Archive for October, 2007

Analysing financial markets and cricket matches

October 31, 2007

I have been wanting to write this post for quite long but I kept forgetting about it.

I have been noticing for quite sometime that there is increasing similarity between the way we analyse financial markets and the way we have started analysing cricket matches/players.

Analysing financial markets is quite similar to analysing a cricket match and when we pick up certain stocks it is quite similar to picking up key players for the match.

There are two kinds of broad financial market analysis – 1) fundamental analysis (looks at macroeconomics, earnings etc) and 2) technical analysis (looks at charts for trends. I would focus on fundamental analysis as that is where most similarities lie.

  • The fundamental analysts justify performance of a sector/company by highlighting macroeconomy, earnings etc. Now we have analysts in cricket who look at pitch, weather, wind direction etc to predict the course of the match.
  • Most financial research companies pick up sector specialists (those that have worked in textiles, aviation etc) to analyse the sector/companies in their area of specialisation. The idea is that they would have some more ‘insights’ as they have worked in that area compared to someone who has not. This would give them an edge over others and would help produce certain winners.
    Similarly, we have sector experts in cricket-pitch (who talk to groundsman, local ground staff, etc to build their opinion on whether the pitch would suit spinners, batsman, etc.), weather experts (rain, humidity etc).
  • Just like the way analysts dissect the performance of a company/sector in terms of various ratios , multiples, growth numbers to identify winners and loosers we have analysts in cricket that look at various statistics (performance of the  team on the ground the match is being played, best bowling, best batting, averages etc) to predict the winning side.
  • Fundamental Analysis is of 2 kinds- top down (it first looks at macroeconomy, then sector and then companies within the sector) and bottom up (it first looks at top-performing companies and then sees which sectors they are in. And then tries to see whether these companies fit with the macro trend.

    Even in cricket, we have both kinds of analysis. The first would look at who is hosting the match (advantage is mostly for the home team), which place is it being played (whether pitch,weather would suit the home team), then finally the record of individual players in the place, current form etc. The idea is again to pick the winning team (like the winning company)

    The second type of analysis directly looks at current form of players and then sees whether the pitch,weather would suit their style of play. Then they look at the past record of the player on that ground and so on.

  • As if the current set of ratios was not enough we continue to have new ratios, new multiples to understand the performance. Similarly, we continue to have more and more ideas/analysis in cricket matches to identify the likely winner
  • Finally, just like the way stock analysts find it difficult to pick winners, we have the same case in cricket matches as well. There are numerous examples but let us stick to the latest ones. In world cup 2007, no one expected Aussies would be unbeatable and would win so comprehensively especially after the losses to England and New Zealand. Likewise, no one expected India to do so well in Twenty-20.

The learning is not that analysis does not help. It helps as it makes us more aware of the developments. Instead the learning is – it is difficult to pick winners with confidence be it markets be it cricket.

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Assorted Links

October 31, 2007

1. WSJ Blog points to a nice interview of  Alex Weber, ECB Governing Council member.

2. Mahalanobis points to a note by Andrew Lo, MIT financial economist which helps you find out if you are a quant.

3. Rodrik pointsto a huge database being built up at UIUC that will code 30 million plus news reports from all over the world going back to 1946. MR points to a new paper which analyses why research is so good in US.

4. PSD Blog pointsto a Jagdsih Bhagwati interview.

5. TTR writeson recent exit of Merrill chief, Stan O’Neal

6. Ajay Shah on capital account convertibility.

Monetary Policy Update: Mid term Review (Oct 07)

October 30, 2007

RBI has released the much awaited monetary policy. The shorter version in form of press release is here.

Before its Credit & Monetary Policy meeting on 30th October 200, RBI had three major issues that needed to be addressed:

 

  1. Inflation:  Inflation was subdued for most of midterm period (Apr-Oct 07) but it was largely on account of base effect and “halt in pass through of higher international oil prices to domestic prices”. Further as food and metal prices have been rising, this could lead to higher inflation in future.
  2. Liquidity: Indian economy continues to attract foreign capital inflows and this has led to surplus liquidity in the system which has numerous consequences.
  3. Currency: Rupee was appreciating against major currencies leading to worsening of trade balance.

