India’s Rs 1,66,276 Crore Problem

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One of the major points that we talk about in India’s Big Government is the fact that the Indian state is overambitious. The government wants to do too many things at the same time, and ends up making a mishmash of everything.

One of the areas where the governments (both central as well as state governments) devote a lot of their time and attention are public sector enterprises. In the past columns, we have discussed many cases of central public-sector enterprises continuing to bleed and the government continuing to bail them out, year on year. This includes loss makers like Air India and Hindustan Photo Films Manufacturing Corporation, which have been losing money for many years.

In fact, very recently, the government revealed the losses of the perennially loss-making Air India, in the Lok Sabha. For 2016-2017, the government owned airline made losses of Rs 5,765 crore. Despite all the government spin around the airline working in a much better way, than it was in the past, the losses increased by 50%. In 2015-2016, the losses of the airline were at Rs 3,837 crore. With these numbers, it is surprising that a few media houses chose to report the fact that the operating profit of Air India, had improved year on year. But how does that matter, when the losses have gone up by 50%?

The airline has lost a total of Rs 41,657 crore, between 2010-2011 and 2016-2017. It continues to function on back of the government investing money in it, every year. Between 2011-2012 and 2017-2018, the government has invested a total of Rs 26,545 crore, into the airline. Of course, as we keep saying, every extra rupee invested in this airline, is a rupee taken away from more important areas like defence, education, health, agriculture etc.

Over and above this, the banks give the airline working capital loans. These loans as of March 31, 2017, amounted to Rs 31,088 crore. The question is why do banks give an airline which has accumulated losses of greater than Rs 41,000 crore, more loans? The answer lies in the fact that Air India is ultimately owned by the Indian government. No private sector airline in a similar situation, will get bank loans.

And lending to Air India is essentially lending to the government. Any default on loan repayment by Air India will be seen as a default by the Indian government. Hence, the assumption is that such a default is never going to happen. Given this, banks are happy to keep giving loans.

The point in throwing all these numbers at you, dear reader, is to show you, that it takes a lot of money to keep a “dead elephant” like Air India, alive. It is beyond the government babus who run this airline, to breathe life into it. With every new appointment at the top, we are told this gentleman will now revive the airline. But that hasn’t happened in years.

Meanwhile, the government continues to invest money in the airline. At the same time, the accumulated debt of the airline stands at Rs 48,447 crore (this includes aircraft loans over and above, the working capital loans). The good part is that the total debt is down from Rs 52,817 crore as of March 31, 2016. This is ultimately, the liability of the government of India, which actually does not show on its books.

In the recent past, there has been some talk about selling the airline, lock, stock and barrel. But then, until things really happen, talk is just talk. In fact, the government has been talking about selling the airline since June 2017. The proof of the pudding, as they say, is in the eating.

Air India, over the years, has become a poster boy of the government owning and continuing to run, loss making enterprises. This problem is well known at the central level. In 2015-2016 (the latest set of agglomerated numbers which are currently available) 78 out of the 244 central public sector enterprises, were loss making. Of these nearly half of the companies had made losses three years in a row. Further, between 2006-2007 and 2015-2016, a period of a decade, the net profit to capital employed ratio, of the central public sector enterprises has fallen from 12.27% to 5.97%. This tells us how well the government’s capital (or in other words the taxpayer’s capital) is being put to use.

The story of central public sector enterprises not doing well has been well highlighted over the years. But the same cannot be said for public sector enterprises owned by the state governments. Economist Vijay Joshi in a recent lecture pointed out: “In addition to Central PSEs, there are around 1000-odd State PSEs, of which two-thirds make losses, including notably the zombie electricity distribution companies. The aggregate losses of all PSEs, central and state, amount to about one per cent of GDP annually.”

One percent of  the GDP is not a small amount. The GDP (gross domestic product) at current prices for 2017-2018 is projected to be at Rs 16,627,585 crore. One percent of this works out to around Rs 1,66,276 crore. This is a large amount of money.

Of course, a lot of this amount, the government is not currently paying for directly. Many public sector enterprises borrow from banks, in order to make up for their losses. The banks lend them money simply because these companies are ultimately owned by the central and the state governments.

Hence, the total liabilities of the government keep increasing day by day and will have to be paid for one day, simply because a government cannot default.
Rs 1,66,276 crore are just the projected losses of India’s public sector companies, for this year. Imagine, the kind of losses that have been accumulated over the years. Now imagine the kind of money that has been borrowed by these companies to keep running.

And now imagine, the kind of money that the government of India will have to provide in the years to come, to keep repaying these loans.

It’s a very scary proposition. And since, in the end, we are always asked, but what is the solution, let’s provide a solution, at least this time around. As Joshi said in his speech: “So far, successive Indian governments have been stuck with the fetish of 51 per cent ownership and have only flirted with the idea of privatization…It is high time the government grasped the nettle of mounting a substantial programme of privatization, at least of those PSEs that make losses or meagre profits… This gain could be used by the government to invest in socially beneficial activities that the private sector would normally avoid, such as rural roads and irrigation.”

But this is what we call an impossible solution. Joshi is not the first economist to have recommended the sale of public sector enterprises and the investment of the money thus generated into public goods. The government(s) have been in the know of this solution for a very long time, and have chosen to do nothing about it, up until now. And there is no reason for them to change that.

