“Capital Flows and Monetary Policy” was the subject of a talk yesterday in Singapore by recently promoted central banker, Glenn Stevens. (Yesterday! Do they ever rest?)

It was a nice exposition of the difficulties Australia experienced with its “managed float” regime and the improvements since the free currency float was adopted by the Hawke-Keating government.

Note in particular the stunningly interesting graphs showing volatility of interest rates before and after the currency was floated. In conclusion, Stevens notes:

Capital mobility can complicate the conduct of monetary policy. In Australia, we have found that the complications which arise under a floating exchange rate – while often not trivial – are not of the same order of magnitude as the monetary control problems we had when capital was less mobile but financial prices were heavily regulated. In the system we have had for some years now, the inflation target, rather than the exchange rate, is our anchor for policy. When capital flows suddenly change, the exchange rate is free to move to absorb at least part of the shock, and we are able to decide how much of the shock should show up as changed financial conditions in Australia. This seems to be a pretty durable arrangement.

Two days earlier, at a meeting in Hong Kong (on a Friday, we are pleased to report), Stevens remarked at length on one of the consequences of less volotile interest rates:

More generally, a long period of interest rates being low and fairly steady, however well justified it might apparently be by short‑term macroeconomic fundamentals, also causes behaviour to change. The search for yield eventually explores some fairly remote territory – be it more pension fund or retail money going into hedge funds, the rise of private equity funds, or the use of ever more exotic strategies by various managers to generate returns. The real question here is whether investors are consciously accepting higher risk in order to keep the sorts of nominal rates of return that were characteristic of a different era, or whether they are, in fact, not cognisant of the degree of risk they are taking on.

Unlike yesterday’s speech, which seems to have so far evaded the laser-like gaze of our financial journos (who are better at resting on Sundays), this talk was noted. It was interpreted as showing considerable concern about the activities of hedge funds. As Henry has lost money feeding hedge fund managers, he has great sympathy for this view.

Milton Friedman’s oft quoted statement about “stabilising speculation” does not apply if investors mostly chase the trend de jour, as they often do.

Glenn Stevens says this more elegantly if with slightly more words:

… the increasing complexity of the activities of various investors makes it hard for any one counterparty to know whether they really have a good understanding of their customers’ business (including with their competitors) and therefore their own exposures. Their direct exposures might be considerably smaller than the indirect ones, which will perhaps only come to light under conditions of duress. It is under abnormal conditions, when liquidity in markets is under pressure, that the leverage employed by some of the funds will be at its most damaging. It is at those moments that markets are most prone to freezing up, as all participants, wary of the unknown exposures of all others to the leveraged risk‑takers, pull back. But this maintenance of liquidity and the smooth functioning of markets has become central to financial stability because even as regulated institutions have become more sound, they and other participants have come to rely more on markets for their own risk management. Hence dislocation can have serious consequences.

Read more at Henry Thornton.

Peter Fray

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