Economy

How much central banks might lose on their engorged bond portfolios as interest rates rise and whether these losses even matter has been a subject of interest at FTAV Towers for a while. Now the BIS has also tackled it. It’s a hot topic, given the scale of the already realised losses, what is to come, and (unfortunately) the political optics in some countries. Central bank accounting is pretty esoteric stuff, but that doesn’t mean that some politicians might not try to weaponise it. The Bank for International Settlement’s general manager Agustín Carstens has written up his thoughts on the matter for the FT today, but FT Alphaville wanted to dive into the underlying paper itself. So far ~deep breath~ the Reserve Bank of Australia, the National Bank of Belgium, the Bank of England, the Bank of Japan, the Netherlands Bank, the Swiss National Bank, the Czech National Bank, the Reserve Bank of New Zealand, Sveriges Riksbank and the US Federal Reserve have all already announced that they are facing losses on their asset purchases, according to the BIS report. Notably, the BIS has in the past been on the sceptical side when it comes to quantitative easing. But the report — authored by Sarah Bell, Michael Chui, Tamara Gomes, Paul Moser-Boehm and Albert Pierres Tejada — is clearly in the “nothing to see here, move along” camp.You can find the full report here, and here are their main points:— Rising interest rates are reducing profits or even leading to losses at some central banks, especially those that purchased domestic currency assets for macroeconomic and financial stability objectives. — Losses and negative equity do not directly affect the ability of central banks to operate effectively. — In normal times and in crises, central banks should be judged on whether they fulfil their mandates.— Central banks can underscore their continued ability to achieve policy objectives by clearly explaining the reasons for losses and highlighting the overall benefits of their policy measures. Basically, the BIS is saying that the losses don’t matter, they don’t affect a central bank’s ability to operate, should be seen in a wider context and should just be explained a bit better.The heart of the issue is that normal concepts of accounting and solvency don’t really apply when it comes to central banks, which can, well, create money, and are just one side of the overall sovereign balance sheet. Diving a bit deeper though, central banks take different approaches to how their profits and losses get tallied and reported. Here is a good overview:From the BIS report: The three main accounting approaches (Part A in Table 1) affect the size and volatility of net income from asset valuations in the short term, although the results wash out over the longer term. 6 For central banks that use fair value accounting, eg the RBA and BoE, current losses from declines in asset valuation have been front-loaded, and future valuation gains will be reflected as revenue as the assets approach maturity. Others, eg the Eurosystem and Sveriges Riksbank, reflect declines in asset values in reported losses, but reflect unrealised gains only in revaluation accounts. For those that use historic cost accounting, eg the Federal Reserve, unrealised valuation changes are disclosed for transparency, but not recognised in reported income. Income recognition and distribution rules (Part B in Table 1) determine the size of buffers against losses. These vary considerably across central banks. Some can establish discretionary loss-absorbing buffers before accounting P&L is calculated (eg NBB and DNB). Some make the size of the profit distribution contingent on targets for various types of buffers (eg the Riksbank and BoE). Some also use distribution-smoothing mechanisms, such as distributions based on rolling averages, to make profit transfers to government more predictable over a longer horizon. While these arrangements may reduce transfer volatility and offset accounting losses, they are unlikely to be sufficient to do so under all circumstances. Indemnity arrangements (Table 1, Part C) may reflect a desire to insulate the central bank from the financial consequences of some policy measures. For example, the BoE APF, established as a subsidiary to conduct APPs, is fully indemnified by the UK Treasury. 7 In other cases (eg RBNZ), the government authorised indemnities for specific operations without a subsidiary. In contrast, some central banks such as the RBA, do not have indemnities. Central banks that have indemnity arrangements view them as a way to ensure that policy measures are not constrained by the prospective financial impact on the central bank, thereby preserving independence. Some that do not have indemnities note that they are irrelevant from the perspective of the overall public sector balance sheet and could even risk reducing policy effectiveness if they weaken perceptions of central bank independence. However, whatever the approach taken, central banks have no minimum capital requirements, cannot become insolvent in a conventional way, and even sizeable losses don’t compromise a central bank’s ability to operate. For example, the central banks of Chile, the Czech Republic, Israel and Mexico have all had years of negative capital without impeding their primary job of ensuring financial and price stability, the BIS notes. The one caveat is when “misperceptions and political economy dynamics can interact with losses to compromise the central bank’s standing”. But for the most past the BIS is relaxed, concluding: . . . A central bank’s credibility depends on its ability to achieve its mandates. Losses do not jeopardise that ability and are sometimes the price to pay for achieving those aims. To maintain the public’s trust and to preserve central bank legitimacy now and in the long run, stakeholders should appreciate that central banks’ policy mandates come before profits. More

