Monday 23 February 2015

Should a Central Bank Target Domestic Inflation Only?

Inflation targeting and cholesterol...

Central banks around the world generally have a mandate to target inflation. Whilst this makes sense, I would argue that it is not specific enough and that this target by its nature leads to policy errors.

I think of this as similar to the question of cholesterol. Whilst it is widely considered fact now that there is a 'good' and a 'bad' cholesterol (HDL and LDL respectively), for years the two were linked together in one number and labelled 'bad'. Since the 1950s, this has led to poor dietary recommendations as a diet that increased the 'good' cholesterol was shunned.

With inflation targeting, I would argue that there similarly are two components. Domestic and foreign inflation. And these two components require opposite action regarding interest rates.

Inflation on domestically produced goods and services

When demand goes up and supply is limited, the result is inflation. This is the sign of a healthy economy. Too much demand can lead to overheating and therefore should be controlled by raising interest rates to increase savings. Too little inflation is a sign of too little demand and this demand should be stimulated by a reduction in interest rates. This is a rational justification for inflation targeting. And I would argue that it is completely true for inflation on domestically produced goods and services. This is 'good' inflation targeting.

 Inflation on imported goods and services 

There are a number of reasons why imported goods may go up or down relative to domestic goods. Commodity prices can go up and down. Exchange rates can change. Internal wages relative to output can change in other countries. I will go through each of these and explain why I think that this, if anything, should have an opposite impact on the desired interest rates. I call this 'bad' inflation targeting.

Commodity prices: When commodity prices go up, inflation in commodity importing nations goes up. This leads to a reduction in buying power for consumers and, in turn, to a reduction in demand for home produced goods. So in this case inflation (deflation) should ideally be combated by a fall (rise) in interest rates. However, mandated central bank policy suggests that the opposite should be done. In terms of bad policy created by this, one could, for example, look at the ECB raising rates in 2011 at a time when inflation was high due largely to high commodity prices.

Exchange rate changes: A stronger domestic currency leads to lower inflation on imported goods. But it increases the buying power of domestic consumers. Therefore it is likely to increase overall demand but at the same time export some demand to the countries with weaker currencies. Effectively this is an increase in living quality for the domestic consumers. Here an increase in interest rates would help increase savings and keep demand in check. Vice versa for a weakening currency. Once again, mandated central bank policy suggests the opposite should be done.

Wage inflation in other countries: Supposing another government, let's call it China, follows policies which keep currency undervalued, wages low, and interest rates negative in real terms. Production of goods in that country is going to be cheaper as it is heavily subsidised. This is going to lead to deflation being exported. This can mask the effects of inflation in the domestic country. I believe that this should be treated as the boom that it is - a large increase in the buying power of domestic consumers. Therefore interest rates should be increased to quell demand and counteract the build-up of external debt. Instead the opposite has been done. Central bankers have seen the low inflation and kept interest rates low. For examples of policy errors, see the UK and US (to name but two) with interest rates too low in the years leading up to 2008.

To put this more generally, imported inflation/deflation is like a tax/subsidy on the people of the country. Monetary policy should be used as a counterbalance to this, rather than reinforcing the effects further.


'Good' and 'bad' inflation targeting should be separated into the two parts - the domestic and the imported. At the very least, the imported inflation/deflation should be ignored in the calculation. Even better, the two constituents of inflation should be studied separately and an optimal interest rate should target a composite figure that could actually (if empirical evidence supports it) have a negative coefficient for imported inflation.

Friday 20 February 2015

Why I am short AUDJPY

On the folly of making market calls

I am generally of the belief that publicly making predictions about the market opens one up to ridicule when you are wrong and has not got that much upside. And rightly so, as the implicit assumption is that you are right and everyone else in the whole market is wrong. This is a pretty arrogant assumption.

Having said that, please treat this as a discussion piece to which I am very open to hearing opposing views. It goes without saying that this is not a recommendation to trade - just an explanation of my position.

Also, please note that Dacharan specialises in systematic repeatable strategies. This idea, due to the lack of large quantities of inflation linked bond data, is not fully tested. As such this is a personally held position.

