Speaker 1: Hello, and welcome to another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway and I'm Joe Wisenthal. Joe, we are
Speaker 1: still here at Jackson Hole. We are coming to the
Speaker 1: end of our sort of discussion series, however, and I
Speaker 1: think one of the themes that has emerged from a
Speaker 1: lot of the people that we've been talking to at
Speaker 1: this event is this idea of living with high levels
Speaker 1: of public debt and high inflation all while having basically
Speaker 1: a global financial system that is built on bonds, things
Speaker 1: that are supposed to be boring. They're not supposed to
Speaker 1: see their yields kind of swing wildly, and yet that's
Speaker 1: been what's happening.
Speaker 2: Two things. One is to your point on yields, I mean,
Speaker 2: it's the story of the last year, but it's really
Speaker 2: also like the story of the last month, sure, which
Speaker 2: is that you know, you think things have mellowed out
Speaker 2: and suddenly you get a new spike mortgage rates at
Speaker 2: the high since two thousand and ten year or thirty
Speaker 2: year year old's highest lease since like two thousand and seven.
Speaker 2: The other thing is, can I just say one fun
Speaker 2: thing about Jackson The whole is running into possible odled
Speaker 2: guests on a hiking trail, Yes, which is a really
Speaker 2: fun aspect of here. You notice, like when we're back
Speaker 2: in New York, we have to do all this work
Speaker 2: to try to find guests. You know, here you just like,
Speaker 2: oh hey, it's you.
Speaker 1: You just pick them off in the wilderness. Yeah, like
Speaker 1: creditors you.
Speaker 2: Want to come on the show? Yeah, all right.
Speaker 1: Well, one person we did actually run into while hiking
Speaker 1: is one of our favorite all blots guests. We're going
Speaker 1: to be speaking to Hyun Sung Shin. He is, of
Speaker 1: course economic advisor and head of research at the Bank
Speaker 1: for International Settlements, and we're going to try to synthesize
Speaker 1: a lot of the discussion points we've been having for
Speaker 1: the past day or so, right.
Speaker 2: And to your point, you know, I do think that
Speaker 2: and this was sort of part of the interesting thing
Speaker 2: we talked about with Darryl Duffy, which is that we
Speaker 2: came out of two thousand and eight very focused or
Speaker 2: two thousand and eight two thousand and nine like very
Speaker 2: focused on credit risk, like downside risk, etcetera. And I
Speaker 2: think by and large policy makers, we probably did a
Speaker 2: good job of de risking the system from the perspective
Speaker 2: of credit. Right then we got Silicon, we got this
Speaker 2: rate spike, we got the highest inflation in at least
Speaker 2: four decades, we got Silicon Valley Bank, and suddenly like, oh,
Speaker 2: there's other risks. It's not just credit risk.
Speaker 1: Well, we reduced credit risk at the expense of interest
Speaker 1: rate risk, it feels like, and we sort of buy
Speaker 1: design made bonds really fundamental to the way that, again
Speaker 1: the financial system works. So we need to dig into
Speaker 1: these financial stability risks as they are now. So without
Speaker 1: further ado, let's bring in Hun Hun. Thank you so
Speaker 1: much for coming back on. I think this must be
Speaker 1: your fourth or fifth opposite something like that, but.
Speaker 3: Our first person, which yeah, absolutely, I mean I was
Speaker 3: going to say, it's such a pleasure to do this
Speaker 3: in person, Tracy, and it's a great topic, of course,
Speaker 3: and I think you've had other people on during the
Speaker 3: day that have explored bits of this. But maybe the
Speaker 3: thing to the point to stop this is just to
Speaker 3: take a step back and have an overview of the
Speaker 3: way that the structure of intermediation has changed since the GFC.
Speaker 3: As you say, Joe, the GFC very much was around
Speaker 3: the banking sector and in particular credit risk. The idea
Speaker 3: is that you need capital there to absorb losses on
Speaker 3: the assets because they're risky assets, and that's the way
Speaker 3: that you protect the depositives and other claimholders. I think
Speaker 3: what we saw in March twenty twenty with the stress
Speaker 3: episode in the treasury market is that even safe securities,
Speaker 3: it can be at the center of a financial stress event.
Speaker 3: I think the UK guilt episode last year. Again, these
Speaker 3: are safe assets, but they were very much at the
Speaker 3: center of financial stress. And I think what that does
Speaker 3: point to is the shifting nature of risks, the different
Speaker 3: propagation mechanisms, and you know, the different set of players
Speaker 3: out there. So we're going from banks to non bank players.
Speaker 3: In the jargon they're called MBFI, it's non bank financial intermediaries.
Speaker 3: But it's not just the intermediaries. I mean, it's also
Speaker 3: the way that infrastructures, you know, CCPs, exchanges, they've also
Speaker 3: become very important as well. So this is I think
Speaker 3: a very very important topic for us to touch on.
Speaker 4: Well, talk to.
Speaker 1: Us more about who those non bank financial intermediaries are,
Speaker 1: because I think people often hear the term, the more
Speaker 1: colloquial term shadow banking, and it sounds kind of nefarious.
Speaker 1: But there are all these different flavors of non bank investors,
Speaker 1: So talk to us about who they are and what's
Speaker 1: happened to them in the years since two thousand and eight.
Speaker 3: Well, you can draw a kind of flow chart here.