RBI in its midterm policy review has made it clear that surplus liquidity and huge foreign capital inflows is an issue that takes priority over others. It has raised Cash Reserve Ratio by 50 bps to 7.5% which would be effective from 10th November, 2007. The surplus liquidity in the system is estimated at Rs 30,000 cr and the CRR hike would absorb roughly 17,000 cr from the system. In its review, RBI has raised concerns over rising capital inflows on number of fronts (money supply, rising asset prices etc).

 

RBI has not changed the policy rates (repo and reverse repo rates) against the market expectations of a rate cut. By keeping the policy rates unchanged, RBI has suggested that inflation continues to be a concern and rate cut would only lead to built-up of inflationary pressures in the economy. RBI has also kept its GDP growth rate forecast for the year 2007-08 unchanged at 8.5% suggesting GDP would continue to grow and hence inflationary pressures would remain.

 

The policy appears quite balanced, as RBI has also proposed certain reforms to improve Indian financial markets. Recent research reports from IMF, World Bank etc have shown that capital inflows would continue in emerging markets in search for higher yields. If they are controlled, it could lead to capital outflows as we saw in the case of Thailand. Moreover, the emerging markets are generally capital deficient and need more capital to develop their economies. Therefore, the best possible solution to manage these capital flows is by strengthening their financial systems. RBI has been continuously trying to strengthen Indian Financial System and has proposed more reforms in its mid-term policy. Some of the key reforms are:

 

  • Government Bond: Covering of Short-sale and When Issued transactions would now be allowed outside NDS-OM system. This would lead to higher volumes on both the segments. Further, systematically important non-deposit taking NBFCs would be allowed access to NDS-OM system. This would make the system more broad based as it would increase participation. Developments are being made to allow Floating Rate Bonds to be traded on NDS-OM system. This should help build a floating rate bond market in India.
  • Currency Markets: RBI has permitted exporters and importers having exposure to currency risk to write covered call and put options in both foreign currency and cross currency. Further, they can receive premia as well. This would imply treasury departments of various corporates would need to improve their skills to take advantage. Authorized Dealers have also been allowed to run cross currency options books and can also offer American options as well. This would imply Authorized dealers would have to strengthen their risk management systems to manage the American options.
  • Corporate Bond: It has been suggested numerous times to allow corporate bonds in repo markets that would provide the necessary impetus to the moribund secondary corporate bond market. However, nothing has been done on that front. RBI says it is committed to allowing corporate bonds for repos but feels the corporate bond market still needs to be widened. Moreover, RBI feels corporate bonds should have an efficient and safe settlement system in place based on delivery versus payment (DVP III) and Straight Through Processing. Corporate Bonds are now in SEBI’s domain and it is important that both the regulators decide on a timeline for the same.
  • Others: RBI would be issuing final guidelines for Credit Default Swap market that is becoming a necessity for banks to manage their assets liability management. RBI also proposes to cover specific risks like credit risk arising out of deficient documentation and settlement risk under its supervisory process.

 Impact on financial markets

  • Bond Markets: The yields in the bond markets would harden marginally tracking the hike in CRR rate in coming days but are expected to be rangebound over the medium term. The policy document is hawkish on inflation and market participants would be looking at any possible increase in inflation. The inflation is expected to move up on account of rising food and metal prices and if government raises oil prices as well, the yields could be expected to harden in future. Further, higher numbers in GDP, IIP could also lead to build up of higher inflationary pressures in the economy.
  • Currency markets: RBI is silent on the appreciating rupee and has instead shown its commitment to move towards capital account convertibility in gradual manner. It has proposed certain reforms that require corporates/dealers to improve their skill-sets. Rupee is expected to appreciate further as capital inflows are expected to continue.

  • Equity Markets: Hike in CRR would not impact equity markets except for banking sector. The share prices in banking sector are expected to decline in coming days.

Assorted Links

October 30, 2007

1. WSJ Blog points that most economists expect a 25 rate cut in Fed meeting on 31 Oct. All its assorted links for the day are quite good.

Gary Becker has been awardedthe Presidential Medal of Freedom, the highest civilan award in US. Well, he has won Clark Medal and Nobel as well.

2.  Rodrik has Ricardo Hausmann as a guest blogger. Hausmann points to increasing share of women in workforce in quite a few countries.