Ukraine’s battle against Russia is consuming ammunition at unprecedented rates, with the country firing more than 5,000 artillery rounds every day — equal to a smaller European country’s orders in an entire year in peacetime.The dramatic shift to a war footing is creating a supply chain crisis in Europe as defence manufacturers struggle to ramp up production to replenish national stockpiles as well as maintain supplies to Ukraine.Nearly a year since Russia’s invasion, the pace of demand for ammunition and explosives is turning into a test of Europe’s industrial production capacity in a race to re-arm.“It is a war about industrial capacity,” said Morten Brandtzæg, chief executive of Norway’s Nammo, which makes ammunition and shoulder-fired weapons.He estimates Ukraine has been firing an estimated 5,000-6,000 artillery rounds a day, which he said is similar to the annual orders of a smaller European state before the war.The pressure on producers has not been helped by lingering supply chain bottlenecks following the coronavirus pandemic, a lack of production capacity and a shortage of critical raw materials for some explosives, which is holding back efforts to increase output.Arms maker Nammo says the scale of investments to meet demand puts a ‘huge strain on the financials of an otherwise healthy defence company’ © John Macdougall/AFP via Getty ImagesSome components are in such high demand, Brandtzæg said, that their delivery time has increased from months to years.It has led to a scramble to source materials, from chemicals for explosives to metals and plastics for fuses and artillery shell casings. Most companies have increased production shifts ahead of expected orders from national governments, and are hiring more people, another challenge since the start of the pandemic.Yves Traissac, deputy chief executive at military explosives producer Eurenco, said the company is looking to increase production capacity to meet the higher demand from customers that include Germany’s Rheinmetall and Britain’s BAE Systems. “We are currently managing a ramp-up to meet our customer demand. It is a challenge but we are working on that,” he said.One particular challenge is sourcing nitric acid, which the company uses in small quantities to make explosives but which is also a key ingredient in the manufacture of fertiliser. With parts of Europe’s fertiliser production reduced due to the high cost of energy, the supply of nitric acid “has to be secured with our suppliers”, said Traissac. Eurenco, he added, is working to “have additional sources of critical raw materials”.Rheinmetall, Germany’s largest defence contractor, announced last month it would build a new explosives factory in Hungary in a joint venture with the government to address the shortage. The explosives produced in the new plant will be used for artillery, tank, and mortar ammunition, among other things. The company has also restarted decommissioned ammunition production facilities, it told the Financial Times, and has “bought in large stocks of important materials”. Mick Ord, chief executive of Britain’s Chemring, which supplies a range of explosives and propellants to defence contractors, said some customers have asked if it is possible to “increase output [of certain materials] by 100-200 per cent”. According to Ord, a “lot of the post-pandemic supply chain challenges are starting to abate”.The “bigger challenge is that our capacity has been sized to what our customer demand was and the industry has been run very broadly on that basis, where capacity meets demand”.To increase output significantly takes time and investment in new plants, he said. “These are pretty capital intensive projects which take a few years to build, commission and bring online. It’s not the kind of supply chain where you can just flick a switch.”UK-based Denroy, which makes shell casings and other components for a range of defence companies, has benefited from pre-ordering certain materials such as polymers and composites.The challenge, said chief executive Kevin McNamee, is “not so much our capacity but the lead times of some of the materials are very long — it can be a six-month lead time on some specialised materials”.A collection of shells in the Kharkiv region of Ukraine. The country is estimated to fire at least 5,000 artillery rounds a day © Sergey Bobok/AFP via Getty Images“Companies might do a batch once or twice a year, so