Own goals from the ECB and FED this past week highlight yet another secular trend in the current paradigm shift: the rise of the engineer and the fall of the economist. While both deploy a mathematical toolkit, economists are ideologues and engineers are pragmatists. Only the latter is consistent with the scientific method. The problem is not unorthodox policy, which is only a reflection of the new reality of structural spare capacity, low growth, and the threat of deflation. Rather, it is the lack of sufficient skills at Central Banks for dealing with the challenges of implementing these new and unfamiliar policies. As the plumbing of the system has become dramatically more important, a different blend of skills and training is required to appropriately structure and risk manage policy…
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Own goals from the ECB and FED this past week highlight yet another secular trend in the current paradigm shift: the rise of the engineer and the fall of the economist. While both deploy a mathematical toolkit, economists are ideologues and engineers are pragmatists. Only the latter is consistent with the scientific method. The problem is not unorthodox policy, which is only a reflection of the new reality of structural spare capacity, low growth, and the threat of deflation. Rather, it is the lack of sufficient skills at Central Banks for dealing with the challenges of implementing these new and unfamiliar policies. As the plumbing of the system has become dramatically more important, a different blend of skills and training is required to appropriately structure and risk manage policy.
ECB and FED Own Goals
After the ECB lowered the DFR by 10bps to -0.5% and introduced a tiering formula for bank reserves at their last meeting, some analysts pointed out that the average deposit rate for reserves actually increased by 13 bps. Not the ideal headline for a CB looking to loosen monetary policy. The generous interpretation is that the ECB was aware of this but decided it was the contortion required to help shield the banking sector from even further pain as the other policy announcement of the resumption of QE leads to an even further build-up of excess reserves. However current European dynamics, it is difficult to see how bond buying will be effective in spurring real economic growth without either governments spending more or banks doing more to round trip their excess reserves around the real economy. With only the latter in their control, it is reasonable to assume that there was some intent to incentivize banks to make better use of non-exempt excess reserves.
The intuition that decreasing the marginal rate of reserve remuneration should drive banks to lend more is not an incorrect one but there is one vital constraint that was overlooked. The average decrease in reserve remuneration should be at least the same or lower than in the case before the change. To change behavior on the excess portion of reserves being targeted, either (i) rates needed to be cut significantly more negative than what was delivered, (ii) the amount of zero interest reserves needed to be far lower or (iii) this was achieved with some combination of both levers. The table below indicates the various breakeven options at the ECB’s disposal. In practice, the marginal rates on the targeted portion of reserves would need to be far more negative than the break-evens to change behavior. Given the justified concerns around the health of the banking sector, the most effective course of action would have been to (i) stick with a relatively high multiple for exempt reserves, (ii) chosen a penal marginal DFR well above break-even and (iii) announce the effective DFR rate so as to dilute the psychological effect of the penal marginal rate.
Table 1: Break-Even Permutations
The credibility of the FED has also been under pressure as US overnight repo rates spiked by over 600 bps to reach 8.75% intraday on Tuesday as too much collateral and too little cash sent markets into a tailspin. This emerging market like volatility represents a stronger rebuke to FED credibility than anything that can be mustered from political circles. The combination of macroprudential measures and multiple interest rates is a complex and difficult system to manage but any implementation scheme should be employing some basic risk management skills that appear to have been lacking.
The bottom line is that both implementation schemes have been naïve ex-ante and indicate a strong argument that the mix of skills among the leadership of contemporary Central Banks is insufficient for the new paradigm of central bank engineering.
Gary Licht focuses on emerging and frontier markets, where he has researched and traded a wide collection of countries and asset classes for over 13 years. He also maintains a strong interest in macro, social and development issues. Gary can be reached here.