3. ET(India’s leading business newspaper) has an irritating headline today (30 Oct, 2007, Mumbai edition) which says:

 The first 10,00 took over 20 years. The next came in just 20 months. At $ 1.58 trillion m-cap, India’s No. 9 in the world. Superpower 2020?

Superpower on the basis of rise in the stock market ? Give me a break! I don’t know/understand why/how such learned people in media write such misleading headlines.

Anyways, ET has a nice debate on capital inflows and SEBI move on the PN route. MK Venu feels SEBI did the right thing by putting restrictions via PN route.

4. BS has a nice interviewof ICICI chief KV Kamath. I wonder which research/analysis he is referring to when he says this:

When the economy is growing nearly 10 per cent, the financial services industry has to grow by 30 per cent.

5. 2 new blogs –  first by IMF research director Simon Johnson, two, the Repec Blog.

Monetary and Macro developments- Mid-term review(2007-08)

October 29, 2007

RBI has released its report on developments in Indian economy and financial markets so far i.e. for Mid-term 2007-08. A neat summary of the events is given in RBI’s press release as well. RBI releases this report a day before its monetary policy meeting (whgich is to be held tomorrow Oct 30, 2007).

The report is a summary of developments and economic data releases and most of these are widely covered in media e.g. IIP, BoP, growth in GDP etc. However, in areas like agriculture, public finances etc the report is pretty useful.

On a quick glance, it seems rainfall this year has been above average and as a result kharif crop (on aggregate level) has been better.

On fiscal front, the situation looks grim as both fiscal and revenue deficit are higher.

I would post more as I read the entire report along with RBI’s monetary policy review to be released tomorrow.

Core Inflation vs Headline Inflation

October 29, 2007

I am just trying to catch up with times after the long vacation. I just read this excellent speechfrom Mishkin where he discusses which inflation measure is better in monetary policy- headline or core?

For the uninitiated, Headline inflation is your general index like WPI (for India), CPI etc. that includes all the items used for measuring inflation. Core inflation index excludes a certain items whose prices are more volatile and hence may not represent a true picture of the inflation.

Most countries have their own baskets of goods and services on the basis of which they make an index and inflation is tracked.  But, the excluded items from core inflation are mostly fuel and food items. As both are quite important items for consumers (households) should they be excluded? Or in other words do we need to at all follow core inflation?

Mishkin says yes, despite the problems it makes more sense for a central banker to follow core inflation than headline inflation.

 When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump.  Temporary supply shocks such as these raise the prices of food and energy relative to other prices and can have substantial effects on inflation in the short run.  By including all items–including particularly volatile items like food and energy–headline measures of inflation are inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and that monetary policy can affect.

Research has shown that headline inflation tends to revert strongly towards core inflation over a time period making the case for core stronger.  

Thus, as long as the permanent change in relative energy prices does not lead to a change in the underlying trend rate of inflation–a crucial assumption–then headline inflation will come back down again.  This is what we seem to have seen recently in the United States.  From a low near $30 per barrel in late 2003, the price of oil rose to $70 per barrel by the middle of 2006, and it has stayed high, with the current price more than $80.  That move increased headline PCE inflation to the 4 percent level for a time, but it has since retreated to around 2 percent

However, it is important to distinguish between temporary and permanent changes in prices. Temporary changes would reverse and do not warrant attention but permanent changes especially in the case of oil prices is important.

He goes on to show how economy would look if Fed responds to a oil shock by looking at both headline and core inflation.

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected . 

Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes. 

More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. 

Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate–variability that is much more subdued when policy responds to core inflation

Then he discusses various ways to measure core inflation and why central bankers need to also look at headline inflation. He stresses that Central Banks should clearly communicate their strategy to fight inflation which would lower inflationary expectations in the economy.

Excellent speech from Mishkin. Go through the rich reference list as well.

Assorted Links

October 29, 2007

I am back to work after a long break and hope blogging would be more regular now. Let me begin with putting some useful links/readings together of other bloggers.

1. Ajay Shah hasput together number of articles on India’s mon pol and capital controls. He pointsto an interesting analysis of India’s government bond market. The analysis is good but it just points to one side of the story. I think NDS system has improved transparency in the market by a great deal.

There is an interesting articleby Ila Patnaik on IIP data in India.

