSR), which captures the share of income used for interest payments and amortisations. These debt-related flows are a direct result of previous borrowing decisions and often move slowly as they depend on the duration and other terms of credit contracts. They have a direct impact on borrowers’ budget constraints and thus affect spending.

Since the DSR captures the link between debt-related payments and spending, it is a crucial variable for understanding the interactions between debt and the real economy. For instance, during financial booms, increases in asset prices boost the value of collateral, making borrowing easier. But more debt means higher debt service ratios, especially if interest rates rise. This constrains spending, which offsets the boost from new lending, and the boom runs out of steam at some point. After a financial bust, it takes time for debt service ratios, and thus spending, to normalise even if interest rates fall, as principal still needs to be paid down. In fact, the evolution of debt service burdens can explain the dynamics of US spending in the aftermath of the Great Financial Crisis fairly well. In addition, DSRs are also highly reliable early warning indicators of systemic banking crises.

Latest Basel III monitoring results

The Basel Committee has published the results of its latest Basel III monitoring exercise based on data as of 30 June 2016 in a 65 page report. Virtually all participating banks meet Basel III minimum and target CET1 capital requirements as agreed up to end-2015. The report does not reflect any standards agreed since the beginning of 2016, such as the revisions to the market risk framework.

It also highlights that the capital build processes will continue as the higher targets come into force. Higher capital costs, and this will translate into higher loan rates as banks seek to preserve shareholder returns.

The report provides summary data for a total of 210 banks, comprising 100 large internationally active banks. These “Group 1 banks” are defined as internationally active banks that have Tier 1 capital of more than €3 billion, and include all 30 banks that have been designated as global systemically important banks (G-SIBs). The Basel Committee’s sample also includes 110 “Group 2 banks” (ie banks that have Tier 1 capital of less than €3 billion or are not internationally active). It includes Australia’s “big four” banks and one other using data from APRA.

On a fully phased-in basis, data as of 30 June 2016 show that virtually all participating banks meet both the Basel III risk-based capital minimum Common Equity Tier 1 (CET1) requirement of 4.5% and the target level CET1 requirement of 7.0% (plus the surcharges on G-SIBs, as applicable).

Between 31 December 2015 and 30 June 2016, Group 1 banks continued to reduce their capital shortfalls relative to the higher Tier 1 and total capital target levels; in particular, the Tier 2 capital shortfall has decreased from €5.5 billion to €3.4 billion. As a point of reference, the sum of after-tax profits prior to distributions across the same sample of Group 1 banks for the six-month period ending 30 June 2016 was €263 billion. In addition, applying the 2022 minimum requirements for Total Loss-Absorbing Capacity (TLAC), 18 of the G-SIBs in the sample have a combined incremental TLAC shortfall of €318 billion as at the end of June 2016, compared with €416 billion at the end of 2015.

The monitoring reports also collect bank data on Basel III’s liquidity requirements. Basel III’s Liquidity Coverage Ratio (LCR) was set at 60% in 2015, increased to 70% in 2016 and will continue to rise in equal annual steps to reach 100% in 2019. The weighted average LCR for the Group 1 bank sample was 126% on 30 June 2016, slightly up from 125% six months earlier. For Group 2 banks, the weighted average LCR was 155%, up from 148% six months earlier. Of the banks in the LCR sample, 88% of the Group 1 banks and 94% of the Group 2 banks reported an LCR that met or exceeded 100%, while all Group 1 and Group 2 banks reported an LCR at or above the 70% minimum requirement that was in place for 2016.
Basel III also includes a longer-term structural liquidity standard – the Net Stable Funding Ratio (NSFR). The weighted average NSFR for the Group 1 bank sample was 114%, while for Group 2 banks the average NSFR was 115%. As of June 2016, 84% of the Group 1 banks and 86% of the Group 2 banks in the NSFR sample reported a ratio that met or exceeded 100%, while 98% of the Group 1 banks and 96% of the Group 2 banks reported an NSFR at or above 90%.

The results of the monitoring exercise assume that the positions as of 30 June 2016 were subject to the fully phased-in Basel III standards as agreed up to end-2015. That is, they do not take account of the transitional arrangements set out in the Basel III framework, such as the gradual phase-in of deductions from regulatory capital. Furthermore, the report does not reflect any standards agreed since the beginning of 2016, such as the revisions to the market risk framework (analysed separately in a special feature). No assumptions were made about bank profitability or behavioural responses, such as changes in bank capital or balance sheet composition. For that reason, the results of the study may not be comparable with industry estimates.


