If we ever had the means and resources to launch our own academy of finance and economic higher learning, we might dub it Common Sense University and, without question, would appoint Bill White as the Dean.
“One important issue is that we have no agreed model of the interlinkages that affect how financial crises unfold, and thus no way of calculating the probability of a financial crisis. It may in fact be impossible to agree on such models since financial systems are complex, adaptive systems likely to have multiple equilibria and highly non-linear outcomes.” William White, “International Financial Regulation: Why It Still Falls Short”, July 2020.
This is a great note from Bill that was published in 2020 but is just a follow on from decades of explaining the fragility of the financial system and the complex, adaptive nature of economies. Here is a 2004 version of the same thing.
“The principal concern would be that lower interest rates in such circumstances might encourage debt accumulation that, over time, could make the economy as a whole more vulnerable to shocks….The risk is that measures taken to deal with short-term problems in the financial system may inadvertently make problems more difficult to deal with over time.” William White, “Are changes in financial structure extending safety nets?” January 2004.
Common sense, with foresight.
Operating with hindsight, we got a thorough review of the Silicon Valley Bank (SVB) situation from the Board of Governors of the Federal Reserve as overseen by Michael Barr, the Vice Chairman for Supervision. At over 100 pages, you could say it is a comprehensive review, at least for what it covers.
https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf “Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank”
In the cover letter, Vice Chair Barr lays out the four key takeaways as thus:
- Silicon Valley Bank’s board of directors and management failed to manage their risks.
- Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.
- When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough.
- The Board’s tailoring approach to response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) and a shift in stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.
While there is some obvious self-reflection from the Fed here, knocking the efficacy of some aspects of their supervisory oversight, the lengthy report falls short of pointing out the structural flaws of the ticking time-bomb nature of the two-pronged systemic sandpile-stacker of stimulative monetary policy and, what we would call, Sharpe World regulatory constructs.
Just a couple of punchy one-liners hint at what they really think.
“Protecting profitability was the focus.”
This would be better understood by replacing ‘profitability’ with the more accurate descriptor of ‘regulatory accounting profitability’. By managing to the calendar period, accrual accounting driven, nature of their chosen key metric, Net Interest Income (NII), they ignored the balance sheet threatening nature of their Asset-Liability mix. As is far too common in such circumstances, even allowing the respective accounting treatments to drive their decision making on booking profits on interest rate hedges. This all, inevitably, is linked to the next bit of clarity.
“The incentive compensation arrangements and practices at SVBFG encouraged excessive risk taking to maximize short-term financial metrics.”
Again, we might clarify that it is not simply “excessive risk taking” but the wrong sort of risk taking. The sort of risk taking that is optimizing towards a very flawed metric of vastly distorted forms of regulatory based risk and accounting treatment.
For a simpler and clearer discussion on this topic, readers can refer back to our March 2023 Update, “Probability vs Possibility”. https://convex-strategies.com/2023/04/14/risk-update-march-2023-probability-vs-possibility/
The issue of the linkage to the Fed’s extreme monetary policy is not really addressed, other than indirectly in relation to the explosive growth of SVB, overall, and in particular as related to uninsured, low-cost deposits and then, subsequently, to SVB’s misplaced belief in the Fed’s own rhetoric about the transitory nature of inflation and, thus, lack of any necessity for future higher levels of interest rates.
Raghuram Rajan penned a short piece bringing up this same issue.
https://www.project-syndicate.org/commentary/central-bank-separation-principle-a-factor-in-svb-banking-crisis-by-raghuram-rajan-2023-05 Raghuram Rajan. “Not Buying Central Banks’ Favorite Excuse”
“… the report does not address a crucial matter: the Fed’s monetary policy. This is partly by design: the report was intended to review the Fed’s supervision and regulation. Yet by focusing only on these issues, it ultimately ignores one of the most important factors affecting financial-sector stability. SVB was not just one bad apple.”
Rajan poses the obvious, we might say common sensical, rhetorical question – “Could monetary policy be the systemic force that created the systemic vulnerability?”
He went further – “Bankers were greedy, and supervisors erred in not being alert to such greed, but was the Fed not also guilty of ignoring the foreseeable consequences of an extended period of easy money?”