2. JR Varma has a nice take on Northern Rock episode.

3. TTR on service quality in London ( I am surprised by this), points to an interesting article by Taleb who takes a swipe at risk management techniques.

4. MR on sovereign wealth funds, pointsto a paper on subprime crisis

5. WSJ Blog points to an interview with Bill Poole, points to 31 Oct being an exciting day for Economists, points to economists reaction to Chinese economy growing by 11.5% in Q3.

6. Mankiw points to correlation vs causation, points to an excellent graph showing taxes as a % of GDp in different countries.

7. Rodrik on football on globalisation.

8. Fin Prof asks do finance profs practice what they preach?

9. Fin Rounds points to alumni networks matter More so in wall street firms.

10. EPSA Blog on reality of Indian primary education.

11. James Hamilton on why oil prices are rising? He also has a post on whether rising oil prices would lead to a recession or not?

Not able to blog

October 19, 2007

I am away on a vacation and despite many events happening have not been able to blog.

I would be Back on 29 Oct full time and would also try and blog  occasionally if I get time.  

Monetary Policy over 50 years

October 12, 2007

BundesBank celebrated its 50th anniversary by hosting a conference titled ‘Monetary Policy over 50 years’. I covered Mishkin’s paper he presented at the conference here .

Lars Svennson, Deputy Governor at Riksbank and professor at Princeton University, has given a speech on the same topic. It is more or less on the lines of Mishkin’s paper but has some more insights.

He begins with Milton Friedman.

In economic research, 50 years is a long time. I will actually start in 1967, with Milton Friedman’s presidential address at the meeting of the American Economic Association, so I will only cover about 40 years.

He discussed what monetary policy cannot do, what it can do, and how monetary policy should be conducted. Regarding what monetary policy cannot do, he noted that it cannot in the long run control real variables such as unemployment and GDP; it can only control nominal variables, such as the exchange rates, the price level, or mone-tary aggregates. These insights were not obvious at the time, but they are now part of the conventional wisdom.

What have been the broad ideas economists have learnt since then?

  • Target money – too difficult to target the price level
  • Monetary targeting failed, but inflation targeting has worked fine
  • Better knowledge about the transmission mechanism
  • Monetary aggregates matter little for monetary policy
  • The importance of the institutional framework
  • Taylor rules are robust but often overemphasized and misunderstood

What do we need to work upon?

  • I believe that it is desirable to do flexible inflation targeting more explic-itly
  • Regarding the ongoing discussion about the role of asset prices in monetary pol-icy, I believe we know enough to state that asset prices should not be targets of monetary policy. As long as their development is not a threat to financial stability and the payment system, they are relevant for monetary policy only as indicator variables, that is, only to the extent that they contain some information about the future target variables (inflation and resource utilization).  However, if credit or asset-price developments indicate threats to financial stability or the payment sys-tem, this may impose restrictions on the normal conduct of monetary policy and also require special actions
     

All is pretty standard stuff except the last point. Riksbank has for a long time defended the fact that Central banks need to only look at inflation. However, there recent mon pol reports have mentioned importance of housing prices which has been criticised as well in Mishkin’s reporton Riksbank. Ingves, Governor, Riksbank also agreed to this in his recent speech at Kansas Fed.

The question is when do you decide asset markets can lead to financial stability. Take this sub-prime crisis. All along Fed said it is within control and then suddenly came the rate cuts and the analysis that all was not well. I am expecting more research on the same in future.

Assorted Links

October 12, 2007

1. TTR points to lack of Phds in IT industry.

2. New Economist on Goodhart’s law.

3. Rodrik has a nice post on China’s billoinaires.  Most are from real estate.

Revisiting Employment situation in India

October 11, 2007

Dr. C. Rangarajan and his team in Prime Minister’s Economic Advisory Council have written a paper on India’s (un) employment situation. I had expressed my frustration earlierthat EAC in its outlook has not expressed anything on unemployment situation especially after reading this paper from Jeemol Unni et al.

Finally we have some analysis on the topic from the team. The findings are largely similar to what Unni et al said which is Although employment has risen in the country, the increase has happened in informal sector and agriculture.

