All countries with central banks exercise monetary sovereignty, right?  Nobel economist Paul Krugman certainly thinks so.  “Wow,” he wrote, after reading Benn Steil and Manuel Hinds say otherwise in the Financial Times on May 24, “Have these guys ever talked to anyone in Sweden, which doesn’t need euros to create more kronor?” Fortunately, we have the data, which is better than talk.  Since Mr. Krugman throws Australia into the mix, we will too.  As the figures above illustrate, when the Swedish and Australian central banks expanded credit dramatically during the recent financial crisis their net foreign assets plummeted.  And this is not merely a crisis effect, as the three decades of Australian data show. So it turns out that you do indeed need euros and (American) dollars to create kronor and Australian dollars.  A country that plows on creating credit without them eventually becomes a ward of the IMF.

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Back in 2000, the European Central Bank’s first president, Wim Duisenberg, explained how he knew the Bank’s operational framework for implementing monetary policy was working well.  It was, he said, successfully “steering short-term market interest rates” where the Bank wanted them to go.  Prior to the financial crisis, that was indeed the case: the ECB’s policy rate was tightly connected to important short-term interest rates, such as the 3-month government borrowing rate.  In a growing swath of the eurozone, however, this is no longer the case.  As the figures above show, the correlation between the ECB’s policy rate and actual government borrowing rates in Spain, Greece, Italy, Ireland, and Portugal has plummeted since the ECB began its debt-buying program.  The market’s view of default risk on eurozone government debt has increasingly come to dominate these rates, which themselves strongly influence borrowing rates in the private sector.  By Duisenberg’s criterion, monetary policy in the eurozone is becoming less and less effective.  The only thing that will reverse this trend is a resolution of Europe’s growing bank and government debt crisis.  Yet by continually insisting that debt restructuring is out of the question, the ECB is only delaying such a resolution – and almost surely making it more costly.

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At 4:30 p.m. on February 18th the Federal Reserve Board announced an increase in the discount rate, the rate charged for direct lending to banks, by 25 basis points (0.25%) to 75 basis points. When Asian equity markets opened a few hours later they traded down about 2%, on fears that the move signaled the start of tightening credit. Yet borrowing from the discount window, which peaked in the midst of the financial crisis in October 2008 at an historically high 4.2% of commercial banks’ borrowed funds, is unlikely to be affected by the rate increase. Banks borrow from the discount window because they have no other options. The week after the rate increase discount window borrowing dropped by only 2.6%, compared to an average of 3.1% over the prior eight weeks. In itself, then, the move was a non-event. The question remains whether the Fed, despite its protestations, engineered this non-event to begin preparing the market psychologically for increases in the far more consequential fed funds rate – the rate at which banks lend reserves to each other. Read more »

The Federal Reserve plans to stop buying securities issued by government housing loan agencies Fannie Mae and Freddie Mac by the end of the first quarter. This is not only likely to push up mortgage rates; Treasury rates should rise as well. Throughout 2009, the private sector sold a portion of their agency holdings to the Fed and used those funds to buy Treasurys. Once the Fed’s agency purchases stop, this private sector portfolio shift will end, removing a major source of demand in the Treasury market. As the chart shows, since the start of 2009 the Fed has bought or financed the entire increase in Treasury issuance. As Fed purchases slow and Treasury issuance continues at a high level, interest rates will have to move up to attract new buyers. Read more »

Central banks have been consistent suppliers to the gold market, at least up until the second quarter of 2009, when they became a source of demand. India bought a substantial 200 tons, illustrated by the red bar on the far right of the above figure, from the IMF in November. Russia, Sri Lanka, and Mauritius have also been buyers of late. Yet even if the rebuilding of central bank gold stocks turns out to be a long-term trend, in the short run the gold market is much more likely to be driven by volatile private investment demand, which jumped from only 8% of demand in the third quarter of 2008 to 86% in the first quarter of 2009 (see the orange block on the right of the figure). Investment demand is in part facilitated by exchange traded funds (ETFs) such as the SPDR Gold Shares, which has bought a massive 353 tons of gold since the beginning of 2009. Read more »