Again, while we extol his willingness to point out the dangers of mass liquidity provision, we might be slightly critical of Rajan on this point. Should we expect bankers not to be greedy? If the regulatory construct, backed by significant moral hazard and near zero funding costs, incentivizes this behaviour, should we expect bankers to ignore it and behave against their own interests, in direct conflict with the path that regulation is guiding them towards? Take it from us, that is a hard battle to fight from within almighty Sharpe World institutions.
Regular readers will know that we talk about this stuff incessantly. Here from our April 2021 Update, “Shannon’s Entropy” https://convex-strategies.com/2021/05/21/risk-update-april-2021/ :
“We might conjecture that, if in any way the market is using their short time series and probabilistic based risk models, the pricing to protect against a return to longer-term historical norms is probably pretty attractive. Or, looked at from the other side, the low yield and supposed risk-mitigating benefits of fixed income holdings could just be a ticking time-bomb. Even worse so if you factor in the self-organized criticality, cum reflexivity, of leverage applied to “low risk” assets in the fiduciary world. If you think the leverage provided by highly regulated banks to the likes of Archegos (on things like Viacom shares with historical realized volatility of circa 30%) was crazy, just imagine the leverage the same guys are giving on fixed income type structures where the underlying has realized volatility in the low single digits. The Self-Organized Criticality, cum reflexivity, of this exposure is truly the greatest fire risk in the system today. As we have said so many times before, the system is one big LTCM now.
As usual, it all brings us back to dead capital tied up in investment portfolios allegedly with the purpose to diversify and risk mitigate yet measured by a return metric. Broadly speaking, the bulk of this is in fixed income and carry strategies. Again, if you think there is a lot of leverage backing beta, you can hardly imagine how much there is behind carry. In a recent speech, one of the RBA’s Deputy Governors threw out the following gem as regards their upped intervention to keep bond yields from moving higher: “We were not concerned about the fact that bond yields were rising nor the volatility per se, but rather market functioning.” Aside from wondering what “functions” they are worried about that do not encompass direction and volatility, one can only imagine what happens if ever the market truly tests yields out in the tails. Maybe that is why such officials make speeches that sound more like wistful guidance than any sort of valued and thoughtful analysis.”
Of course, Vice Chair Barr, right out of the gates, makes it very clear that SVB is not indicative of any sort of systemic issue.
“Our banking system is sound and resilient, with strong capital and liquidity. And in some respects, SVB was an outlier…” As we have done before, paraphrasing Rick from Casablanca, we would say SVB was just like any other bank, only more so.
Having gotten the obligatory clarification that everything is fine out of the way, Chair Barr throws out a quality stream of hindsight statements of common sense.
“Higher capital or liquidity requirements can serve as an important safeguard until risk controls improve, and they can focus management’s attention on the most critical issues. As a further example, limits on capital distributions or incentive compensation could be appropriate and effective in some cases.”
“Supervisors should be encouraged to evaluate risks with rigour and consider a range of potential shocks and vulnerabilities, so that they think through the implications of tail events with severe consequences.”
“We should re-evaluate the stability of uninsured deposits and the treatment of held to maturity securities in our standardized liquidity rules and in a firm’s internal liquidity stress tests.”
“We should require a broader set of firms to take into account unrealized gains or losses on available-for-sale securities, so that a firm’s capital requirements are better aligned with its financial positions and risk.”
“Oversight of incentives for bank managers should also be improved. SVB’s senior management responded to the incentives approved by the board of directors; they were not compensated to manage the bank’s risk, and they did not do so effectively.” (Highlights are ours)
One cannot help but wonder just to what extent the above points represent a new level of learning and knowledge for the world’s pre-eminent banking regulator. As ever, without accountability, it seems, there can be no learning.
Sticking with the theme of common sense with the benefit of hindsight, this time focusing on the other side of the consequences of extreme monetary policy, we had the great pleasure of stumbling upon a couple of papers that were presented, by very prominent experts, at a recent Hutchins Center on Fiscal and Monetary Policy at the Brookings Institute conference. Both papers focus on the recent, unforeseen by the collected experts, era of higher inflation.