Fair Value Model

In the course of my time in the markets, I have developed what I call a fair value model for currencies. It assumes purchasing power parity but adjusted for real yields. I have found it to be generally reasonably highly correlated with actual exchange rates. I base the numerical part of my analysis on this.

The graph below shows the evolution of the fair value of Australian Dollar against Japanese Yen (AUDJPY) over time, compared to the move in the actual exchange rate. As can be seen, they are not entirely unrelated. Over the past year, you can see on the graph that the 'fair value' of the exchange rate declines considerably. This is due largely to Australian interest rates declining, by 1.5-2% on the 10 year bonds. Instead of a fall in the exchange rate, we have actually seen a rise.

The current fair value, according to my model, is around 71. This contrasts to the 93 level it is currently trading at.

The AUDUSD rate has fallen commensurately in this time period and so we could really call this an unreasonable rise of USD against JPY. This would be fair; according to my model USDJPY fair value is around 100. However, there are good reasons to beware a dollar short in the current environment, and I don't think there are many to beware an Australian dollar short.

To put it simply, I think that Yen is the most undervalued currency in the developed world and that is why I have chosen it for my long. The reasons for AUD as the short are below.

China Rebalancing

As Michael Pettis convincingly argues, China's economy must very quickly start rebalancing from investment to consumption if it is to avoid a crash. China's policy makers appear to be aware of this and I think that the heavy industrialisation must continue to slow down. They are not in position to do another stimulus as they were in 2008 and the previous investments can only make a return if there is consumer spending. Commodity supply has increased due to the past Chinese demand, and when demand falls the prices must follow. To some extent this is already happening, but I can not see anything to significantly reverse this and it may well get worse.

Australian Imbalances

I would say that it is extremely unlikely that Australia can have avoided Dutch Disease in the period of high commodity prices. The Australian economy has been extremely reliant for exports on commodities. Australia has persistently been running large current account deficits of 3-4% of GDP, and I imagine that the parking of Chinese savings in the Australian economy has been a reasonable constituent of this. This means that at the same time as a large windfall of foreign cash was coming in, gross borrowing was also going up. Net debt to foreign creditors had risen to 55% of GDP in 2013, and is getting higher.

Where does this extra money go? Unless there are productive investment opportunities that would not otherwise have been funded, the influx of foreign savings as well as commodity boom almost certainly will lead to a property boom/ bubble, and, although I am not an expert on the Australian property market, this appears to have been borne out in reality.

In short, the end of the commodity boom has got to have placed Australia in a precarious position. In order to keep demand up at previous levels, debt will have to increase greatly. The other option is an Australian recession.

But more generally, with the reduction of commodity exports, and the already high trade deficit something will have to give in order for the economy to rebalance. And really this has to be the exchange rate. I do not know when this will come, but feel that it must do so eventually.

Tuesday 17 February 2015

Why the Bank of England should 'write off' government debt to counteract the influx of foreign savings into the UK.

Current Account Deficits

The U.S. and the UK both have a problem with current account deficits. As Michael Pettis, with wonderful simplicity, shows, this has less to do with the popular narrative of credit hungry consumers desperate for the newest gadgets, and more to do with the fact that these currencies are both considered reserve currencies and that both have liberal, open markets. What ValĂ©ry Giscard d'Estaing called the United States' 'exorbitant privilege' can also be seen as a curse.

From now on, for simplicity, I will talk about my home country, the UK, but the same will apply for both countries.

Many nations currently follow policies, for example an artificially low exchange rate or suppression of workers wages, which reduce household share of GDP, produce excess savings and thus lead to very large current account surpluses. Notable for their size are China and Germany.  For many low income countries this is a very sensible strategy to safeguard against future crises. However, in the low demand world that we are currently living in, these excess savings suck demand out of the deficit countries. In a time of low demand, a beggar thy neighbour approach leads to a race to the bottom. Other countries follow suit in attempting to reduce their own exchange rates, eg Japan and, until recently, Switzerland. The logical conclusion of this is that everyone reduces internal demand in an attempt to improve competitiveness and overall world demand is pushed ever lower. This is a recipe for world economic stagnation.