Speaker 3: You've seen those in those New York Fed charts where
Speaker 3: you have ultimate creditors on one side and ultimate borrowers
Speaker 3: on the other side, and money flows from right to
Speaker 3: left following the balance sheet direction. We can think of
Speaker 3: something like that in this case as well. We have
Speaker 3: fewer of these bank based intermediaries, although we of course
Speaker 3: still have them, but they've shrunk in size and the
Speaker 3: heft if you like, within the system. Instead, what we
Speaker 3: have are many non leverage players in asset managers of
Speaker 3: various stripes, life insurance companies, pension funds. But I think
Speaker 3: a very very important class of players are the other
Speaker 3: hedge funds as well. There are non regulated market intermediaries there,
Speaker 3: and a very important part of the infrastructure here would
Speaker 3: be the new sexual counterparties other exchanges where rather than
Speaker 3: having intermediation go through a dealer balance sheet, you have clearing.
Speaker 3: You have the central counterparties that actually act as creditors
Speaker 3: and debtors to a wide range of participants.
Speaker 2: So you mentioned March twenty twenty, you mentioned the guilt episode.
Speaker 2: There's also, of course March twenty twenty three with Silicon
Speaker 2: Valley Bank. I guess we have had this run up
Speaker 2: in yields over the last month again, but I don't think,
Speaker 2: you know, nothings.
Speaker 3: Floated, nothing's broken yet.
Speaker 2: Nothing's broken just yet. But it feels like we might
Speaker 2: be in for multiple years of a very different direction.
Speaker 2: Whereas the twenty tens were all about you think great
Speaker 2: checking to go up.
Speaker 5: And they go back down.
Speaker 2: Do you think finally you're breaking out, they go back down.
Speaker 2: It will be in the other direction where we think
Speaker 2: rates and inflation are settling down, but it turns out
Speaker 2: they gather steam. We don't know, but maybe that is
Speaker 2: How do you think about that in terms of like
Speaker 2: systemic risk, financial risk? How is it different than a
Speaker 2: period of like credit risk and slow growth.
Speaker 3: It's worth thinking about the journey that we've been on
Speaker 3: for the last ten years or so, well maybe ten
Speaker 3: twelve years. You know, we've had a very long period
Speaker 3: of loaf of long interest rates and of course central
Speaker 3: bank acid purchases that has really compressed the Yel curve,
Speaker 3: and what that's meant is that borrowers have taken advantage
Speaker 3: of that and they've turned out you know, their borrowing.
Speaker 3: And we see it in the corporate sector. They've really
Speaker 3: turned out the bondissuance. We see it in the household
Speaker 3: sector as well. But I think especially important would be
Speaker 3: the government bond market. There's been an increased duration of
Speaker 3: the bond's outstanding. Not surprising really because government that managers
Speaker 3: would also be taking advantage of the low long term rate.
Speaker 3: So just to give you a number in the Biathaniel
Speaker 3: Economic Report this summer, we had a small discussion on this.
Speaker 3: If you look at the duration in aggregate of advanced
Speaker 3: economic government bonds, it was around seven years at the
Speaker 3: end of twenty ten. That's now nine plus years. So
Speaker 3: we've had a tremendous lengthening of duration, and so as
Speaker 3: central banks of race rates in response to inflation, what
Speaker 3: that's meant is that the price impact has been that
Speaker 3: much larger. So if you're not marking to market, if
Speaker 3: you're using ultimaturity accounting, we call that interest rate risk
Speaker 3: on the banking book, and this is what happened with SVB.
Speaker 3: You don't mark the market until you have too. If
Speaker 3: you're marking to market, then it's duration risk. So as
Speaker 3: long term rates go up, the price of your assets
Speaker 3: will go down accordingly. And the longer the duration, the
Speaker 3: bigger the impact. And I think in that sense there
Speaker 3: is a broad continuum here between what we saw in
Speaker 3: SVB the UK guilt episode. But also I think just
Speaker 3: in terms of emerging market bonds that I think we'll
Speaker 3: also talk about during the course of this conference. So
Speaker 3: I think that's if you like looking through the sector
Speaker 3: to the underlying exposures, and if we do that, I mean,
Speaker 3: that's what's out there. What's different, of course, is that
Speaker 3: inflation is high and so monetary policy has to respond,
Speaker 3: and after a very very long period of low for
Speaker 3: long we are seeing, if you like, the consequences of
Speaker 3: raising rates once the exposure has lengthened.
Speaker 1: So I mentioned this in the intro, and you just
Speaker 1: gave a very good outline of duration risk and this
Speaker 1: idea of additional sensitivity to interest rate moves. But I
Speaker 1: mentioned in the intro that a lot of this is
Speaker 1: by design. We have actively encouraged a lot of investors
Speaker 1: to buy more bonds, and maybe that wasn't an issue
Speaker 1: in the lower for longer era, as you just pointed out,
Speaker 1: but it seems to be problematic in an era of
Speaker 1: high inflation. If not bonds, what do you use as
Speaker 1: the sort of safety net for a lot of these entities.
Speaker 3: Well, I think you know, before we go there, Tracy,
Speaker 3: I think we have to point out that lengthening duration has.
Speaker 2: Also a lot of advantages.