Up first, a paper presented by Sharpe World heavyweights, Ben Bernanke and Olivier Blanchard: “What caused the U.S. Pandemic-Era Inflation?”
The authors construct what they dub “A Simple Model of Wage-Price Determination”. Once you get past the mumbo-jumbo of the Sharpe World construction (eg. SVAR, structural vector autoregressions, and PCA, principal component analysis) and questionable assumptions, it is not such a bad paper, in that it reaches some obvious common-sense conclusions. No small achievement in this crowd.
“If, in our model, an economy experiences large price shocks, they will lead to strong but mostly temporary increases in (headline) inflation. The persistence of those increases depends on the anchoring of expectations and the degree of real-wage rigidity. If the economy experiences overheating in the labor market, it will see a slow but steady increase in inflation, with the rate of increase reflecting not only the sensitivity of wages to labor market tightness, but, as in the case of a price shock, on the degree to which inflation expectations are anchored and the extent of real wage rigidity. If the two types of shocks hit the economy simultaneously, the shock to prices will dominate inflation initially. However, as those effects fade, higher underlying inflation emanating from the labor market will become increasingly important.”
As we often say, there is likely good reason that the term “wage-price spiral” exists in the lexicon.
A very quick summary of the highlights of their conclusions:
- “In general, the takeaway is that persistent labor market pressure leads to ever-increasing inflation.”
- “(A)s inflation expectations are not fully anchored, extended labor market tightness can lead to significant additional inflation.”
- “By raising inflation expectations, and to a smaller extent by creating a catch-up effect, these shocks ultimately affected wages as well as prices. However, over time a very tight labor market has begun to exert increasing pressure on inflation, pressure which our model predicts will grow over time.” (Highlights ours)
Put most simply, and a point we will come back to later in the note, the Phillip’s Curve might just be non-linear. The authors conclude that driving factors in the persistence of inflation are what they’ve dubbed the “catch up” factor (ie the making up by labour of past real-wage debasement) as well as the “vacancy-to-unemployment ratio” (their exogenous measure of labour market tightness).
In a massive concession to those day-to-day observers of the real world, the authors concede:
“Over the longer run, then, the critics who worried about an overheated economy leading to inflation may be able to claim some vindication”.
Just “may be able”?
Interestingly, in their forward looking scenario analysis, they run only three scenarios. One where the vacancy-to-unemployment ratio (v/u in their equation) remains at its current level of 1.8. One where the ratio returns to it pre-pandemic level of 1.2. And one where it drops to 0.8. There is not a scenario where the labour market gets tighter and, thus, no scenario of higher inflation.
Figure 1: Bernanke-Blanchford Scenario Analysis
The authors close the paper with a fairly strong comment, one that I suspect many of their adherents around the globe, still in the chairs of power, paid attention to – “labor-market balance should ultimately be the primary concern for central banks attempting to maintain price stability.”
Better late than never.
The second paper of note from the Hutchins Center comes from Gauti Eggertsson and Don Kohn. It is titled “The Inflation Surge of the 2020s: The Role of Monetary Policy”.
We would go so far as to say that this is a great paper; quite high praise given our usual scepticism.
The paper zeroes in on the August 2020 revised Federal Reserve “Statement on Longer-run Goals and Monetary Policy”, aka the Fed’s Policy Framework. It was this revised statement that introduced, indeed hardcoded, the practice of Flexible Average Inflation Targeting (FAIT).
You can see our thoughts at the time in our August 2020 Update, “Average Inflation Targeting: the beginning of the end”. https://convex-strategies.com/2020/09/21/risk-update-august-2020/
Messrs Eggertsson and Kohn credit this policy, and its two explicit adjustments – 1) FAIT’s mandate to let inflation run hot to make up for past undershoots of target and 2) the shift to an equivalent asymmetry towards the employment mandate where policy focused not on deviations from maximum employment but on shortfalls – with being a key driver of the failure to respond to the acceleration of inflation measures in the 2020s surge. As the authors state it, these changes lead to their key conclusion “that an asymmetric objective function, coupled with the common assumption that policy affects activity with a lag, implies an inflationary bias.”
As with the previous paper, the authors come to the conclusion that the good old Phillip’s curve might just be non-linear! They give us a couple of nice pictures in support of this concept.