High Household Debt Kills Real Growth

A new working paper from the BIS “The real effects of household debt in the short and long run” shows that high household debt (as measured by debt to GDP) has a significant negative long term effect on consumption, and so growth.

A 1 percentage point increase in the household debt-to-GDP ratio tends to lower growth in the long run by 0.1 percentage point. Our results suggest that the negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds 60%. For GDP growth, that intensification seems to occur when the ratio exceeds 80%.

Moreover, the negative correlation between household debt and consumption actually strengthens over time, following a surge in household borrowing. What is striking is that the negative correlation coefficient nearly doubles between the first and the fifth year following the increase in household debt.

Bad news for Australian households where the ratio is well above 80%, at 130%.

This is explained by massive amounts of borrowing for housing (both owner occupied and investment) whilst unsecured personal debt is not growing. Such high household debt, even with low interest rates sucks spending from the economy, and is a brake on growth. The swelling value of home prices, and paper wealth (as well as growing bank balance sheets) do not really provide the right foundation for long term real sustainable growth.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

The Globalisation of Inflation

The BIS has published an important working paper looking at the consequences of managing inflation given the rise of global value chains. As a result it questions the traditional approach used by central banks to attempt to manage inflation targets.  The monetary policy implications of a greater role for global factors in determining domestic inflation are farreaching, as clearly these factors are beyond the control of individual central banks. Such implications cannot be ignored.

At the heart of the globalisation of inflation (GI) hypothesis is the view that the factors influencing domestic inflation have become increasingly global. One implication of this hypothesis is that global, and not just domestic, measures of economic slack should be relevant determinants of domestic inflation and that their role should have increased with global economic integration. This more “globe-centric” view of the inflation process stands in contrast to traditional, “country-centric”, characterisations, in which a Phillips curve relates a purely domestic output gap to domestic inflation.

Because of its far-reaching implications for our understanding of inflation and the conduct of monetary policy, the GI hypothesis has attracted considerable attention.

While it is generally agreed that domestic inflation rates have been co-moving more closely, the correct interpretation of this finding hinges on the validity of the GI hypothesis. Proponents argue that tighter comovements reflect, in particular, the growing structural integration of goods and labour markets. This would, for instance, propagate national cost shocks more widely and strongly. By contrast, sceptics place greater weight on common policies. The empirical evidence so far has not yielded conclusive results.

The industrial organisation underpinning the expansion of GVCs has evolved. Initially, GVCs arose from firms’ foreign direct investment and within-firm trade across geographic borders. Growth in net international asset positions went hand-in-hand with the increase in international input-output linkages. Over time, however, outsourcing and offshoring have taken on greater prominence. Advances in technology have enabled international supply chains to expand. It is now possible to coordinate and track just-in-time production through international supply chains from start to finish, ie through all the different production stages, and by different firms located in geographically distant world regions. As a result, today’s GVCs include international manufacturing giants, such as Apple, that do not own most of the manufacturing plants in their supply chains.

These developments represent a challenge to the classical assumptions behind the traditional country-centric view of trade and inflation determination.

To assess this hypothesis, we evaluate the extent to which various proxies for GVCs explain the relative importance of global and domestic measures of slack in influencing domestic inflation. We do so in a panel setting, thereby exploring the relevance of GVCs both across countries and over time. To track the growth of GVCs, we consider total trade and its major components, focusing in particular on intermediate goods and services. To measure the influence of global and domestic slack on inflation, we rely on the published estimates of Bianchi and Civelli (2015) – estimates that are in the spirit of the analysis of Borio and Filardo (2007). That recent paper provides estimates that capture greater time variation (annual estimates for each country) and cover a wider range of countries than the earlier paper. We exclude the GFC period and its aftermath owing to the powerful balance sheet dynamics that appear to dominate the typical cyclical forces.

We find that GVCs are a key to explaining the influence of global factors on domestic inflation. There is statistically significant evidence that the growth of international input-output linkages explains the increasing sensitivity of domestic inflation to global factors. This is the case both across countries and over time. The growth of GVCs is associated with both a reduction of the impact of domestic slack on domestic inflation and an increase in that of its global counterpart. Moreover, once the role of GVCs is taken into account, we find that the conventional measure of trade openness so extensively used in the literature, based on the aggregate volume of trade in goods and services, has only limited explanatory power for the link between globalisation and domestic inflation.