NSS (61 round) survey….. shows a reversal of the declining trend in employment growth rate which increased from an annual 0.98 per cent in the period 1993-94 to 1999-00 to 2.89 per cent in the period 1999-2000 to 2004-05. Interestingly there was also a sharp acceleration in the rate of growth of labour force from 1.03 per cent to 2.93 per cent.

This unprecedented growth in labour force is above the population growth rate…But the real story is:

However the Survey and the projections indicate that a large proportion of the increase in employment is happening in the informal sector and agriculture. This trend is a cause for concern as the relatively low wages and lack of social security here translate into the phenomenon of ‘working poor’ i.e. workers in the BPL households. The new challenge is one of improving the total factor productivity in the informal sector and in agriculture so that there is a significant improvement in the emoluments of those who are employed, that is, in the quality of employment.

The paper analyses the trends in detail but does not offer enough suggestions on how best can we avoid this low skill employment. In other words, how can we move people to more value add jobs in manufacturing and services.

The problem is quite a difficult one to address. Paper by Rajan et al saysIndia has so far focused at capital intensive industry. Hence agri/low skilled labour could not migrate as capital intensive sector needs some skills.

However, all is not lost as some people are looking at solutions. Arvind Panagriya offers his advice on transforming India. Keep watching this space for further developments.

Mervyn King defends

October 11, 2007

Most commentators (including me) had criticised the Bank of England move (here and here) to provide help to Northern Rock and the financial system in the current turmoil.

Mervyn King, Governor of BoE has given a speech explaining the move.

 First his analysis on why did this crisis take place? The savings in emerging marklets increased (after South East Asian crisis) and this led to low interest rates worldwide (supply of savings increases implies interest rates fall) . As interest rates remained low for a while, the investors started to search for high yields which meant complex products and finally the fall. He refers (does not mention it though) to BNP Paribas stating in its press release that it can’t value the funds it was running.

Then he goes on to say what went wrong with Northern Rock and how BoE offered help.

First, we did our routine work in the money markets of lending to the banking system against high quality collateral, such as government debt, and at Bank Rate set each month by the Monetary Policy Committee.

We were, however, pressed to do more than our routine job and to lend in exchange for other collateral, including the financial assets for which the markets had virtually closed. Banks, in particular, said they wanted us to help them turn illiquid assets into cash.

Well, it seems there was a lot of pressure. So BoE extended liquidity only at a penalty rate to reduce moral hazard.

The problem was not with the help, the problem was that King always mentioned no help would come from BoE in this crisis.

He takes a dig at Larry Summers comment:

Some commentators have taken issue with these concerns about moral hazard, arguing, by analogy, that fire departments put out fires started by people who smoke in bed. I agree that we have fire services to do precisely that. And if a fire starts in the financial system, the central bank will put it out if it threatens to spread. But fire services do not offer free insurance for people who smoke in bed or set fire to their own house, thereby encouraging them to take risks that endanger others.

Summary: Summers does not believe in Moral Hazard, but King does.

He explains how cases of Northern Rock and Countrywide (a US home mortgage company) were different. Latter could rescue itself as its deposits were well insured and US itself has a well developed insurance scheme for depositors.

What are his lessos?

1) Bank Regulation should focus on liquidity as well. So far the focus is on capital not liquidity. Superb insight. Economist also points this aspect.

2) Authorities in UK should be allowed to pre-emptively take action in case of Banks (it is allowed in US)

3) Central banks should operate as lenders of last resort.

Then he discusses Bank of England stance on inflation, economy etc.

Excellent speech from King. Highly recommended reading, 

Assorted Links

October 11, 2007

1. TTR says biggest factor in the improved performance of the Indian economy is the increase in savings and investment rates. He also has a nice point about to changing fashion in bank regulation.

2. MR pointsthat this year’s Physics Nobel Prize is what has led to devices like i-pod.

3. WSJ Blog points to a speech from Boston Fed President who says sub-prime lending should continue.

4. New Economist points to new book on Economics and Psychology.

5. Mankiw points to a useful service from Cleveland Fed.

6. EPSA Blog onB’Desh paradox.

Bernanke’s twin

October 10, 2007

I was watching CNBC today and was completely taken aback when I saw the photo of Lupin India’s MD, Dr. Kamal Sharma. Here is his photo:

KK Sharma

Looking at Bernanke, the resemblance is quite stark.