if you miss that batch, you have to wait.”The crisis has prompted companies to work more closely with their suppliers and also with those further down the chain. Several industry executives said they were spending more time making sure on a daily basis that individual suppliers were able to deliver. The huge demand for investment is also prompting calls for a change in the way procurement is handled by governments, with executives saying they need longer-term contracts. Nammo, which is co-owned by the governments of Norway and Finland, usually receives annual contracts from state customers. The company started to invest in its facilities early last year and has been able to meet the demand from its customers. Nevertheless, Brandtzæg said the scale of the investments are such that they are a “huge strain on the financials of an otherwise healthy defence company”. The investments for the company were “more than three times higher in 2022 than in the year before”. The defence industry needs longer, multiyear contracts, he added, “so that they can carry those massive investments”. In the UK, BAE Systems has been in talks with the Ministry of Defence about ramping up production of a number of munitions for months. The company is the main supplier for the British Armed Forces and in January began a new 15-year supply contract but it is still waiting for a formal agreement to cover the additional output required by Ukraine.Lee Smurthwaite, programme director for munitions at BAE, said the company had already increased the number of shifts at its plants, in addition to hiring temporary workers, both to meet the demands of the new contract as well as in anticipation of more work. The company’s three main munition plants typically run two to three shifts over 24 hours a day, five days a week.The rush to re-arm and the prospect of the war lasting for some time has prompted debate about the need to pool purchasing across the EU, despite its separate industrial bases. Countries are also looking at collaboration further afield, with France late last month announcing it would work with Australia to jointly produce and send several thousand 155mm artillery shells to Ukraine. The production of the shells will be led by France’s Nexter. “You will never end up with just one propellant plant in Europe but if ever there was a time to say, we should be co-operating on munitions, it is now,” said Francis Tusa, editor of Defence Analysis, pointing to a recent speech by French president Emmanuel Macron where he revealed that the number of shells manufactured in France each year corresponded to a week of shelling sent by Russia into Ukraine. There could be merit in an agreement on common purchasing of weapons such as ammunition or explosives, he added. Work on this is under way. The European Defence Agency, set up in 2004, is part of an EU effort launched late last year to explore with industry how member states can co-ordinate the procurement of some critical equipment, including ammunition.“It was clear that for a number of capacities there was an urgent need,” said Pieter Taal, head of the EDA’s industry, strategy and European policies unit.Progress, however, will take time, he admitted, adding that “between member states it always takes a lot of talking back and forth”.Trevor Taylor, of the Royal United Services Institute, said: “Scale matters in defence production and the functional case for Europeans (including the British) working together is very clear.”But he warned: “The political hurdles to such co-operation are significant: settling who would pay for what would be challenging.” More

The writer is a former chief investment strategist at Bridgewater AssociatesWhile moderating inflation and more benign interest-rate expectations have helped boost markets this year, there is a more structural risk that remains under-appreciated: demographic decline. Policymakers have recently homed in on challenges stemming from ageing populations alongside shrinking workforces. But so far, their responses are woefully inadequate to prevent higher rates of inflation and more difficult fiscal trade-offs in the years ahead. This in turn suggests a greater probability of higher interest rates, as well as more policy uncertainty that weighs on spending and investments, both a drag on cyclical assets including equities. Demographics are often shrugged off — too slow moving, too far away. So why the policy focus now? Like many economic forces today, it comes back to the pandemic. Participation of those aged 55 and older fell sharply during Covid-19, stabilising now in the US around 15-year lows below 39 per cent. This larger than expected cut to the labour supply helped push wages up to multi-decade highs and left many companies struggling to meet production goals.The rise in inflation has also put governments under political pressure and central banks have had to pursue the fastest tightening cycle in decades to bring inflation back towards targets, slowing growth. This has left companies facing increased wage demands even as the economy slows.While policymakers have taken note, action so far is unlikely to materially assuage near-term