Our evidence supports the view that the rise of GVCs has been a key factor behind the growing importance of the global output gap in determining domestic inflation.

We also find that controlling for the impact of GVCs, conventional measures of trade openness only have limited explanatory power. It is natural to think that a reason for this close link is the increased crossborder competition generated by the expansion of GVCs. The more easily measurable channel of this competition is through price pressures from inputs that are actually imported at all stages of the production process. The much harder-tomeasure, but possibly even more important, channel works through the inputs that could potentially be imported at the various production stages (ie through the contestability of markets for goods and services). Unfortunately, our analysis cannot distinguish between the two.20 But more detailed GVC measures based on increasingly available intermediate trade data could eventually shed further light on these channels and help refine the analysis.

Our findings point to the need for further theoretical and empirical research on the globalisation of inflation hypothesis, especially on the role of GVCs. On the theoretical side, this raises questions about approaches that model inflation as largely a country-centric phenomenon and derive the corresponding policy implications. On the empirical side, questions remain about whether it would be possible to develop more informative measures of global slack that would reflect differences in the sectoral value-added content of trade rather than simply in its economy-wide content. For example, Auer et al (2016) provide a quantification of one specific channel of interest, finding that most of the international co-movement in producer price inflation can be attributed to input-output linkages. There is also a need to extend the analysis carried out in this paper to a consideration of
alternative measures of domestic and global slack. The monetary policy implications of a greater role for global factors in determining domestic inflation would be farreaching, as clearly these factors are beyond the control of individual central banks. Such implications cannot be ignored.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

The costs of the financial crisis are significant (and still with us)

Given all the talk about deregulation of US banking, it is worth reflecting on this chart, from a recent presentation by William Coen, Secretary General of the Basel Committee, to students at Harvard Law School, on “The global financial crisis and the future of international standard setting: lessons from the Basel Committee“, Cambridge, United States, 12 December 2016.

Bank failures, government bail-outs and subsequent monetary policy settings have combined to lower overall real GDP.

Actions which weaken supervision, and increase risks of a further collapse need to be seen in this light.

The Credit-to-GDP Gap – Early Warning Of Trouble Ahead?

The BIS has released their updated series on the Credit-to-GDP Gaps.  In essence, the bigger the gap the greater the concern. Specifically, the bigger the gap, the more likely it is regulators should be lifting counter-cyclical buffers when it comes to capital management and control.

The largest gaps are from Hong Kong, China. Singapore. Australia is up the list, behind Canada, but ahead of USA, UK and New Zealand.

Here are the raw GDP to Credit ratios. Australia sits behind China and Canada, but well ahead of USA, UK and New Zealand. We are at the higher risk end of the spectrum.

The Credit to GDP Gap trends over time also tell a story. Our gap is higher now, compared with the past few years. Again a signal of rising risks?

The BIS says:

The build-up of excessive credit features prominently in discussions about financial crises. While it is difficult to quantify “excessive credit” precisely, the credit-to-GDP gap captures this notion in a simple way. Importantly from a policy perspective, large gaps have been found to be a reliable early warning indicator (EWI) of banking crises or severe distress.

The published series cover 43 countries starting at the earliest in 1961.

The credit-to-GDP gap (gapt) is defined as the difference between the credit-to-GDP ratio (ct/yt) and its long-run trend tt.

Importantly, while the use of these total credit series as input data facilitates comparability across countries, it means that the credit-to-GDP gaps published by the BIS may differ from credit-to-GDP gaps considered by national authorities as part of their countercyclical capital buffer decisions. Given the EWI qualities of the gap, the indicator was adopted as a common reference point under Basel III to guide the build-up of countercyclical capital buffers (BCBS (2010)). Authorities are expected, however, to apply judgment in the setting of the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risk rather than relying mechanistically on the credit-to-GDP guide. For instance, national authorities may form their policy decisions using credit-to-GDP ratios that are based on different data series from the BIS’s as input data, leading to credit-to-GDP gaps that differ from those published by the BIS.




Household Debt Service Ratio Latest Data

The BIS has just released their December 2016 update of comparative Debt Service Ratios for Households. Australia sits below Netherlands and Norway, but well above most other countries, including USA, UK and Canada. We are awash with household debt, but remember our current interest rates are ultra low. The ratio will deteriorate as rates rise, which is what we expect to happen.

By way of background, the debt service ratio (DSR) is defined as the ratio of interest payments plus amortisations to income. As such, the DSR provides a flow-to-flow comparison – the flow of debt service payments divided by the flow of income.