Speaker 3: One thing that is very good with very long duration
Speaker 3: exposures is that with very long duration liabilities is that
Speaker 3: you're not facing the rollover risk that you used to
Speaker 3: if you were borrowing short So you know, for example,
Speaker 3: if you go back to the Asian financial crisis, there
Speaker 3: you have the combination of currency mis as well as
Speaker 3: in maturity mismatch, and if your liability is very short
Speaker 3: term and your creditors want their money back, then that's
Speaker 3: actually going to lead to a much sharper episode of stress.
Speaker 3: So lengthening duration has also a lot of advantages for
Speaker 3: financial stability, for mitigating financial stability risks.
Speaker 1: This would be one reason why we perhaps haven't seen
Speaker 1: as many bankruptcies as were expected as the FED raisers rates,
Speaker 1: because everyone spent the past two years terming out their debt.
Speaker 3: Absolutely, and that's especially true for those homeowners who actually
Speaker 3: refinance their mortgage. I think that's a very very good example.
Speaker 3: And what we also see is that in the household
Speaker 3: sector mortgage duration has also lengthened as well, not just
Speaker 3: in the US, and US is special because of its
Speaker 3: of its institution of a thirty year fixed rate, but
Speaker 3: it's also true in other economies that there's been this
Speaker 3: shifting out. I think on balance, I would say that
Speaker 3: the lengthening of the liabilities is a good thing on balance,
Speaker 3: but every you know, silver lining as a cloud, and here,
Speaker 3: you know, we have exactly this problem that it's not
Speaker 3: a free lunch. You have to pay for the additional
Speaker 3: risk that comes from greater duration.
Speaker 1: And what about the if not bonds, what question? Because
Speaker 1: this is what I struggle with, What is the next
Speaker 1: safe asset? Basically, well, I.
Speaker 3: Think the safest asset is just money, and I think
Speaker 3: this is where the money, in the sense of the
Speaker 3: high powered money that is issued by the central bank.
Speaker 3: So when a central bank conducts QE, what happens is
Speaker 3: the central bank takes out duration by purchasing the bonds,
Speaker 3: but then pays for it by creating reserves that are
Speaker 3: held by the sellers of those bonds, typically commercial banks,
Speaker 3: who then would pass that on to the sellers, you know,
Speaker 3: their customers. What that means, though, is that as interest
Speaker 3: rates rise, the assets that the central banks hold will
Speaker 3: also be subject to losses, and this is why we're
Speaker 3: seeing the spate of losses on set bank balance sheet.
Speaker 3: The important thing about central bank liabilities, though, is that
Speaker 3: they're not subject to redemption. The central bank doesn't have
Speaker 3: to repay the dollar with another dollar, because that is
Speaker 3: the ultimate that is the ultimate liability, and as we
Speaker 3: argue in a BIS bulletin recently, we should not be
Speaker 3: so concerned about central bank losses in the same way
Speaker 3: that we are concerned about losses suffered by a private
Speaker 3: sector entity who are subject to those redemptions. But it
Speaker 3: doesn't mean that there are no limits. I mean, clearly
Speaker 3: there are limits, and we see those limits especially in
Speaker 3: very fragile, emerging and developing economies that don't have the
Speaker 3: same credibility in the value of money as with the
Speaker 3: FED or with an advanced economy with other advant economy central.
Speaker 2: Bank, this is a good time to ask you a question,
Speaker 2: and I also pose this to very Eike and Green
Speaker 2: and earlier conversation balance sheet policy. I mean, I think
Speaker 2: we typically associate FED, QEY, Etceteram. Central banks are building
Speaker 2: out that capacity, and it seems like in the post,
Speaker 2: in the sort of COVID era, we are seeing more
Speaker 2: central central banks having some credibility or capacity enough to
Speaker 2: like be a buyer of last resort for their own
Speaker 2: government bond markets in a way that we didn't have
Speaker 2: in the past. Is that fair? Is that an accurate character?
Speaker 3: I think, Joe, what I would say is, if we
Speaker 3: look at the events of last year, if anything, it's
Speaker 3: been the emerging markets that have done better in some
Speaker 3: respects than the advanced economies. And let me explain what
Speaker 3: I mean by that. So you know, good comparison is
Speaker 3: between the events of last year with the earliest stress
Speaker 3: episode for emerging markets in twenty fifteen twenty sixteen. So
Speaker 3: back then, what we saw was a very strong dollar
Speaker 3: coupled with very low commodity prices capital outflows for emerging markets.
