‘Normalisation’ of Monetary Policy: The Candour Behind the Curtain – Part Two

In part one of this series we looked at how central banks are undertaking a programme of ‘normalising‘ monetary policy, a process which began in the U.S. with the Federal Reserve and is now bearing down on the UK and the Euro Zone. To gain an idea of the true meaning behind the term of ‘policy normalisation‘, I presented an overview of the narrative in which Bundesbank Chairman and Chairman of the Board at the Bank for International Settlements, Jens Weidmann, has been communicating over the past twelve months. Let’s now expand on this and develop our understanding further through the perspective of Weidmann himself.

In July 2017, Weidmann delivered a speech at the Austrian Society for European Politics in Vienna titled, ‘Exercising responsibility – how monetary union can be made future-proof‘. As well as reiterating information he had long since conveyed, subtle developments in the narrative of ‘normalising‘ monetary policy were evident throughout the text.

In the run up to the speech, European Central Bank chief Mario Draghi had gone on record as saying that deflationary pressures in the Euro Zone were no longer a concern of the central bank. This was a fact which Weidmann also raised, one that tied in with his long held belief that government bond purchases should be an ‘instrument of last resort‘ and exercised primarily to stave off deflation. As we learnt in part one, price stability (inflation in and around the 2% level) is held up as the beacon of a central bank’s remit. In other words, policy accommodation should come to an end once price stability is assured. Inflation in the Euro Zone is currently at 1.3%, reason enough for Weidmann to state that an accommodative stance on monetary policy remains justified for now. However, this has not stopped him from insisting that the ‘ultra loose‘ policy of the ECB can and must be wound down sooner rather than later.

Weidmann says that monetary policy alone cannot achieve stronger growth in the economy. It can assist for a time insofar as regaining price stability, but it is fiscal and economic policy at government level (such as structural reforms) that are the main drivers for sustainable growth. The lack of support to embrace governmental reform, however, is an issue which Weidmann regularly draws attention to (as have the International Monetary Fund).

Political factors are a major component in how a central bank disseminates policy. It is Weidmann’s belief that the UK Brexit negotiations will ‘absorb the majority of political attention and leave little scope for other major projects‘. A paralysis of progress if you will. The parallel between events on a political level and the actions of central banks is an area which garners little attention within the public sphere. Therefore, discontent within the market can and will in part be attributed as a cause of Brexit. It has been used as a scapegoat ever since the leave vote was confirmed back in June 2016. As I proved in part one, Weidmann has been calling for a tightening of monetary policy in the Euro Zone since 2014 – two full years before Brexit even entered the national lexicon. The plan to ‘normalise‘ policy was already beginning to creep into the narrative – the only element missing was a series of political crisis to divert attention away from what central banks were building up towards.

Another subject that Weidmann devotes attention to is private capital investment. He encourages this as a necessary substitute for central bank intervention, which over the past few years has come in the form of government bond purchases. Back in March 2015, the ECB began their Public Sector Purchase Programme, and have so far invested €1.68 trillion into buying bonds. This programme will come under fresh scrutiny in December 2017, when the ECB are expected to announce a sizeable reduction in purchases starting in 2018. The gradual process of withdrawing stimulus from the Euro Zone began in December 2016 after the central bank ‘tapered‘ its bond buying scheme from €80 billion of purchases a month down to €60 billion. Altogether, the ECB’s balance sheet today amounts to over €4 trillion.

Weidmann is clear when he states that private investors, as opposed to the general public, should bear the most risk when it comes to bond investments. What we have seen instead since 2008 is the Euro Area having to ‘cushion the unsound practices of individual states to preserve the union.’ Namely, an avalanche of government bond purchases by central banks, with the ordinary taxpayer accountable for the liability as a result.

This takes us back to the premise of The Maastricht Treaty (highlighted in part one). Building upon what Weidmann has already discussed, he believes that the safeguards built into the treaty were insufficient to prevent government debt from spilling over and causing a near collapse of the Euro Area financial system. Monetary measures have since ‘softened the principle of independent responsibility‘. In essence, economic and fiscal policy are issues of ‘national ownership‘.

The need for ‘restoring the balance between actions and liabilities‘ equates to ‘reinforcing the principle of individual national responsibility‘. Weidmann views this as the most likely option over a full scale fiscal union, one in which countries would have no choice but to cede a majority of national sovereignty and hand decision making over to a centralised authority. Discounting for a moment the idea of a fiscal union, what it would leave us with is financial markets taking the brunt of risk on matters such as lending. The Euro system, shored up as it presently is by the ECB, would become ‘less of a firefighter‘.

This brings us onto one of the main topics of Weidmann’s discourse – the subject of government bonds. A starting point to this conversation is the role of the European Commission. The EC was founded back in 1958 and is recognised as a political institution. It has the responsibility of proposing legislation, implementing decisions and upholding EU treaties. From Weidmann’s perspective, it ‘strikes a balance between various policy interests of member states‘, meaning that ‘compromises are made at the expense of budgetary discipline‘. A solution to this would be for an independent institution to assume responsibility for fiscal surveillance from the European Commission and employ a ‘less political approach‘.

A strengthening of the European Stability Mechanism (ESM) in overseeing fiscal surveillance is also encouraged by Weidmann. The ESM was first established in 2012 as a permanent agency and is based in Luxembourg. Possessing a lending capacity of €500 billion, the mission of the ESM is to:

provide financial assistance to euro area countries experiencing or threatened by severe financing problems. This assistance is granted only if it is proven necessary to safeguard the financial stability of the euro area as a whole and of ESM Members.