It takes the stock of debt, and the average interest rate on the existing stock of debt. To accurately measure aggregate debt servicing costs, the interest rate has to reflect average interest rate conditions on the stock of debt, which contains a mix of new and old loans with different fixed and floating nominal interest rates attached to them. The average interest rate on the stock of debt is proxied by the average lending rates on loans from  financial institutions.

So whilst there will be some cross-border statistical variations, we can be confident the results are relatively accurate.

Delving Deeply into Currency and Derivatives Markets

The December 2016 BIS Quarterly Review: Delving deeply into currency and derivatives markets – has been released.

Trading on global currency and over-the-counter (OTC) derivatives markets continues to grow, but why are some segments thriving while others fall back?

The December 2016 issue of the BIS Quarterly Review examines the data collected earlier this year from close to 1,300 banks and other dealers in 52 jurisdictions as part of the Triennial Central Bank Survey of foreign exchange and OTC derivatives markets, the most comprehensive snapshot of the size and structure of these markets.

Three underlying themes emerge, said Hyun Song Shin, Economic Adviser and Head of Research: changes in the role and composition of market participants, the evolving role of emerging market economy (EME) currencies and monetary policy as a driver of market developments. These developments can in turn have an impact on the real economy. “What happens in financial markets does not always stay in financial markets,” Mr Shin said.

The December BIS Quarterly Review also:

  • Finds that the increase in global bond yields over the last few months has not caused major disruption in financial markets. Equity markets rallied and yields rose further as markets priced in a greater likelihood of fiscal expansion after the US presidential election. However, EME assets came under pressure.

    “Developments during this quarter stand out for one reason: for once, central banks took a back seat,” said Claudio Borio, Head of the Monetary and Economic Department. “It is as if market participants, for once, had taken the lead in anticipating and charting the future, breaking free from their dependence on central banks’ every word and deed.”

  • Presents new data from China and Russia, which have started to contribute to the BIS locational banking statistics. The new data show that banks in China are the 10th largest lenders in the international banking market and banks in Russia the 23rd largest.
  • Finds that differences in the regulations applying to different classes of derivatives partly explain why central clearing has become more entrenched in OTC interest rate derivatives markets than in other OTC markets.
  • Documents the increased use of the Chinese renminbi in financial trading. The shares of FX derivatives trading compared with spot trading, and of financial counterparties compared with non-financial counterparties, are approaching those of well established liquid currencies. The market for renminbi-denominated interest rate derivatives, however, remains small.

Five special features analyse currency and financial market developments:

  • Michael Moore (Warwick Business School), Andreas Schrimpf (BIS) and Vladyslav Sushko (BIS)* find that the downsizing of FX markets reflects a fall in the activity of “fast money” traders and hedge funds, and a drop in FX prime brokerage. In contrast, more long-term investors are hedging currency risk, supporting trading in FX derivatives. FX dealer banks are less willing to take on risk, and competition from non-bank market-makers has risen.
  • Torsten Ehlers and Egemen Eren (BIS)* argue that changing monetary policy stances helped drive a near doubling in the turnover of US dollar OTC interest rate derivatives, while euro-denominated contracts nearly halved. Exchange-traded markets continue to handle the majority of interest rate derivatives turnover, but are growing more slowly than OTC markets. Regulatory reforms have encouraged a move to central clearing and electronic trading and made OTC markets more similar to exchanges.
  • Christian Upper and Marcos Valli (BIS)* explore why derivatives markets for EME currencies and interest rates are smaller than their advanced economy counterparts. They argue that lower levels of financial development, less integration in the global economy and lower per capita income may be holding back growth in these markets.
  • Robert McCauley and Chang Shu (BIS)* explain that the rise of non-deliverable forwards (NDFs), contracts which allow hedging and speculation in a currency without providing or requiring settlement in it, masks significant differences across currencies, reflecting different paths of FX market development. While the internationalisation of China’s renminbi has favoured deliverable forwards over NDFs, such contracts have become more popular in the Brazilian real and Korean won.
  • Jonathan Kearns and Nikhil Patel (BIS)* use trade-weighted exchange rates and BIS-constructed debt-weighted exchange rates to assess competing forces influencing the impact that currency moves have on an economy. They find that exchange rate devaluation could damage rather than stimulate activity in emerging market economies where borrowers have a high share of foreign currency debt, probably because of the impact on their balance sheets.

* Signed articles reflect the views of the authors and not necessarily those of the BIS.