Speaker 3: We saw a sharp steepening of yeld curves. That combination
Speaker 3: of stresses are very typical of emerging market stress episodes
Speaker 3: that were familiar from the textbooks. What we saw last
Speaker 3: year was actually quite different. What we saw was the
Speaker 3: nature of the shocks were different. We had a war
Speaker 3: and a pandemic, and what that meant was when commodity
Speaker 3: prices rose, emerging markets that were commodity exporters actually did
Speaker 3: very well relative to historical experience. If you look at
Speaker 3: the Mexican peso or the Brazilian reality, it actually appreciated
Speaker 3: last year, and that's very different from later the Euro,
Speaker 3: the yen, even all the other advanced economy currencies. We
Speaker 3: see quite a resilient picture and so they didn't even
Speaker 3: need to enter the market like that. Now, Joe, your
Speaker 3: question raises very important issue, which is when can a
Speaker 3: central bank come into the market, intervene and play the
Speaker 3: role of a buyer of last resort. I think this
Speaker 3: is a very very important policy, Sue. Maybe we can
Speaker 3: get back to some of the discussions that's happening in
Speaker 3: the official world, But when we look at the emerging markets,
Speaker 3: in particular emerging market central banks policy makers generally are
Speaker 3: very reluctant to wade into markets in those stressed circumstances,
Speaker 3: and for good reason, because when you go into the market,
Speaker 3: you have to buy the bonds and you're creating reserves
Speaker 3: as the byproduct of that that's going to be held
Speaker 3: by some of the domestic participants. You're creating money, so
Speaker 3: liquidity injection. That has many, many good aspects, But what
Speaker 3: it means is you're also going to put pressure on
Speaker 3: exchange rate. So if you're pushing a lot of liquidity
Speaker 3: into the system and you're a central bank that doesn't
Speaker 3: have the credibility of a central bank like the FED,
Speaker 3: then that's going to lead to a very sharp depreciation
Speaker 3: of exchange rate that could in fact do more harm
Speaker 3: than good. So I think the short answer to your question, Joe,
Speaker 3: is that last year we saw a very different set
Speaker 3: of circumstances. Emerging markets actually did pretty well. I would
Speaker 3: say the major emerging markets did very very well. I mean,
Speaker 3: they are clearly more stressed developing economies that still have
Speaker 3: to borrow in dollars and so on, but emerging markets
Speaker 3: did particularly well. But I think there is a very
Speaker 3: important lesson here on what are the circumstances that mean
Speaker 3: that you can enter the market with impunity and you know,
Speaker 3: when can you enter the market and get away with it?
Speaker 1: Well, why don't we go back to central banks that
Speaker 1: can create reserves without putting necessarily downward pressure on their
Speaker 1: own currencies. I wanted to talk to you about leverage
Speaker 1: and bonds because I think we're used to talking about
Speaker 1: leverage in the context of credit, and everyone remembers credit
Speaker 1: derivatives from their starring role in the two thousand and
Speaker 1: eight financial crisis. But I guess what's perhaps underappreciated, although
Speaker 1: it feels like more people are becoming aware of it now,
Speaker 1: is that there's also a lot of leverage attached to
Speaker 1: the bond market, and we've seen sort of flashes of
Speaker 1: it emerge, most notably in the March twenty twenty treasury event.
Speaker 1: But how are you thinking about that issue and how
Speaker 1: do you see leverage emerging in the world of bonds.
Speaker 3: I think that's a very important question, Tracy, and I
Speaker 3: think it goes to the point made at the outset,
Speaker 3: how is it possible that a safe asset can still
Speaker 3: be at the center of a stress event? And I
Speaker 3: think I think here we have to think about the
Speaker 3: possible reasons for perverse demand responses, and I will sort
Speaker 3: of make it more concrete shortly. By a perverse demand response,
Speaker 3: what I mean is when a price falls, we typically
Speaker 3: would think, well, that means that it's more attractive to buy,
Speaker 3: and so people would come into the market. So when
Speaker 3: the price falls, you expect people to come in and
Speaker 3: pick up the cheap assage. But in these stress episodes,
Speaker 3: which you typically find is that a price decline actually
Speaker 3: generates more sales and that actually, of course leads to
Speaker 3: further price declines and you can have this loop. Now
Speaker 3: why would you have this perverse demand response. Well, leverage
Speaker 3: is one way that you can have that. So if
Speaker 3: you're leveraged. If you're levered and the price of your
Speaker 3: assets fall, well, your creditors want their money back, you
Speaker 3: need to meet margin calls, and you have to sell, right.
Speaker 1: This is something we spoke with Daryl Duffy about that
Speaker 1: typically the thing you sell first is your safest, most
Speaker 1: liquid asset, which would usually be a bond, probably a
Speaker 1: US Treasury of so.
Speaker 3: Absolutely, and so this is how a safe asset can
Speaker 3: still be at the center of a stress event. But
Speaker 3: it doesn't have to be leverage as such. It could
Speaker 3: be leverage like behavior. And what I mean by that
Speaker 3: is what other ways can you have where a price
Speaker 3: decline would beget more sales. I think a typical and
Speaker 3: a very very classical example, and it's in the mortgage market. Actually,
Speaker 3: a well known historical episode is what happened in nineteen
Speaker 3: ninety four when you have this rapid steepening of the
Speaker 3: Yelk curve. The way that the embedded option in the
Speaker 3: mortgage market, in mortgages means that you know when you hedge,
Speaker 3: so when rates go up, the duration increases. Actually because
Speaker 3: people stop refinancing.
Speaker 1: This was the big convexity.
Speaker 3: This was the convexity issue. Now there's something similar also
Speaker 3: in I mean, something similar can happen even in very
Speaker 3: boring sectors like you know, pension funds or life insurance.
Speaker 3: So if you're trying to match duration, and you know
Speaker 3: you have liabilities to your policy holders which are let's say,
Speaker 3: you know, thirty years, but you have assets that are
Speaker 3: ten years, liabilities are much longer duration than your assets. Now,
Speaker 3: when rates rise, the duration comes in both on your
Speaker 3: assets and your liabilities. But because your liabilities are much
Speaker 3: longer duration than your assets, liability duration comes in much faster.
Speaker 3: So what ends up happening is that you find that
Speaker 3: you've got too much duration on the asset side, so
Speaker 3: you have to sell. So what's just happened, you know,
Speaker 3: race rows, but you're ending up selling. That's another example
Speaker 3: of level.
Speaker 2: This is this is the UK story, right, I mean,
Speaker 2: this is similar. This is what happened. I think the UK.