Ultimately, the retention of member states’ fiscal autonomy means that the ‘sustainability of public finances cannot be safeguarded by rules alone‘. According to Weidmann, a necessity going forward has to be a normalisation of interest rates and a greater acceptance from investors to take on more risk:

Interest rate levels have to be aligned more strongly again with the risks in government budgets. Investors must accept more risk of losing money if bonds are bought from governments overseeing unsound public finances.

Weidmann’s solution is for government bond maturities (which usually vary between 1 month and 30 years) to be extended as soon as a government issuing bonds applies for ESM assistance. As Weidmann has put it, this would leave investors ‘on the hook‘ as opposed to the taxpaying public. At present, assistance loans through the ESM are being used to pay off original creditors and are letting banks off the hook at the expense of taxpayers. Extending maturities would therefore curtail this process and maintain original bond holders as liable. In short, the extension of bond maturities would reduce the reliance on ESM assistance given that the private financial capital of investors would remain their own personal liability.

Another factor is that the appetite of banks to purchase sovereign bonds would be limited ‘if bonds had to be backed with capital‘, as is the requirement with private loans. Currently, financial institutions in the Euro Area are not required to hold any capital against government bonds to provide cover for the possibility of a default. Weidmann also confirms that there is no limit on the amount of government bonds that a bank is authorised to purchase. In contrast, corporate bonds do require that capital is leveraged against the bonds.

Banks will be able to cope with the restructuring of sovereign debt only when banks hold sufficient capital against government bonds and a limit is placed on the size of individual exposures. And only then is there also likely to exist the political will to take such action.

Weidmann takes this a stage further by stating that the ‘nexus‘ between sovereigns and banks must be ‘severed‘. This being the nexus that ‘fanned the flames of the Euro area crisis‘. Weidmann once more touts a solution to the problem, in the form of a proposal from a man called Markus Brunnermeier. Brunnermeier is a German economist and also a member of several different advisory groups including with the IMF, the Federal Reserve Bank of New York, the German Bundesbank and the U.S. Congressional Budget Office. The solution is for sovereign bond-backed securities.

The premise for the idea is that the range of AAA rated bonds would be increased, allowing for two tranches of new securities to be created. Both tranches would be collateralised with bonds from all countries in the Euro area. Losses in these bond investments would initially occur in the junior tranche, with the senior tranche designed to be safer and less penetrable to loss. The senior tranche would therefore be designated as ‘European Safe Bonds‘, which have already been coined as ‘ESBies‘.

According to Weidmann, the present risk of a sovereign bond default is highly correlated, meaning that the struggles of one country presents the likelihood that others too will endure difficulties. He is quick to stress that Brunnermeier’s proposal must not result in new securities leading to ‘greater mutual liability‘. This takes us back to the ‘no bail out‘ principle that Weidmann regularly discusses. The more culpable the Euro Zone as a whole becomes for the failings of one nation’s finances, the more this undermines ‘individual national responsibility‘. This is further underscored when he says that sovereign bond backed securities should only be issued by ‘private financial market players‘, and not by ‘European debt agencies that have a government guarantee‘. The separation of public and private liability is a key component in Weidmann’s narrative, but perhaps not for the reasons he espouses.

Whilst Weidmann is supportive of Brunnermeier’s idea, he ultimately returns to what he has been saying for months – that safe investments can only be generated by member states by ‘ensuring sound public budgets‘. Simply splitting bonds into separate tranches will not be sufficient in eradicating risk.

In conclusion, what we can take from Weidmann’s position is that the preservation of the union was ensured by way of ‘ultra accommodative‘ monetary policy. This is now coming to an end as we have already observed through the actions of both the Federal Reserve and the European Central Bank. The process is gradual however. It is not going to amount to a sudden withdrawal of all stimulus, but what it will do over time is allow for the creeping of negative sentiment to gain a foothold in the financial markets. As evidenced in 2008, the stock market is a fledgling indicator. It is the last link in the chain to break when a collapse occurs.

Weidmann’s narrative of individual responsibility could be construed as a way of maneuvering national governments into a position of failure. He speaks of how a decentralised approach is the most likely outcome towards monetary reform, but it is logical to surmise that tightening policy now creates the necessary conditions for the management of government debt to become unsustainable. The truth is that there are no foundations beneath the trillions of dollars of stimulus that central banks have plied the markets with for the past decade. Ultimately, should national debt come under increased strain amidst the withdrawal of accommodative measures, then the calls would grow vociferously for greater economic union and for powers to be stripped from individual nations in favour of centralised control.

From my perspective, the most critical aspect to remember here is that globalist institutions like the Bank for International Settlements and the International Monetary Fund (of which Weidmann is a important figure in both) are ultimately seeking complete centralisation and control of the financial system. If we take that to be true, consider how debt levels have spiraled over the past nine years since the collapse of Lehman Brothers. Central banks have played the leading role in artificially inflating the markets, by way of almost 0% interest rates and trillion dollar monetary easing programmes. The backstop of central banks has allowed for record highs in leading indexes throughout the world. Take that backstop away and the consequences should be self explanatory.

In part one I stated that:

culpability for an economic downturn is likely to be held up as a consequence of events stemming from Trump and Brexit. The actions of central banks become secondary at exactly the time when they should be most prominent in people’s minds.

As highlighted in my regular economic updates, leading economic indicators are both stagnating and contracting, at a time when interest rates are ‘normalising‘ and ‘ultra accommodative‘ monetary policy is being tightened. This is why the geopolitical climate running parallel to the behaviour of central banks is of utmost importance, and why the decisions made by banks should not be looked upon in isolation.

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