voter unhappiness or longer-term economic risks. In France, protests over a push to raise the retirement age from 62 to 64 are evidence of how politically contentious it is to address demographic challenges.Only Canada among the larger economies seems willing to pull out the stops to meet labour needs, dramatically raising immigration goals and targeting half a million new immigrants in 2025. Immigration now accounts for nearly all the country’s labour-force growth and 75 per cent of overall population growth.Without significantly more immigration, more children, longer working hours and lives, and/or more technology to increase productivity, we face a combination of lower labour output combined with a larger group of dependants. The degree of the demographic challenge can be debated, but the risk for longer-term inflation and fiscal policy is not sufficiently discounted.Even without the union participation seen in the 1970s, labour supply trends will give workers more bargaining power in the years ahead, which should provide sustained support for wages. Further, without an offsetting increase in productivity, a smaller labour force suggests production will struggle to keep up with the broader population’s consumption — an additional inflationary dynamic. Contrast that picture with signals from trading in US Treasury inflation-protected securities. That implies annual inflation is expected to be about 2.2 per cent on average over 10 years.

Disinflation optimists will understandably point to Japan’s experience in recent decades to question the link between a growing dependency ratio and inflation. However, it’s important to note at least two factors that helped Japan keep wages and prices low that may not be replicable in other ageing countries. First, the Japanese have stayed in the workforce longer, which seems less likely in other countries where retirees appear content and financially able to remain on the sidelines. Second, Japan was able to increase its labour pool in recent decades via overseas investment and manufacturing that relied on foreign workers — this will be less politically palatable for many governments that would rather reshore.Beyond inflation, we should expect more difficult fiscal trade-offs for governments. Policymakers will increasingly have to choose between reducing expenditure in politically sensitive areas such as elderly-related spending programmes, raising taxes or accepting wider budget deficits. In the current polarised state of many countries, reaching any decision will be noisy, to say the least. For markets, these demographic headwinds should result in interest rates settling relatively higher. In addition, we should expect higher labour and borrowing costs to weigh on profit margins. Sustained higher levels of political uncertainty can also leave individuals wary on spending. Just as sentiment feeds into equity valuation multiples, more cautious investment and spending will flow through to earnings. More

The writer is general manager of the Bank for International SettlementsUnlike businesses, central banks are designed to make money only in the most literal sense. They have a mandate to act in the public interest: to safeguard the value of the money they issue so that people can make financial decisions with confidence. The bottom line for central banks is not profit, but the public good.Today, following an extraordinary period in economic history, some central banks are facing losses. This is particularly true if they bought assets such as bonds and other securities to stabilise their economies in response to recent crises. Many will not contribute to government coffers for years to come.Does this mean that central banks are unsound? The answer is “no”. Losses do not jeopardise the vital role played by these institutions, which can and have operated effectively with losses and negative equity. And the unique nature of central bank tools means that sometimes losses are the price to pay for meeting their objectives — to support growth and jobs, ensure stable prices and help keep the financial system safe and stable.In normal times, it is possible for central banks to both fulfil their mandates and earn profits without taking on significant financial risk. Traditionally, being the unique issuer of money provides a reliable revenue stream. But central banks with large foreign exchange reserves, built to cushion external shocks, will often experience ups and downs in income from exchange rate fluctuations. This means they sometimes make losses when pursuing their goal of a stable currency.In times of crisis, central banks may also need to take on additional risks. And they do so with their eyes wide open. One example is the purchases of government bonds, including those made during the Great Financial Crisis and more recently during the Covid-19 pandemic, to avert economic disaster by supporting financial stability, keeping credit flowing and boosting economic activity. In the past decade, with inflation and interest rates low for a long period, these bond purchases boosted income. In fact, some central banks were able to transfer unusually large profits to