Ben Bernanke

Mr Sharma also has impeccable credentials as his profile shows. Too much of a coincidence this 🙂

Monetary Policy and Stock Market

October 10, 2007

If Central banker raises/lowers interest rates how do stock markets react? Do they go up or down? This question is of immense interest to most.

Bernanke and Kuttner had written a very useful paper on the issue in 2003. As paper is time consuming Bernanke had explained the findings (in English) in his speech in 2003. It is 2007 now and there could be some changes in the results in terms of numbers but I would guess the trend would be similar.

Bernanke explains that it is important to distinguish between expected and unexpected changes in interest rates (the fed funds rate) . If the actual change is as the market expects, then financial markets would have already priced the change, but if it is unexpected (i.e. markets expect a 25 bps cut and Fed announces a 50 bps increase) then the impact can be best measured.  

So, for example, on November 6, 2002, the Federal Reserve cut the federal funds rate by 50 basis points. (A basis point equals 1/100 of a percentage point, so a 50-basis-point cut equals a cut of 1/2 percentage point.)

However, this cut in the federal funds rate was not entirely unexpected; indeed, according to the federal funds futures market, investors were expecting a cut of about 31 basis points, on average, from the Fed at that meeting.

So, of the 50 basis points that the FOMC lowered its target for the federal funds rate last November 6, only 19 basis points were a surprise to financial markets and thus should have been expected to affect asset prices. Note, by the way, that if the Fed had not changed interest rates at all that day, our method would have treated that action as the equivalent of a surprise tightening of policy of 31 basis points because the Fed would have done nothing while the market was expecting an easing of 31 basis points.  

And what were the results? They find that the stock price multiplier for monetary policy is about 4.7 which means if there is a rate cut of 25 bps or 0.25% then stock market is likely to move up by 125 bps or 1.25%.

However, if certain extreme events like when stock markets increased by 5% etc due to rate cut, the stock price multiplier is 2.6.

Now, what accounts for this rise in stock prices? Bernanke says there are three broad channels why stock prices change:

  • First, news that current or future dividends will be higher should raise stock prices.
  • Second, news that current or future real short-term interest rates will be higher should lower stock prices.
  • And third, news that leads investors to demand a higher risk premium on stocks should lower stock prices

Which factor is more responsible?

What we actually found when conducting this statistical experiment was quite interesting. It appears that, for example, an unanticipated tightening of monetary policy leads to only a modest change in forecasts of future dividends and to still less of a change in forecasts of future real interest rates (beyond a few quarters). Quantitatively, according to our methodology, the most important effect of a policy tightening is on the forecasted risk premium

Why risk rises when monetary policy is tightened?

….Tighter monetary policy may raise the riskiness of shares themselves by raising the interest costs and weakening the balance sheets of publicly owned firms. In the macroeconomy more generally, by reducing spending and economic activity, tighter money raises the risks of unemployment or bankruptcy faced by individual households or firms.

Lessons for Mon Pol:

1) Easy Mon Pol (i.e lowering the rates) leads to higher stock prices
2) But mon pol is not very effective for controlling stock prices as the change in stock prices due to changes in mon pol is very small.

This is a wow speech and is highly recommended. It is a la Bernanke.  I however still wonder why he cut rates by 50 bps?

Assorted Links

October 10, 2007

 1. WSJ Blog pointsto Economits comments over the much awaited minutes of 18 Sep 2007 FOMC meeting.

2. Rodrik feels Bhagwati has an evil twin that sometimes takes over when Bhagwati writes.

3. JR Varma comparesCDOs with Banks.

Effective Central Banking

October 9, 2007

Marvin Goodfriend, Professor, Tepper Business School at Carnegie Mellon University, gave a wonderful speech at RBI recently on Central Banking.

He is another inflation hawk and supports inflation targeting framework. The speech is full of examples on why inflation is important and how monetary policy help in lowering the same.

He looks in particular at the Volcker era and how Volcker managed to lower inflation in the US economy despite odds heavily against hiom. He explainns, earlier on the Fed struggled to rein in inflation and preferred to lower unemployment instead and let inflation rise. As a result inflation expectations were always high and inflation could never be lowered. Volcker changed all that.