Speaker 3: It's a combination of both leverage and this story because
Speaker 3: there was the LDI fund aspect, which actually gave it
Speaker 3: a further amplification boost. But the underlying exposures I think,
Speaker 3: are you know, really all the same. Depending on exactly
Speaker 3: how it will play out depends on you know, who
Speaker 3: are the main players, but the principles are very similar.
Speaker 3: So even very conventional, very supposedly boring sectors can still
Speaker 3: be the source of these kinds of you know, perverse.
Speaker 1: That's a fun thought.
Speaker 2: Forgive me if like this is like too big picture
Speaker 2: or too meta of a question, but like for a
Speaker 2: sort of market capitalist system, like someone's got to hold
Speaker 2: the risk people need anycome, you know, it seems to me.
Speaker 2: I don't know, maybe there's not even a question here,
Speaker 2: but it seems to me it's like you know, two
Speaker 2: thousand and eight, Okay, if there's too much credit risk
Speaker 2: and too much bad lending to households and German banks
Speaker 2: somehow financed construction in the sun Belt in some way.
Speaker 2: And then now we're talking about like pretty boring in
Speaker 2: boring bonds. Treasury is going up boring sort of simple
Speaker 2: life insurance companies, pension companies not particularly exotic. Is this
Speaker 2: our fate that for the rest of our careers is
Speaker 2: just every ten years we just have to like pinpoint
Speaker 2: a new area. I mean, because it's not like risk
Speaker 2: can ever go away. Someone's got to hold the sse
Speaker 2: that someone's got to make the income to pay the savers.
Speaker 3: I think the key here is that we have a
Speaker 3: diversity of investors. Okay, so whatever we do, we have
Speaker 3: to make sure that when someone is selling, someone is
Speaker 3: actually willing to come in and buy. And the diversity
Speaker 3: of the market participants is absolutely key for this. And
Speaker 3: this is all about finding the right price, and finding
Speaker 3: the right price means that you know, we have buyers
Speaker 3: as well as sellers. The reason why these financial stability
Speaker 3: channels of propagation can be so corrosive is because sometimes
Speaker 3: one part of the market just becomes too big. They
Speaker 3: grew without our knowing it, without our really noticing it,
Speaker 3: and then when something happens, this is when all these
Speaker 3: dynamics take hold. I don't think we need to worry,
Speaker 3: you know, in every ten years that something big will happen.
Speaker 3: It's just a case of making sure that we have
Speaker 3: a diversity of buyers and sellers, of participants in the market.
Speaker 3: And there are some rules of thumb that we should
Speaker 3: use both in the regulation but also for the private
Speaker 3: sector institutions themselves in the risk management. So what are
Speaker 3: some of the potential kind of decision rules that might
Speaker 3: be baked in given the kinds of leverage and other
Speaker 3: exposures out there. Relative value hedge funds I think were
Speaker 3: very important in March twenty twenty that was very much
Speaker 3: about leverage using futures and the cash bonds. Futures implied
Speaker 3: yields a little bit lower because it doesn't take up
Speaker 3: balance sheet, and so you're selling the futures and buying
Speaker 3: the bonds. But then if margins go up, you know,
Speaker 3: you have to either come up with additional equity from somewhere.
Speaker 3: That's very difficult and stressed episode, so you typically end
Speaker 3: up selling. And so this is another case where say
Speaker 3: FACET can still be at the center of this kind
Speaker 3: of episode. So as market observers, as observers from the
Speaker 3: official sector. We just have to be very careful to
Speaker 3: be on the lookout for where these stress episodes might arise.
Speaker 3: I mean, there are some rules of thumb we can use,
Speaker 3: and I think one of the interesting things is that
Speaker 3: for the relative value hedge funds, we're seeing again the
Speaker 3: short positions in futures growing, not in the thirty year
Speaker 3: horizon that we saw into it to twenty, but more
Speaker 3: in the five year horizon, more in the belly of
Speaker 3: the curve this time. But it seems that that's something
Speaker 3: that has come back. It's much smaller than it was
Speaker 3: before the March twenty twenty episode. But these are the
Speaker 3: things that you know, it's not a precise science, but
Speaker 3: these are the things that we can look out for.
Speaker 1: So maybe we could talk a little bit about potential
Speaker 1: solutions to some of these issues. And again we touched
Speaker 1: on this with Darryl Duffy, and he was advocating for
Speaker 1: possibly all to all trading, where you would allow investors
Speaker 1: to trade bonds with each other so that you would
Speaker 1: have to your pointhand a more vibrant, diverse body of
Speaker 1: participants in times of crisis. And the other thing he
Speaker 1: was talking about is central clearing the idea being that
Speaker 1: you create a central entity that can then net positions
Speaker 1: and sort of offset the risk. But a classic critique
Speaker 1: of central clearing is that you are in effect concentrating
Speaker 1: the risk.
Speaker 4: In one big entity.
Speaker 1: And I'm curious you were in the room with all
Speaker 1: the policymakers at Jackson Hall. What were some of the
Speaker 1: debates around these proposals and what are your own views?