governments. But in the wake of the pandemic and since the invasion of Ukraine by Russia, inflation has returned. This requires higher interest rates to contain spiralling prices — and exposes central banks to losses related to assets purchased in past successful rescue efforts.Central banks should put purpose above profits. Would it make sense for a central bank with large foreign currency reserves to increase their value by haphazardly triggering a devaluation of its own currency just to generate a windfall? Or for a central bank with domestic currency assets to keep interest rates low, even in the face of high inflation, just to preserve low-cost funding and generate profits? Such actions would be wildly inappropriate, violate their mandates and destabilise the economy.The soul of money is trust. To operate effectively, business must maintain the trust of investors. And central banks must maintain the trust of the public.Governments also have a role to play in the face of today’s central banks’ losses. Because these institutions are ultimately backed by the state, trust in money requires sound government finances and good financial management.Losses matter because they may inflict a bruise on public finances but a far greater injury would result from central banks neglecting their mandates to avoid a loss. The public, via elected officials, have given central banks the job of price and financial stability because of their enormous societal benefits. Now, and in the long term, the costs from central bank losses are insignificant compared with the costs of runaway inflation and prolonged economic crisis. More

Can the world reconcile its hunger for energy with the need to fight climate change? The answer depends on whether it can find greener, cheaper, more efficient ways to produce and deliver that energy. But that in turn depends on the level of research and development spending, and overall investment, in this area — and the figures do not look promising.Take the Mission Innovation initiative announced by then US president Barack Obama at the 2015 Paris climate summit — the gathering at which world leaders agreed to limit global warming to well below 2°C above pre-industrial levels. MI’s 20 participant governments pledged to double their clean energy R&D investment in the five years to 2020. But that didn’t happen. Instead, there was a cumulative shortfall over the five-year period of more than $50bn, based on estimates from the Information Technology and Innovation Foundation, a US public policy think-tank. According to the ITIF, of the 34 countries it covers, only Norway spent more than 0.1 per cent of its GDP on low-carbon energy R&D in 2021. But, if all 34 countries had invested at the 0.1 per cent level, it would have equated to an additional $71bn. The latest World Investment Report from the Paris-based International Energy Agency estimates that, in 2021, total public spending on energy R&D was $38bn, of which almost 90 per cent was allocated to clean-energy technologies.Much of the emphasis on clean energy is a response to the climate emergency. However, elevated fossil fuel prices and concerns over energy security — both factors that have come to the fore since Russia’s invasion of Ukraine — also play a part.Public spending on non-fossil fuel energy R&D doubled in IEA member countries between 1974 and 1980, after oil price shocks, and doubled again between 1998 and 2011 — another period when oil prices were elevated.Economic recovery packages have also helped to boost investment — as happened after the global financial crisis of 2008-09, again during the Covid-19 pandemic, and, most recently, after the return of high inflation in 2022. Funding from the US Inflation Reduction Act (IRA), passed last year, is expected to accelerate investment into clean technologies.Although pressure on government budgets may work against this, levels of R&D spending today account for a smaller share of GDP than in previous crisis periods — suggesting that increases should be affordable.

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As well as arguably being too low, current levels of R&D investment may be unbalanced. Data from the IEA shows that research into renewables, such as wind and solar, actually trended down slightly in the decade to 2021. Energy efficiency R&D has risen, mostly in the transportation sector rather than in buildings or industrial processes — both a significant source of emissions. The nascent technologies of carbon capture and storage (CCS) and hydrogen and fuel cells have very low shares of R&D (though some experts say that attention is in any case better focused on more proven areas).A rising trend in government investment is likely to stimulate private investment. Incentives such as tax breaks could also help lure private investors away from fossil fuel projects and towards cleaner alternatives.While the share of non-carbon sources in the energy mix is increasing, global fossil fuel consumption has almost certainly not yet peaked. In fact, it looks likely to keep rising in some developing economies for decades to come. The pressure to develop greener alternatives will only grow.