He mentions about the importance of independence of central banks and makes a very vital point

Central bank independence in support of a commitment to price stability is rightly regarded as an essential element of effective monetary policy. Yet neither central bank independence nor the commitment to consistent price stability can be secure unless the Treasury’s power over exchange rate policy is clearly subordinated to the nation’s commitment to price stability.

He suggests price stability in form of an explicit target helps both the Central Bank and the public. If the commitment to price stability is just implicit, the public may not be able to understand the actions.

Suman Bery in BS shares his thoughts over Goodfriend speech.

Assorted Links

October 9, 2007

1. Fin Rounds pointsto a profile of Victor Niederhoffer, a well known hedge fund manager.

2. EPSA Blog is picking up. It has a new guest blogger Emmanuel Jimenez who talks about importance of youth.

3. Economist Blog pointsthat Bill Easterly suggests ADB to shut shop.

Monetary Policy a science or art?

October 8, 2007

Mishkin has presented another excellent paper on Monetary Policy. It is a useful primer addressing the learnings in monetary policy so far.

As Monetary policy has evolved over the years since Milton Friedman days, certain scientific learnings have taken place. Governor Mishkin asks a basic question – is mon pol becoming more of science (i.e. based on scientific principles) or is it still an an art (i.e some judgement is still required)?

What do you think the answer would be? Well, of-course both. 🙂  all economists are two handed.

Jokes apart, it is a good quick read on the learnings so far. Mishkin points to 9:

1) inflation is always and everywhere a monetary phenomenon;
2) price stability has important benefits;
3) there is no long-run tradeoff between unemployment and inflation;
4) expectations play a crucial role in the determination of inflation and in the transmission of monetary policy to the macroeconomy;
5) real interest rates need to rise with higher inflation, i.e., the Taylor Principle;
6) monetary policy is subject to the time-inconsistency problem;
7) central bank independence helps improve the efficiency of monetary policy;
8) commitment to a strong nominal anchor is central to producing good monetary policy outcomes; and
9) financial frictions play an important role in business cycles.

He discusses each one in plain English and cites evidence that why despite many learnings, we still need judgements or why Mon Pol would continue to remain an art as well.

Useful stuff.

Explaining rising forex reserves

October 8, 2007

I had posted about this topic earlier as well where I featured a paper from Joshua Aizenamn.

I read another paper from him and Jaewoo Lee which looks at rising forex reserves from a different angle.

The sizable hoarding of international reserves by several East Asian countries has been frequently attributed to a modern version of monetary mercantilism – hoarding international reserves in order to improve competitiveness. From a long-run perspective, manufacturing exporters in East Asia adopted financial mercantilism—subsidizing the cost of capital—during decades of high growth. They switched to hoarding large international reserves when growth faltered, making it harder to disentangle the monetary mercantilism from precautionary response to the heritage of past financial mercantilism. Monetary mercantilism also lowers the cost of hoarding, but may be associated with negative externalities leading to competitive hoarding.

The broad idea is that East Asian economies have focused on exports to drive their growth. Earlier, they did this by providing export subsidies, easy credit to exporters etc which the authors term as financial mercantilism. When the South east Asian crisis happened this was exposed and an attempt was made to create more competition and do away with providing implicit help to exporters.

However, most East Asian economies still rely on exports for their growth. They do this by keeping their currencies undervalued compared to their peers. The currencies are kept undervalued by intervening in forex markets and buying foreign currencies and not letting the currencies appreciate. This they call as Monetary Mercantilism.

The authors then discuss the positives and negatives of each.

The two forms of mercantilism differ considerably. Financial mercantilism operates though the direct cost of investment, and may increase investment in enduring ways. In its incarnation as export-oriented growth strategy in East Asia, financial mercantilism can improve long-run economic efficiency when there are strong dynamic externalities in the economy, such as learning by doing and knowledge spillovers.

In contrast, for monetary mercantilism to be potent, prices and wages should adjust in an extremely sluggish manner, and trade rivals should refrain from adopting similar policies. If other countries adopt similar mercantilist policies, they can undermine the exchange rate effect of the mercantilist attempt by the home country and lead to a competitive real depreciation.

The costs- FM increases financial fragility and MM leads to costly sterilization. If other countries also hoard, then problems become more acute as it leads to competitive hoarding.

Read the paper for more insights.


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