Speaker 3: Well, actually I was sitting next to darryl oh Okay,
Speaker 3: and so we had a great discussion on this. I mean,
Speaker 3: and we've had some very good discussions on this over
Speaker 3: the years. I think the plumbing is important. I think
Speaker 3: whenever the plumbing can be improved to improve if you
Speaker 3: like the day to day functioning of markets, that's something
Speaker 3: that we should see. And in fact, the analysis in
Speaker 3: Daryl's paper is really excellent, I think on the policy
Speaker 3: prescription that comes from that, I think that can be
Speaker 3: some diversity views should we say. I mean, you mentioned
Speaker 3: the diversity of the market participants, but that's a necessary condition,
Speaker 3: if you like, for the ol to old trading or
Speaker 3: for central clearing itself to bring to channel that diversity
Speaker 3: into the market. But that is a necessary condition. We
Speaker 3: have to be quite sure that there will be a
Speaker 3: large enough body of buyers out there who will actually
Speaker 3: come into the market. Now, if we don't have that
Speaker 3: diversity sufficiently, and we still have this, you know, one
Speaker 3: way type of market, then simply changing the infrastructure is
Speaker 3: not going to do that. I think the way that
Speaker 3: the policy debate, the policy discussion has gone is to
Speaker 3: look for, if you like a happy mean, some kind
Speaker 3: of balance between how much should we make sure that
Speaker 3: the leverage and other perverse type of demand behavior that
Speaker 3: could arise can be mitigated from the outset? How much
Speaker 3: do we need the Central Bank or other authorities to
Speaker 3: play a kind of backstop role, And in this connection,
Speaker 3: you know, I would just point to your listeners to
Speaker 3: a very important BIS Market's Committee report that we put
Speaker 3: out earlier this year. It was actually from a working
Speaker 3: group that was chaired by Laurie Logan when she was
Speaker 3: at the New York Fed and Andrew Houser at the
Speaker 3: Bank of England. It was very much motivated by the
Speaker 3: March twenty twenty episode, and it turned out that it
Speaker 3: was also know very well timed for the guilt stress
Speaker 3: as well. To kind of long story short, the story
Speaker 3: there is we have to strike a strike a balance.
Speaker 3: In the end, the central bank has to be a backstop.
Speaker 3: So if no one else is there to really pick
Speaker 3: up the pieces, the central bank has to be there
Speaker 3: to cushion that shot, because otherwise the consequences of not
Speaker 3: doing so would be very, very large. But it should
Speaker 3: not be a first resort to the extent possible, So
Speaker 3: whenever possible, it should be a market determined outcome. The
Speaker 3: central bank shouldn't weighed in that the drop of a hat,
Speaker 3: and if you like, influence market outcomes that way. The
Speaker 3: other important point is that there's a very important issue
Speaker 3: here of incentives. If it becomes generally known that the
Speaker 3: central bank's threshold for pain is here and therefore they
Speaker 3: will enter, what that could do is to shift the
Speaker 3: if you like, the incentives in the portfolio decision of
Speaker 3: the private sector market participants. What you're doing by doing that,
Speaker 3: by having a kind of you know, a rule to
Speaker 3: enter the market, would be to lop off the left
Speaker 3: tail of the outcome distribution. Means that it becomes less
Speaker 3: risky to one layer of leverage. And so I think
Speaker 3: it's so if you're looking for a simple answer, there
Speaker 3: isn't one okay, and I think this is where we are.
Speaker 3: The central bank has a very important role to play
Speaker 3: as a backstop, but it should be a backstop rather
Speaker 3: than a intervener of the first result.
Speaker 2: Let me ask this question, but from a very non
Speaker 2: plumbing standpoint, how much would it be beneficial for financial
Speaker 2: stability if fiscal authorities were to play You know, right
Speaker 2: now we've sort of tasked the central banks with fighting
Speaker 2: and there's a lot of spending, and there's a lot
Speaker 2: of stimulus, particularly in the US, and it's sort of
Speaker 2: the central bank's job maybe to counteract that and figure
Speaker 2: out a way to get back to two percent inflation.
Speaker 2: Would it be good for financial stability if the central
Speaker 2: bank didn't have to work row cross purposes with fiscal
Speaker 2: authorities as much and didn't weren't facing so much pressure.
Speaker 3: From that, Actually, Joe, in our Annual Economic Report this year,
Speaker 3: our chapter two, it's great that you asked this question.
Speaker 3: You know, we have a whole chapter on this point.
Speaker 3: What we argue is fiscal policy has to row in
Speaker 3: the same direction as monetary policy, not only for Phillip's
Speaker 3: curve reasoning or aggregate demand, but the for the kinds
Speaker 3: of arguments that we raised earlier about if the central
Speaker 3: bank has to enter the market, intervene in the way,
Speaker 3: and you're going to inject liquid it in a situation
Speaker 3: that might actually undermine financial stability through a very sharp
Speaker 3: depreciation of the exchange rate, you could actually end up
Speaker 3: doing more harm than good. What we call is we
Speaker 3: need to be at the region of stability. So we
Speaker 3: need to make sure that monetary policy and fiscal policy
Speaker 3: are working in concert rather than at cross purposes.
Speaker 1: So how do you actually do that? Because you know,
Speaker 1: we were speaking with Adam Posen earlier and he was
Speaker 1: talking about how there's a lot of uncertain around how
Speaker 1: central bankers should react to fiscal A lot of them
Speaker 1: are completely separated from fiscal for very obvious reasons, and
Speaker 1: it can be awkward for them to even start to
Speaker 1: talk or consider this issue, at least publicly. So how
Speaker 1: do you actually get there?