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The consumer price index (CPI) rose 8.7% in January, way above the 7.7% forecast in a Reuters poll and topping the 8.1% rate in December.Core inflation, which strips out volatile food and fuel items, increased to 7.4% from December’s 6.9%.The Philippine central bank, which had forecast January CPI to be between 7.5%-8.3%, said on Saturday it will focus on inflation rather than the Federal Reserve’s 25-basis point hike when it meets on Feb. 16 to review key interest ratesIts governor has previously signalled further interest rates hikes at the central bank’s first two policy meetings this year to bring inflation back within a target range of 2% to 4%. (This story has been refiled to correct the day to Tuesday, not Monday in paragraph 1 ) More

TOKYO (Reuters) -Japanese real wages rose for the first time in nine months thanks to robust temporary bonuses, but uncertainty remains on whether pay hikes will continue to sustain Japan’s economic recovery.Separate data showed household spending falling for a second month in December, as rising prices offset otherwise robust private consumption fuelled by the country’s reopening from the COVID-19 pandemic.”Real wages would have likely fallen again in January … Rising prices have clearly curbed shopping activities since November, and the overall consumption stays lukewarm,” said Takeshi Minami, chief economist at Norinchukin Research Institute.Japan’s real wages rose 0.1% in December from a year earlier, posting the first gain since March, a labour ministry data showed on Tuesday.Strong winter bonuses pulled the nominal total cash earnings to 4.8%, the fastest growth since January 1997 and slightly above December’s inflation rate the ministry uses to calculate the wages in real terms.”But the wage growth needs to be achieved though rising base salary, rather than relying on bonuses,” said Minami, suggesting the December figures may remain an outlier.The market closely watches wage trends in the world’s third-largest economy as a substantial pay growth in the spring labour talks is seen as an essential condition for the Bank of Japan (BOJ) to scale back its massive monetary stimulus. Japan’s household spending fell 1.3% in December from a year earlier, other data found, versus economists’ median estimate for a 0.2% drop and following a 1.2% fall in November.On a month-on-month basis, spending decreased 2.1% in December, disappointing economists that forecast 0.3% growth. It marked the biggest monthly decline since the 2.8% decrease in Feb 2022.Japan’s private consumption, which occupies more than half of the country’s gross domestic product, has underpinned the economy since last year as COVID-19 restrictions eased.The government lifted all domestic curbs in March and relaxed border controls in October, stimulating a tourism boom supported by a weak yen. But inflation running at a 41-year-high speed has put a lid on domestic consumer spending.Major companies have rolled out one-off inflation allowances and promised higher pay hikes at the spring labour talks season, including Uniqlo parent Fast Retailing Co Ltd that last month announced wage hikes by as much as 40%. But analysts think the pay hikes will remain limited to big firms and will not be sustained, challenging the rosy picture the government and BOJ officials sketch of higher economic growth accompanied by modest price and wage inflation.”Looking ahead, we expect the labour market to soften a little, which suggests that base pay growth won’t accelerate any further,” said Darren Tay, Japan economist at Capital Economics, adding slowing inflation and economic growth ahead would make firms reluctant to labour cost increases.”The upshot is that wage growth should settle around 1% this year”. More

Shares of Spirit rose over 7% to $21 in aftermarket trade.U.S. airlines have been trying to cash in on strong demand for air travel, undeterred by rising interest rates and a looming recession, as pandemic restrictions ease. “Leisure demand has remained strong,” said Spirit’s chief executive Ted Christie.However, adverse weather, worker shortages and technical glitches have snarled operations over the past year. Spirit earned $0.12 per share on an adjusted basis, above analyst estimates of $0.04 per share, according to Refinitiv data. The Miramar, Florida-based airline’s total operating revenue in the quarter rose nearly 41% to $1.39 billion, compared with analysts’ estimates of $1.38 billion. More