Executive summary (max 100 words)
After the recent crisis of 2007, the role of central banks has greatly changed. Most of the assumptions of central bankers and economists have been revealed imprecise, or completely wrong. This paper explores a few important points about central banking and, in particular, it will focus on:
– “Flexible Targeting Inflation” in the “Great Moderation”.
– Moral hazard and high risk-taking.
– The (wrong) natural dichotomy between monetary policy and financial stability policy.
– Unconventional monetary policies.
– Fed and ECB’s behaviour in response to the different market conditions.
– Outcomes of central banks’ intervention and change in their role.
Introduction Max 200.
The aim of this report is to provide a general analysis of the evolution of central banks’ duties. We will discuss about the numerous challenges they faced, from their unpreparedness in preventing such a catastrophe, due to believes based on inadequate models (linear vs non-linear) of the reality, to their incapacity to promptly react and find the most effective countermeasures to reduce the impact of the crisis on the nations’ welfare. Among these, we will examine in depth the possible counteractions at their disposal and try to explain how non-conventional monetary policies will be adopted, central bankers’ attempt to forecast their efficacy and the results after their implementation. To have a better understanding of these changes, it is fundamental considering as the starting point the period before the crisis in order to portray the most faithful scenario in which central banks had to operate. Then, we will compare the different decisions made by ECB and Fed regarding the specific non-conventional tools they used which led to different outcomes that matched different objectives. Finally, we will conclude with the results of policies implementation in the aftermath of the financial crisis of 2007-08 and their renewed role.
Main body of the report. 1000-1300 words.
The “Great Moderation” and moral hazard
From the early 1980s until 2007, economists at central bank pursued a unique objective, named “flexible inflation targeting”. They believed that through monetary policy, they could stabilize inflation in the long run and, in addition, maintain the level of output close to its natural level (Mishkin, 2012). Its success led many countries to adopt this policy, and the results have been positive. It was based on the believe of a “natural dichotomy between monetary policy and financial stability policy”, accompanied with the certainty that it was fiscal authorities’ responsibility to use prudential regulations and supervision to maintain financial stability in the long run and avoid any disruption (Mishkin, 2012).
It is not sufficient saying that after the burst of the financial bubble the world economy collapsed. There are many reasons why the financial bubble originated. Among these, moral hazard played an important role, often underestimated. Moral hazard is “where one party is responsible for the interests of another, but has an incentive to put his or her own interests first” (Dowd, 2009). Let us take as example the case of subprime loans. In the days before the crisis, a bank lending money would keep a mortgage until its maturity. It had a big incentive in choosing his borrower in order to be fully repaid. But, whenever the lender faces the possibility of selling the mortgage to another party, his interest in valuing the “quality” of the mortgage radically changes. Indeed, the only concern is to get back the money spent to originate the loan and reuse them to more loans.
Subprime loans were just an example of the different ways moral hazard became established. Consider the low interest rate policy set by central banks in the early 2000s. Excessive low interest rates caused the “risk-taking channel of monetary policy” mechanism (Borio & Zhu, 2012). It induced asset managers to increase risk-taking in search of higher yields and also expanded the leverage capacity of financial firms, so increasing the risk. In general, banks’ started securitising all their assets, together with the trade of “structured financial instruments” (CDOs, ABSs, etc…), originating the so-called “originate-to-distribute” loop (Visco, 2013). Any asset backed by collateral represented an occasion to fall into moral hazard. As long as the value of the collateral reflected its true value, the incentive in risk-taking was reduced, but when it decreased, problems like these started emerging. People started taking speculative positions and with the consequent creation of a loop in the economy that ended only with its stagnancy and an increase in spread in the interbank markets.
Trading both structured financial instruments and asset-backed securities, in addition to a lack of transparency and excessive risk-taking are responsible for the deterioration of the economic conditions. We have learnt from the recent crisis that during turmoil times, macroeconomic linear models, aimed at describing the reality, fail to provide significant results for the analysis of the latter, due to insufficiency or incompleteness of data. “Complexity was used, somewhat perversely, as an argument in favour of a sort of benign neglect on the part of regulators” says I.Visco in 2013. After the bankruptcy of Lehman Brothers, the economy contracted exponentially. In the U.S. the real GDP fell from -1.3% to 6.4% from the 4th quarter of 2008 and the 2nd quarter of 2009 (Mishkin, 2012). Moreover, after every financial disruption it is usually needed a long time for the economy to recover. Indeed, 82% of observations of per capita GDP from 2008 to 2010 remained below or equal their GDP in 2007 (Reinhart & Reinhart, 2010). One of the big consequences of pursuing a long-run low inflation policy was that people undertook excessive speculation, under the wrong believe of quasi-risk-free economic environment, making the economic system weaker (Mishkin, 2012).