Speaker 3: I think this is why talking about fiscal policy is
Speaker 3: actually a very important function of the central bank. And
Speaker 3: it's true that when central banks talk about fiscal policy
Speaker 3: it can sort of raise eyebrows, But I think we
Speaker 3: have to make it very clear that monetary policy and
Speaker 3: fiscal policy are not separate policy functions. They're actually very
Speaker 3: closely interrelated, and so in order to perform monetary policy well,
Speaker 3: fiscal policy also has to play its part. Now there
Speaker 3: is the whole issue of the Filipsko of reasoning, what
Speaker 3: is aggregate demand? When mandatary policy is tightening, should fiscal
Speaker 3: policy play more of a role. If the economy is
Speaker 3: depressed even with very low rates, should fiscal policy take
Speaker 3: up the slack and stimulate the economy more? Those are
Speaker 3: very very important debates, and you know, I think that's
Speaker 3: something that is more more conducive to these formal economic modeling.
Speaker 3: But when muntary policy physical policy are joined up because
Speaker 3: of the balance sheet interconnections, then I think it's much
Speaker 3: more difficult. And I think, you know, these kinds of
Speaker 3: issues are more or less second nature in emerging markets,
Speaker 3: because in emerging markets and developing economies that have really
Speaker 3: a painful history of a financial crises, the debate is
Speaker 3: on much firmer footing. There's a lot more consensus. I
Speaker 3: would say. The difficulty, I think is more when that
Speaker 3: recognition is not so strong. It's a bit of an
Speaker 3: uphill struggle to put that on the agenda. But I
Speaker 3: think that's really why we at the BIS are here.
Speaker 3: I mean, this is one of our jobs to actually,
Speaker 3: you know, put these things on the table.
Speaker 2: Just to take it back to I think maybe the
Speaker 2: first part of this conversation. How much has the turning
Speaker 2: out or the fixed nature of debt in the US
Speaker 2: and maybe elsewhere contributed to the fact that we've had
Speaker 2: this extraordinary rapid rate of nominal rate hikes, particularly the
Speaker 2: short end, without a ton of evidence that it's done
Speaker 2: a whole lot. I mean, inflation is down, but there
Speaker 2: is some question about why, and there hasn't been much
Speaker 2: economic slowing. How much would you attribute it to that
Speaker 2: simple fact that there is not a lot of floating
Speaker 2: rate debt here?
Speaker 3: This is actually a very important part of the debate
Speaker 3: right now, discussion and the research at central banks, and
Speaker 3: it goes to the channel of monetary policy. So when
Speaker 3: the central bank raises rates, what are the levers that
Speaker 3: it's pulling to actually slow the economy down? You know,
Speaker 3: one channel is the classic credit channel, where you know,
Speaker 3: when you raise rates, and there's plenty of evidence both
Speaker 3: from Yeah, so let me just finish the sentence and explain.
Speaker 3: So when you raise rates, banks tend to lend less
Speaker 3: and the lending standards tend to become higher, and that
Speaker 3: channel I think is very well established. It is less
Speaker 3: strong in the data this time around. I think there
Speaker 3: is an interesting set of questions as to why not.
Speaker 3: You're pointing to another interesting channel, which is if the
Speaker 3: debt has been termed out, how much does raising the
Speaker 3: short rate due to slow spending when liabilities are so
Speaker 3: long term. If homeowners have refinanced their mortgage at very
Speaker 3: low rates, then they're sitting on very big gains and
Speaker 3: raising short rates will have limited impact. I think empirically
Speaker 3: these things still need to be worked out. I mentioned
Speaker 3: earlier that this turning out is not just the US phenomenon.
Speaker 2: It's pretty global.
Speaker 3: I would say countries like the UK used to be
Speaker 3: more or less completely floating rate. Now we have mortgages
Speaker 3: that are actually between two and five years. That's quite typical,
Speaker 3: and I think debate is what has been the impact
Speaker 3: of that turning out. But I think there is a
Speaker 3: bigger puzzle that we're all wrestling with, which is why
Speaker 3: did we have the inflation in the first place, and
Speaker 3: how have we managed to get the disinflation without triggering
Speaker 3: a recession. And I think that's a good puzzle to have.
Speaker 5: What's the answer here, you're here to tell us it's
Speaker 5: I mean, if you look at the standard textbook models
Speaker 5: for how the Phillips go would work, I mean, we
Speaker 5: should not have had that inflation outbreak, at least not
Speaker 5: the persistent inflation.
Speaker 3: Or clearly there were supply chains the flare up with
Speaker 3: the used cast prices and so on that you've covered
Speaker 3: extremely extensively on this podcast, but we should not have
Speaker 3: had the persistent inflation cropping up because I think the
Speaker 3: excess demand, if you like, was I mean, it was
Speaker 3: clearly there. It had a very important role to play,
Speaker 3: but it wasn't way off the charts, and yet we
Speaker 3: still had this very persistent inflation taking hold. And by
Speaker 3: the same score, we are very happy to see the disinflation,
Speaker 3: and the disinflation has come and it's confounded. Some of
Speaker 3: the pessimists have said that, look, we have to have
Speaker 3: a very deep recession in order to bring the inflation down,
Speaker 3: and that logic is completely watertight if you look at
Speaker 3: the Philips curve. If you look at the Phillips curve,
Speaker 3: you do need activity to slow very substantially to bring
Speaker 3: inflation down. But we are very happy to see that
Speaker 3: inflation has come down. So there are still many things
Speaker 3: that we don't understand fully. I think having gone through
Speaker 3: the pandemic and the shocks, especially the Russian invasion of Ukraine,
Speaker 3: shocks the commodity prices, food and energy, these were very
Speaker 3: unusual shocks that subjected the global economy to really unprecedented
Speaker 3: a really unprecedented combination of sharks, and so I think
Speaker 3: we have to be modest here. But I think one
Speaker 3: thing is for sure, which is that if we knew
Speaker 3: exactly what the channels of monetary policy transmission were, then
Speaker 3: we were a little bit too over confident. We were
Speaker 3: over confident there, and in that respect, I think one
Speaker 3: of the candidates that we have to look at is
Speaker 3: to what extent has determined out of debt meant that
Speaker 3: short term rates are having less purchase on the real economy.
