Helicopter Money: Unconventional Policies & Their Effects On Financial Markets by Shane Obata
These are interesting times for financial market participants. Central Banks (CBs) all over the world have been cutting rates in an attempt to support their economies. According to JP Morgan Asset Management, CBs cut rates more than 650 times from the collapse of Lehman Brothers in September, 2008 to the end of March, 2016. Moreover, central banks that tried to raise rates have had to reverse course. One issue is that many of these banks find themselves at or near the Zero Lower Bound (ZLB). This level was previously thought as the lower bound for interest rates. That is no longer the case. Europe and Japan have been toying with negative interest rates for some time, with mixed results. Ironically, their currencies, the Euro (EUR) and the Yen (JPY), respectively, appreciated following recent announcements. EURUSD rallied following the ECB’s announcement to lower three key interest rates on March 10th, 2016. In the same light, USDJPY fell from >120 to <110 after the Bank of Japan (BOJ) introduced negative rates in late January of 2016. One possible explanation is that market participants believe that central banks are nearing the limits of their effectiveness with Zero interest rate policy (ZIRP), quantitative easing (QE) and now Negative Interest Rate Policy (NIRP). As HSBC’s Stephen King said, “central bankers have thrown the monetary equivalent of the kitchen sink at the problem.”
There are a couple problems associated with the current state of affairs. The first is that it is Monetary Policy is distorting the prices of financial assets. Interest rates are the most important variables in the financial markets because they determine prices. According to the concept of the time value of money, an asset is worth the present value of its discounted future cash flows. With interest rates near all-time lows, the cost of debt, and accordingly, the Weighted Average Cost of Capital (WACC) are exceptionally low. In sum, it is very hard to determine the intrinsic value of an asset when the rates market is distorted. The second problem is that policymakers have limited means to deal with the next economic downturn. On the monetary policy side, central banks do not have much room to maneuver. Furthermore, the implementation of new expansionary policies may call into question the credibility of CBs. On the fiscal side, governments are constrained by high debt levels and budgets that are set to deteriorate as a result of demographic headwinds & rising entitlements. Prudent reforms, such raising the retirement age, would help; however, they are politically in unfeasible.
This paper is organized as follows. The next section of this paper reviews industry and academic research about unconventional policies and their effects on financial markets. Here are some of the key takeaways:
- Extreme events have become more common because of internal changes to the system
- Helicopter money has strong historical precedent
- The world economy is following in Japan’s footsteps
- Policymakers have used up most of their ammunition
- Even at the ZLB, expansionary monetary policy shocks boosted the economy
- The Federal Reserve’s (Fed) QE programs exerted larger effects on asset prices than on capital flows
- Global CBs should be concerned about the spillover effects of unconventional policies
- Unconventional monetary policies were effective in both the pre and post-Lehman periods
Section 3 outlines the data & methodology and examines the effects of unconventional policies on rate volatility. Section 4 summarizes the main findings and presents an overview of policy options.
*Unless otherwise stated, quotations belong to the authors of each research report. (ls – left side, rs – right side).
Helicopter Money: Unconventional Policies & Their Effects On Financial Markets – Background
“The polarization principle” – Matt King (Citi Research) – May’16
Extreme events are becoming more common, as a result of intrinsic changes to the system. There are many risks abound. In the US, there is the risk of a Trump presidency. In the UK, there is a potential for a Brexit. All over the world, there is a trend towards polarization in politics (ls). In Europe there is the UK Independence Party (UKIP) and the Front National. In America, congress is more divided than it ever has been. Polarization is also evident in the economy (rs). “Labor is losing out to profits” and small businesses are losing out to big ones.
Finally, there is polarization in the markets (ls). Pairwise correlations are elevated across indices and asset classes. The world has become complex (nonlinear, sensitive to initial conditions) and adaptive (co-evolving with the environment, feedback determines behavior). In terms of systems, “interconnections are everything, unintended consequences are the norm.” As a result, the global system has become less physical and more evolutionary (rs).
Technology is accelerating these processes. The world is extremely efficient in terms of information & connections. This “hastens feedback loops and evolution.” A “high degree of interconnection” leads to great vulnerability, since distress in one area can spread quickly to another. The resulting distribution of outcomes is negatively skewed.
There are many implications of a polarized world. In politics, populations are disaffected. This leaves them vulnerable to influencers (populism), which increases the probability of extreme outcomes. In terms of profits, it is a “winners take all” situation. Big firms will continue to increase their market shares, making it difficult for smaller companies to make profits (ls). With fewer dominant firms, brand value is increasingly important. That said, top brands are more vulnerable to technological disruption? than they ever have been.
On the employment front, more jobs have been created at the lower and higher extremes of the income distribution, with not much in between. In regards to the economy, a smaller labor share of has led to slower growth. Moreover, labor rigidity, which makes the hiring and firing of workers inefficient, could be reducing productivity (rs).
In the credit markets, cheap financing has resulted in a massive increase in leverage. As a result, the potential for tipping points is high. Excess debt and a risk-off environment could lead to a wave of defaults.
With respect to the markets, it seems as though the leverage cycle is almost over. “This may help to explain why equities are jittery.” Heightened volatility is also apparent across markets and asset classes. Daily moves > 4 standard deviations (SDs) have been quite frequent since late 2014.
In conclusion, extreme events are becoming more common because of internal changes to the system. As a result of how things have developed, the world economy & markets are more vulnerable to external shocks.
“Helicopters 101: your guide to monetary financing” – George Saravelos, Daniel Brehon & Robin Winkler (Deutsche Bank Research) – Apr14’16
There are four types of monetary financing: 1) QE combined with fiscal policy expansion: “Central banks purchase interest-bearing government debt with a temporary increase in the monetary base. This is accompanied by increased fiscal spending (or tax cuts), enacted by the Treasury in reaction to implicit central bank support for bond markets.” In this case, Assets (A) and Liabilities (L) rise in parallel: Bond holdings increase (A) and so do private-sector cash holdings (L). 2) Cash transfers to governments: “Same as option 1 except the government debt is non-redeemable [perpetuity], and hence the increase in the monetary base is permanent.” Assets and liabilities rise in parallel; however, “in the case where cash is swapped for a zero-coupon perpetuity, assets and liabilities would rise correspondingly, but the central bank would make a loss because it would not receive a coupon on government debt while eventually having to pay interest on bank reserve balances if interest rates rise.” 3) Haircuts on existing CB-held debt: “Restructure or forgive its government debt holdings, improving government debt sustainability and allowing the Treasury room for future deficit spending.” In this case, the value of government bond holdings falls (A) and Equity (E) turns negative to account for the loss. 4) Cash transfers to households: Direct cash transfers from the central banks to individuals. Liabilities rise, “as the public’s cash holdings against the CB would show up and equity goes negative to account for the “loss.”
Monetary financing, aka “Helicopter money,” is a policy tool that has historical precedent in both developed economies (during the two world wars, etc.) and, with less success, in developing economies (Zimbabwe, Venezuela, etc.). In Japan, monetary financing was used successfully in the 1930s. As a result, Japan’s economy rebounded faster than other countries’ did. Moreover, wholesale prices “returned to pre-depression levels and stabilized in 1932…”
In terms of implementation, it is more about politics than institutional constraints: “Historical experience and institutional flexibility provides plenty of room for monetary financing. Ultimately, it is a question of political desirability rather than technical or legal constraints.”
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