Central Banks’ intervention and non-conventional monetary policies
Until now, we have described the circumstances in which the crisis proliferated and analysed its main causes. We are ready now to examine in depth which countermeasures central banks adopted and how did the economy react. As mentioned above, during the “great moderation”, central banks pursued a low interest rate policy, aimed at stabilizing the economy in the long-run. After the burst of the financial bubble, the economy froze and central banks stepped in to provide additional liquidity to financial markets. Initially, it seemed that conventional monetary policies could have eased the economy. Indeed, despite the tensions across the euro area, the interbank market reacted positively. However, after Lehman Brothers declared bankruptcy, the spread between the Euribor and EONIA (Euro Overnight Index Average) interest rate rose to 156 basis points in October 2008 (Smaghi, 2009). The situation was worsening and central banks had to recur to unconventional monetary policies to revitalize the economy.
If it is not easy to implement a monetary policy in “normal” times, it is even more difficult to adopt unconventional policies, especially during “abnormal times”. In fact, policy-makers had to define the objectives of these policies and also to forecast possible side-effects of these measures on both the bank’s balance sheet and the market.
On one hand, they could manage the expectations to influence the long-run real interest rate. They can resort to a conditional commitment to maintain policy rates at the lower bound for a significant period of time (Smaghi,2009).
On the other, they could straightforwardly affect the market conditions through direct/indirect “quantitative easing” which influences mainly the market for risk-free assets (e.g. government bonds) or “credit easing” which aims to lessen the risk spread across assets from particularly compromised markers and not. As we were discussing before, it is important to remember that both of these methods involve an expansion of the bank’s monetary liabilities.
However, a problem can emerge if banks decide to keep additional liquidity from quantitative easing instead of extending credit. In fact, this policy ought to be used when the interest rate is close to its lower bound, so that banks don’t have any incentive in keeping liquidity in their reserves because any remuneration of the deposit would be almost null. However, incentives to promote investing might not be enough, leading to the so-called “liquidity trap”. Furthermore, leaders of G20 agreed to refrain from competitive devaluation because of its ineffectiveness due to the involvement of all the countries in the crisis (Smaghi, 2009). Lastly, the central bank has to pay attention in buying government bonds because it risks to make itself a market maker of public debt and violate the articles 101 and 102 of the Treaty of Rome (Smaghi, 2009).
Differently from quantitative easing, credit easing is addressed to provide liquidity through the purchase of assets (mainly commercial paper, corporate bonds, asset-backed securities), attempting to reduce the spread in certain segments of the market. Either in this case, caution is needed. “Purchasing privately issued securities implies central banks to interact with the private sector and stepping into the realm of credit risk” (Smaghi, 2009). Central bank risks to compromise its balance sheet risk profile and to alter its financial independence. Furthermore, it has to evaluate carefully which assets to buy, to avoid biased allocations of capital and guarantee an equal treatment to all the companies.
Fed and ECB actions
Fed established the “Term Auction Facility” to encourage additional borrowing, which started with auctions of $20 billion and reached the $400 billion when the crisis intensified. It also created the “Commercial Paper Funding Facility” (that helped J.P. Morgan to absorb Bearn Stears to avoid its failure) to help companies to have adequate access to short-term credit, because the lowering of the interest rate (conventional policy) had a weak impact in stimulating the economy. It also bought $1.25 trillion of asset-backed securities from government-sponsored agencies Fannie Mae and Freddie Mac (Mishkin, 2012).
In the case of ECB, during the years of the crisis, its balance sheet increased dramatically, but its composition wasn’t prevalently due to non-standard monetary policy, if compared with the ones of the other central banks (Fed, Bank of England). At the beginning of the financial crisis, ECB didn’t lower its policy rates, but after Lehman Brothers went bankruptcy they reduced the interest rate at historical low levels. The refinancing rate decreased by 325 basis points from 2008 and 2009. In parallel to Fed, ECB announced an “Outright Monetary Transactions” (OMTs). It was part of the “Enhanced Credit Support”, aimed at restoring the original creditworthiness of banks. With a reduced interbank lending and the increased demand for liquidity ECB provided unlimited liquidity through “fixed rate tenders with full allotment” for both short and long run (MROs and LTROs) refinancing operations. It means that banks could borrow unlimited amount of money at a fixed rate, of course with an acceptable collateral. In December 2011, the ECB lent almost €490 billion to banks, in February 2012, €530 billion (Pattipeilohy, et al., 2013). Finally, in August 2012, ECB announced its intention to extend the OMTs in the secondary sovereign market for bonds under the strict respect of the European Financial Stability Facility and European Stability Mechanism (EFSF & ESM), programme devoted to absorbing EU nations’ public debt through the purchase of short-term sovereign bonds and safeguard the implementation of the monetary policies (Pattipeilohy, et al., 2013).
Conclusions. Briefly summarize report findings.
The results has been positive. In fact, the spreads on eligible commercial paper have come down to less than 50 basis points and also the purchase of mortgage-backed securities from government’s agencies resulted in a decrease in the mortgage rate by 156 basis points in less than a quarter of year (Smaghi, 2009).
The conclusion is that central banks’ liquidity support has significantly reduced money markets rates; liquidity provision (LTRO) had a favourable (short-term) effect on bond yields, while the Securities Market Programme had a visible downward effect on bond yields in 2011 but it lasted for only a few weeks. We can conclude that the results from the application of these countermeasures have been positive in supporting financial transmission and the economy (Pattipeilohy, et al., 2013).
Briefly Suggest solutions, idea or recommendations.