Speaker 1: So to sum it all up, the risks are safe
Speaker 1: assets can be the locusts for instability. There's still hidden
Speaker 1: leverage in the system. Monetary policy might not be as
Speaker 1: effective as we think because of the shift from banks
Speaker 1: to bonds and the terming out of debt. And finally,
Speaker 1: we're not clear how any of this works. These are
Speaker 1: sobering thoughts.
Speaker 3: You know, I wouldn't put it in those terms, sure,
Speaker 3: and I think you probably overplayed at somebody's points, but
Speaker 3: it's definitely. I mean, it's it's true of economics pore
Speaker 3: generally and policymating especially. We just have to be very humble.
Speaker 3: We're always learning, and I think what the last three
Speaker 3: years has taught us is that we need to be
Speaker 3: extremely open minded on what the channels are. And it's
Speaker 3: very very fortunate that it seems that we're now we've
Speaker 3: opened the door to a soft landing, it seems where
Speaker 3: we haven't had the very deep recession to bring inflation down.
Speaker 1: All right, Well, I think that's a great place to
Speaker 1: leave our Jackson Hale series of Odd Loots discussions with
Speaker 1: the note of very reasonable humility that you just described
Speaker 1: to you. And thank you so much for coming back
Speaker 1: on Odd Lots and walking through these issues with us.
Speaker 2: Yeah, that was great, Thank you so much, and so great.
Speaker 1: To Yeah, finally finally.
Speaker 3: Do this in person. This great.
Speaker 2: Thanks for the invitation, Thank you so much.
Speaker 1: So Joe, always a treat to catch up with you,
Speaker 1: and I'm so glad that we caught him while he
Speaker 1: was how hiking and managed to drag him back for
Speaker 1: a podcast recording.
Speaker 2: I feel like it's a good thing. Humility is sort
Speaker 2: of like maybe the latch.
Speaker 1: Word humility should be the theme of the content.
Speaker 2: I feel like humility has been the theme and it's
Speaker 2: come up over and over again. And I don't think
Speaker 2: anybody could look at the last three years and come
Speaker 2: away with anything but some people, you know, maybe a
Speaker 2: better intuition than others or whatever, but with it like
Speaker 2: everyone needs a dose.
Speaker 1: Of humility, absolutely, And I did think his point about
Speaker 1: how you want to avoid the central Bank becoming the
Speaker 1: first lender of last resort or the lender of first
Speaker 1: resort makes a lot of sense. I remember after the
Speaker 1: FED announced the corporate bond buying program, there were some
Speaker 1: analysts that came out with notes and basically said, the
Speaker 1: FED has changed the corporate bond market forever because now
Speaker 1: we know that this backstop will come out if things
Speaker 1: get bad enough. So you did see that moral hazard
Speaker 1: sort of creeping into the market.
Speaker 2: You know, and made the point you just talk about
Speaker 2: in the ideal world, which never happens. You know, the
Speaker 2: Central Bank and the fiscal authorities work together on some level,
Speaker 2: and we saw it. We saw the breakdown in the
Speaker 2: twenty tens. I'm always going back to this idea of
Speaker 2: like how twenty twenties like the Bizarro twenty tens. In
Speaker 2: the twenty tens, fiscal was probably too tight and we
Speaker 2: expected central banks to do everything to get the economy
Speaker 2: back going, and it was a long slow process and
Speaker 2: many people were disappointed by the pace of the recovery.
Speaker 2: It feels like in the twenty twenties, we're once again
Speaker 2: the entire burden of the inflation adjustment, this time is
Speaker 2: being put on the central banks. Actual they do seem
Speaker 2: to be working cross purposes with fiscal authorities, and b
Speaker 2: it does seem like that contributes to financial stability risks
Speaker 2: when the only move really is higher and higher rates.
Speaker 2: And then you get SVB like its situations very well.
Speaker 1: Put, Joe, you basically just summed up what five hours
Speaker 1: of All Blots episode.
Speaker 2: There we go?
Speaker 1: All right, shall we leave it there?
Speaker 2: Let's leave it there?
Speaker 1: Okay, this has been another episode of the All Bloughts podcast.
Speaker 4: Away.
Speaker 1: You can follow me at Tracy Alloway.
Speaker 2: I'm Joe Wisenthal. You can follow me at the Stalwart.
Speaker 2: You can follow our guest Hunan Sungtion at Hun Sung Shin.
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Speaker 2: Bennett at dashbod, and our special Jackson Hole producer, Sebastian
Speaker 2: Escobar under dicibass. Follow all of the Bloomberg podcasts under
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Speaker 4: Thanks for listening in in