The excess savings created by these policies must be exported to another country, and reserve currencies are seen as the safest. If countries are running trade surpluses they must buy US dollars and often will also choose to diversify into Pound Sterling (GBP).

By definiton, the net buying of UK assets by foreigners leads to a UK current account deficit. The simple mathematics here is that if the UK is to run a deficit then the UK public must be net sellers of GBP to purchase the currencies needed for the goods to import. It requires foreign buyers to want to buy and hold GBP to match the amount of UK currency sold by the UK public. But as Pettis shows, the converse must also be true. Increased inflows of excess savings from abroad into GBP must, as an accounting identity, increase the current account deficit. The mechanism for this is that the buying of Pound Sterling keeps the exchange rate too high, therefore encouraging the consumption of foreign goods that are artificially cheap. A deficit is effectively forced upon countries with reserve currency status and to avoid this requires strong policy resistance.


No-one forces people to buy stuff or take out credit. People should have self control, etc etc. I have read a lot of this in the comments section of blogs. But the nature of foreign purchases of UK assets is that, if there are not any productive uses of the capital which UK savings can't fund (which is likely), then either credit must go up or demand must come down so much that savings at home can be exported that match the savings from abroad.

As a worked example; imagine an economy that produces £10m in goods and services, exporting half of this. It also consumes £10m in goods and services, importing £5m of this. This is a balanced economy. Now imagine that someone abroad buys £1m of currency for their reserves, thus forcing a current account deficit of £1m. In order to keep the demand for the £10m of goods and services it was originally selling, the county must now consume £11m worth. The remaining £1m must be borrowed; increasing debt in the country by £1m. Alternatively the country could adjust by continuing to buy £10m worth of goods and services but decreasing domestic demand by £1m. The country will now only sell £9m of goods and services. This means that there will be unemployment in the domestic industries that lost business.

The options for a receiver of excess savings, as shown by Pettis, are either a) public/private sector debt or b) unemployment caused by reduced demand. Most countries chose debt (until, of course, they can't any more). Asset price bubbles typically ensue due to too many savings chasing too few returns.

To emphasise, if an increase in unemployment is to be avoided, foreign net purchases of UK assets necessarily leads to an increase in debt in the UK. This is a problem.

The perniciousness of debt for growth should not be underestimated. The current UK government policy of trying to control state spending (albeit not particularly drastically in any area other than benefits spending) but at the same time encourage private debt to stimulate the economy, is just loading up problems for the future. Any solution to our current economic difficulties which involves raising the already high level of private sector debt is going to cause at best stagnation in the future, at worst crisis.

One major reason for this is that the dynamics of debt are such that the poor/middle class, either through private debt repayment or taxes, tend to have to pay interest and principal to the rich or foreigners. The poor/middle class tend to spend a higher proportion of their income on consumption than the receivers of the interest payments. Therefore the repayment of debt means a reduction in demand in the economy. This must either lead to unemployment or the taking out of more debt. Once again this is quite simple mathematics.

So, if we are to avoid recession, the buying of UK assets from abroad must be funded by credit expansion in the UK and increased public/private sector debts to abroad. And the build up of credit is leading the UK on the road to another stagnation/crisis. What to do?

Conventional Responses

Keep interest rates low? This encourages more private borrowing, which at this stage in the UK is, in my opinion, a very bad idea. Further Quantitative Easing? This tends to give money to those with assets, who are less likely to spend. Also, in theory this will be taken back in the future, still leaving an ever larger debt pile.

Both of these blunt monetary policies do have a desired impact of weakening the currency, therefore reducing the deficit. However there are costs to both, in terms of increased borrowing and rising inequality, both storing up problems for the future. Also, both lead to an increase in house and other asset prices, which is increasing inter-generational inequality.