Figure 2: Phillips Curve. US Annual Inflation Rate vs Unemployment Rate
Figure 3: Phillip’s Curve. US Inflation vs Vacancy-to-Unemployment Ratio
This again is something that one might suspect other central bankers should be considering as rises in their own measures of inflation remain unexpectedly sticky.
“Waiting for full employment – even accurately gauged – then overshooting because of lags might be especially costly in terms of inflation if the Phillip’s curve is not flat and linear beyond full employment.”
“If the Phillip’s curve is non-linear, and if the US labor market was tight enough for those non-linearities to become quantitatively significant it means the tightness of the labor market, as measured by v/u, not only gave the Federal Reserve a reason to declare it had satisfied the forward guidance of September 2020. It also suggests that failing to recognize this tightness could have been a major source of the inflation surge.”
The authors conclude with a listing of “Lessons Learned”, some of which stray near many of our past points about policy maker’s role as risk managers, as opposed to pointless forecasters. A few of the notable points:
“(E)very new challenge policymakers face is rarely the same as the last one. The current inflation surge is a vivid example of this.”
“A statement on monetary policy strategy ought to encompass a wide range of possibilities, including some that haven’t confronted policy for some time… Among other things, thinking through the alternative possibilities should help the Committee formulate policy when the unexpected happens.”
“The forward guidance issued by the FOMC impinged too far on the ‘nimbleness’ required for good policymaking.”
This is really quite a fun paper to digest as the authors proceed chronologically through the Fed’s statements, aka forward guidance, over the course of their delayed response to their rising measures of price stability. It is, dare we say, quite reminiscent of many of the notes that we wrote over that period, without quite the same benefit of hindsight (just saying!).
It is easy enough to construct a visualization of the vacancy-to-unemployment ratio these guys are talking about and see the 1.8 current ratio. For the below time series, Bloomberg calculates that ratio to be at the 95.5%tile.
Figure 4: US JOLTS (Job Openings) and Unemployed Workers (top panel) Vacancy-to-Unemployment Ratio
Likewise, it is easy to see the relationship between Job Openings and subsequent price stability measures. Sticking in the Fed’s policy rate, and you can see the lag in the policy response as discussed in the above paper.
Figure 5: US JOLTS (blue), Core CPI yoy% (red) and Fed Funds Rate (yellow). First Hike Mar2022 (white vertical)
Taking a broader perspective on the impact of policy setting, we can substitute in the Goldman Sachs (GS) Financial Conditions Index for the policy rate and get some perspective with how that is interacting with the price stability measure, in this case the Core CPI annual change.
Figure 6: US GS Financial Conditions (white) and US Core CPI yoy% (red)
Just simple eyeballing, you could make the supposition that they got started late, in terms of responding to rising inflation measures through tighter financial conditions but have made some progress. Things are much less ‘loose’ on an absolute basis and the rate of change in their price stability measure is moderating.
Showing the same series of graphs for the UK gives a very similar perspective.
Figure 7: UK Job Openings and Unemployed Workers (top panel). Vacancy-to-Unemployment Ratio (bottom)
Figure 8: UK Job Openings (blue) and Core CPI yoy% (red) vs BOE Bank Rate (yellow). 1st Hike Dec 2021 (white)
Figure 9: UK GS Financial Conditions (white) and UK CPI Core yoy% (red)
Again, very similar. Slow to respond, as they (intentionally?) let things “run hot”, then struggling to catch up ever since. We would agree with the comment made by BOE Monetary Policy Committee member, Catherine Mann, at the recent Treasury Committee hearing on Bank of England Monetary Policy: “Tightening and tight are not the same. There has indeed been tightening in financial conditions… but, by my judgment financial conditions are not tight. In particular, real rates are still below zero.” (Highlights ours) She comes in at the very end of the below link, at roughly the 12:05 mark on the clock.
The rest of the clip makes good listening, along with the previous week’s hearing on BOE’s Quantitative tightening linked below, but from the perspective of all that is wrong with central banking. Broadly speaking, both sessions are great examples of the justification of Sharpe World practices and a whole bunch of “nobody could see that coming”.
There was a veritable replay of the above sessions at the Australian Senate Estimates hearing on May 31st with RBA Governor, Philip Lowe (transcript linked below).
Governor Lowe’s circumstances look, more or less, the same.
Figure 10: Australia Job Openings (blue) and CPI Trimmed Mean yoy% (red) vs RBA Policy Rate (yellow). 1st Hike May 2022 (white vertical)
Same story. Waited too long. Raced to catch up. Hoping to declare victory.
According to Mr. Lowe’s testimony:
“Our current central forecast is that the headline inflation rate returns to three per cent in mid-2025. That’s a bit later than many other countries have inflation returning to target, but we’ve consciously taken that decision to have a slower glide path back to target. The reason we’ve done that is we want to do whatever we can to preserve the gains in the labour market we’ve achieved.”
Governor Lowe is hopeful that all this renewed talk about wage and labour non-linearity is exclusively a Northern Hemisphere phenomenon.
Figure 11: Australia GS Financial Conditions (white) and CPI Trimmed Mean yoy% (red)
Paraphrasing Ms. Mann, tightened but not tight. There is, however, the one obvious exception to the above global consensus. Japan is still on maximum loose.
Figure 12: Japan Job Openings (blue) CPI ex-Fresh Food and Energy yoy% (red) vs JGB 2yr Rate (yellow). No Hike!
Figure 13: Japan GS Financial Conditions (white) and CPI ex-Fresh Food and Energy yoy% (red)
We need not wonder if BOJ is aware of all this noise and fervour around non-linearity because they themselves just published a note on the topic titled “Nonlinear Input Cost Pass-through to Consumer Prices: A Threshold Approach”.
Just like everybody else, the undertakings of these studies landed on the box we would label as ‘common sense’.
They break their results into three main findings. All of which should sound familiar.
- “there is a statistically significant nonlinearity in that the pass-through to CPI inflation of the increases in producer prices, exchange rates, and wages rises once the increase in each of these variables exceeds a certain threshold.
- “our nonlinear model is superior to the linear model used in previous studies in terms of in-sample model fit and out-of-sample forecasting performance, suggesting that the linear model underestimates the degree of the pass-through of an input-cost increase that exceeds the threshold while overestimating that of a smaller input-cost increase.
- “the estimated impact of the nonlinear pass-through of increases in producer prices and exchange rates on CPI inflation is often transitory, whereas that of wage growth tends to be persistent due to the observed higher inertia in wage growth.” (Highlights ours)
The authors come to the same conclusion that was emphasised above:
“These results suggest that whether a nonlinearity will arise in the pass-through of wage growth is one of the most important issues for future developments in CPI inflation.”
They put in a simple theoretical chart that looks very much like the empirical Phillip’s curve ones from Messrs Eggertsson and Cohn above.
Figure 14: BOJ Hypothetical Nonlinear Pass-through of inflation
New BOJ Governor Ueda gave his first speech as Governor this month, and seemingly had not yet been made aware of the ongoing evolution towards non-linear thinking.
https://www.boj.or.jp/en/about/press/koen_2023/data/ko230519a1.pdf. Ueda “Basic Thinking on Monetary Policy and the Outlook for Economic Activity and Prices”
Throughout this speech, Ueda-san continues to espouse virtually the identical arguments made by the Fed, ECB, BOE, RBA, etc, prior to their own subsequent recognitions that the inflationary pressures needed some sort of response other than staying on the most aggressively stimulative monetary settings in history. The BOJ has yet to come to that recognition.
Ueda-san seemingly still firmly resides inside the comforting walls of Sharpe World. His representations of the Phillip’s Curve talk in terms of shifts in the linear regressions, as opposed to some concept that they may in fact represent the non-linearity as shown by his own research staff. He puts in four different charts of the Phillip’s Curve (note, he uses the Output Gap as opposed to something like the Jobs to Applicants Ratio), across three differing time series, all making the argument that the relationship is linear, and any change is a shift in the linear curve.