What about increased government borrowing? This would stimulate the economy and may be beneficial in the long term, but the already high levels of debt are an impediment to this. UK investment spending has plummeted under this government thanks to the attempt to reduce the deficit. One has to think that some of the spending cancelled would have positive net present value with current zero real interest rates.

None of these solutions, unless the government debt purchased using QE is to be written off, solve the problem of increased debt every year caused by foreign purchase of UK assets.

Quantitative Easing and writing off government debt equal to the current account deficit.

I would suggest that the sensible option would be to pledge to buy government bonds each year in an amount equal to the current account deficit, and then write them off. Although this is not allowed in name, by pledging to roll the position indefinitely and pay the interest back to the government it would effectively be a write off. The effect of this would be that, even though the current account deficit was still large, the UK would no longer be increasing net debt. It neutralises the foreign purchases of UK assets.

The adverse effects of the savings inflows are countered in two ways. 1) The required increase in debt that is described above is nullified. Net there is now no increase in debt, although potentially there is an increase in debt to foreign creditors and a corresponding reduction in internal debt. 2) The artificial impact on the currency is cancelled out by an increase in the domestic holdings of GBP which exactly matches the amount of GBP taken out of the country.

The leeway that the debt reduction affords would allow the government to invest more money into productive projects which, with the reduction of government debt levels, can now be judged more on merit. Interest rates are low enough that the bar does not need to be that high. This would increase the future growth potential of the economy as well as stimulating much needed demand now.

In fact, I would agree completely with Lord Adair Turner's suggestion to both increase interest rates and monetarise debt. This would work to reduce private debt but at the same time put money into the economy in a more productive place than housing. The reduction in private sector debt caused by higher rates could be counteracted by the increased government spending. But net debt would go down as private sector debt goes down and government debt does not go up.

And if the UK current account goes into surplus? Then the Bank of England can do the opposite and put back into the market some of the bonds it has taken off. In fact this could be a stated exit strategy for the current QE. This strengthens the Pound when it is too weak and keeps net debt levels the same.

So who loses? The Pound should go lower, reducing the buying power of UK citizens, however it is currently too high as evidenced by the trade deficit. It is, in effect, a tax on holders of cash, but only offsetting the subsidy given by the net purchasers of UK assets from abroad; the tax and subsidy in fact exactly cancel. The foreign purchasers of UK assets would be worse off, but if that discourages the purchase of UK assets, so much the better. In the current deflationary environment, any increase in inflation would be welcomed and come from increased demand, not just the weakening exchange rate. The stimulus made possible by this would allow interest rates to be higher to counteract any future inflationary pressures and give more room to cut in a future crisis.

The inefficiency of market capitalisation weighted indices

The (sensible) advice to people saving for their pension has long been to avoid active fund managers with their high fees and put their money into cheaper exchange traded funds (ETFs) which track major indices.

This is sensible because active fund managers often try to track the index but generally do not add enough value to justify their fees. However a great body of research  over the past 25 years has shown that this is still not optimal. For a number of reasons, probably to do with systematically over-weighting the most popular stocks, and possibly also to do with the sheer volume of trading based on the composition of indices, this has been shown to be inefficient.

My white paper on the subject comes out of research for Dacharan's market neutral equity fund. It shows again how a market capitalisation weighted basket of stocks is, in the long term, considerably worse than any other weighting tested. I suggest that a constrained inverse beta weighting is a good choice of weighting as it is reasonably balanced but also weights more the lower volatility and less correlated stocks.

In fact, the market capitalisation weighted indices are so bad that for a large part of our portfolio, we don't even look for bad stocks. We just sell futures in the index, confident that they will under-perform our portfolio on average. The other advantage of this is much lower costs.

So how can you improve your pension portfolio to avoid this systematic loss, which I would calculate at approximately 1.5% per year. I would look to invest in low cost ETFs which track alternative weightings. For example 'minimum volatility' weighted indices or dividend weighted indices.

Whilst it could be argued that the popularity of these in recent years counts against them, the market is still tiny compared to the market capitalisation weighted indices and I think that in the long term, on a risk-return basis these will outperform..