Figure 15: Shift in Linear Regression of Japan CPI ex-Fresh Food and Energy vs Output Gap. 1983-2012
Figure 16: Shift in Linear Regression of Japan CPI ex-Fresh Food and Energy vs Output Gap. 1998-2019
Figure 17: Regression of Japan CPI ex-Fresh Food and Energy vs Output Gap. 2013-2023
Figure 18: Regression of Japan CPI ex-Fresh Food and Energy vs Output Gap and Shift in Linear Assumption of Inflation Expectations. 2013-2023
We hate to say it, because we were so hopeful that Ueda would be a refreshing departure from the Kuroda led BOJ, but we find this speech terribly disappointing. The speech, in our opinion, aligns much more to the type of central bank “communication” strategy we outlined in our February Update, “Sharpe World is Nefarious”. https://convex-strategies.com/2023/03/16/risk-update-february-2023-sharpe-world-is-nefarious/
Ueda concludes with this piece of expectations management, even as he credits it as being risk management.
“Applying this to the current situation in Japan, the cost of impeding the nascent developments toward achieving the 2 percent price stability target, which are finally in sight, by making hasty policy changes would be extremely high. While there is an opposite risk that inflation will remain above 2 percent if a change in policy falls behind the curve, the cost of waiting for underlying inflation to rise until it can be judged that 2 percent inflation has fully taken hold is not as large as the cost of making hasty policy changes.”
Be careful what you wish for.
The concepts addressed in the above Bernanke-Blanchard note might deserve some consideration. As noted in this story, Japan nominal wages in the fiscal year ending March 2023 rose 1.9%, the fastest increase in 30years. Yet, given the 40yr highs in their CPI measures, this resulted in real wages falling 1.8% over the period. The worst result since 2014. Sounds like a recipe for the non-linearity and catch-up effect discussed in that paper.
Most readers will be familiar with our consistent line of questioning for central banks. We have now added, relevant to them all but most particularly for the BOJ, a fourth question in our series.
- While undertaking extreme policy measures (ZIRP, QE, YCC, etc) targeted at raising their inflation measures, we ask – “What if it works?”
- When economies start to show signs of heating up, yet central bankers want to stick to their extreme stimulative policies because they are concerned about the system-fragility to higher interest rates, we ask – “How did you think it would end up?’
- When central bankers explain that the clear signs of overheating (eg. rising price and employment metrics) will imminently reverse, regardless of their extreme policy measures targeted at stimulating those very metrics, we ask – “If you are certain your extreme policies won’t work, why did you ever do them in the first place?”
- When their price stability measure sustainably exceeds their mandated target, we ask – “How will you attack your price stability mandate from above your target?”
The answers from BOJ representatives to our question number 4 translates to something like this “Does not compute. Does not compute. Does not compute.”
For a small dose of common sense, from a non-Sharpe World resident, we recommend a read of this short note from former BOJ Governor, Masaaki Shirakawa.
Shirakawa-san questions a wide range of the current consensus around central bank orthodoxy. Forward guidance. Focus on the zero lower bound. Monetary policy as the cure to structural problems. Most particularly, the global harmonization around a “one-number-fits-all” inflation targeting regime.
“Inflation targeting itself was an innovation that came about in response to the severe stagflation of the 1970s and early 1980s. There is no reason to believe it is set in stone. Now that we know its limitations, the time is ripe to reconsider the intellectual foundation on which we have relied for the past 30 years and renew our framework for monetary policy.”
Quick run-through of the state-of-play in Japan.
Figure 19: Japan CPI ex-Fresh Food and Energy yoy% (red). USD/JPY FX Spot (white). JGB 2yr Yield (yellow)
Figure 20: Japan GS Financial Conditions (orange – inverted). NKY Index (purple). JGB 2yr Yield (yellow)
Figure 21: JGB 2yr Yield (yellow) vs 2yr Interest Rate Swaps: USD (purple), AUD (orange), EUR (white), GBP (blue)
Next BOJ meeting is June 16th.
None of the above dissuades us from our structural concern that, after circa 30 years of successfully suppressing their price stability measures, the almighty central banks may have lost control of their special metric and the world could be in the process of returning to its longer-term historical norm of much higher volatility of inflation, and everything that flows from that.
Figure 22: Eight Hundred Years of Inflation in the United Kingdom, 1217 to 2016. Revised with 2017-2022
What flows from that? Likely a whole bunch more things that, in hindsight, folks will describe as non-linear.
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