The column originally appeared in Equitymaster as on February 15, 2018.

How We Pay for Incompetence

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Sometime back I got some plumbing work done. The plumber said the work would take around eight hours or one full day. Once he started working, it took me a couple of hours to figure out that he was basically wasting time and he could easily finish work in four hours.

I confronted him on this and he agreed. The logic he offered for wasting time was very interesting. He said, plumbing was a profession that needed some experience and expertise. He had the necessary experience and expertise and could work faster than the average plumber could. The trouble was whenever he finished worked fast, the customers would dilly dally in paying him, the amount of money, that had been agreed on.

The reason always offered was, “but that hardly took any time”. He found it very difficult to explain to his customers that it barely took any time simply because of his experience and expertise. Hence, over the years, he had come to the conclusion that it simply made more sense to waste time and then get paid the amount that had been agreed on.

Both the customer and the plumber lost out in the process. The plumber by having to waste more time, couldn’t take on more work or he couldn’t spend those extra hours in leisure, if he did not want to work. The customer also had to keep engaging with the plumber for those extra hours. In the process, both of them lost out.

Dan Ariley and Jeff Kreisler discuss a similar story about a locksmith in their book Dollars and Sense—Money Mishaps and How to Avoid Them: “A locksmith once told Dan that when he started his career, he took forever to open a lock, in the process, he often broke it, taking even more time and money to get one properly installed and finish the job… People were happy to pay for all this, and they tipped him well… As he became proficient and opened a lock quickly, without breaking the old lock… customers not only didn’t tip, but they also argued about his fee.”

This is a phenomenon, where we confuse effort and outcome, and in the process award incompetence. Take the case of many people leaving office late, even if they have no work and no reason to hang around. But by hanging around they are just trying to send that signal to their bosses that they are putting in a lot of effort, which hopefully will be rewarded once appraisals come around.

Of course, many bosses confuse this “useless” effort of hanging around, with the employee adding value to the organisation. And once a few employees start doing this in an organisation, almost everyone else has to. In the end, more than rewarding anyone, this just becomes a “nuisance” that everyone needs to follow.

In fact, Dan Ariely carried out a research along with On Amir, on how much would people pay for data recovery. The result was very interesting: “When the data recovery took only a few minutes, willingness to pay was low, but when it took more than a week to recover the same amount of data, people were willing to pay much more. Think about it: They were willing to pay more for the slower service with the same outcome.”

The point being that when effort is more valued than outcome, we end up paying for incompetence. There is a great story about the painter Pablo Picasso, perhaps apocryphal, which shows precisely this. A woman once approached Picasso and asked him to paint her portrait. The painter looked at her, and then with a single stroke, drew her a perfect portrait.

The woman was impressed and told Picasso that he had captured her essence in a single stroke. She asked him: “How much do I owe you?” Picasso asked for $5,000. The woman was aghast. “It only took you a few seconds,” she said. To which Picasso replied: “No, ma’am. It took me an entire life and a few more seconds.”

The column originally appeared in the Bangalore Mirror on Feb 14, 2018.

Taxpayer Funded Bailouts of Public Sector Banks Will Only Get Bigger

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In the first column that we wrote this year, we said that even the Reserve Bank of India (RBI) is not sure of how deep the bad loans problem of India’s public sector banks, runs. And from the looks of it, the central bank has finally gotten around to admitting the same and doing something about it.

Up until now, the banks (including public sector banks) could use myriad loan restructuring mechanisms launched by the RBI and available to them, and in the process, postpone the recognition of a bad loan as a bad loan. Restructuring essentially refers to a bank allowing a defaulter more time to repay the loan or simply lowering the interest that the defaulter has to pay on the loan. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

These mechanisms came under fancy names like the strategic debt restructuring scheme to the 5/25 scheme. Banks, in particular public sector banks, used these mechanisms to keep postponing the recognition of bad loans as bad loans. This allowed banks to spread out the problem of bad loans over a period of time, instead of having to recognise them quickly.

This has led to a situation where the bad loans of public sector banks in particular, and banks in general, have kept going up, with no real end in sight.

We have seen senior bankers say, the worst is behind us, for more than a few years now. And that is clearly not a good sign.

The bad loans of banks jumped to 10.2 per cent as on September 30, 2017, up by 60 basis points from 9.6 per cent as on March 31, 2017. One basis point is one hundredth of a percentage.

This basically means that for every Rs 100 that banks have lent, more than Rs 10 has been defaulted on by borrowers. The situation is worse in case of public sector banks. For every Rs 100 lent by these banks, Rs 13.5 has been defaulted on by borrowers. For private sector banks, the bad loans stood at 3.8 per cent.

This has led to the RBI, having to revise its future projections of bad loans, over and over again. In fact, in every Financial Stability Report, published once every six months, the RBI makes a projection of where it expects the bad loans to be in the time to come. And in every report over the past few years, this figure has been going up.

As the latest Financial Stability Report points out: “Under the baseline scenario, the GNPA ratio [gross non-performing assets ratio] of all scheduled commercial banks may increase from 10.2 per cent in September 2017 to 10.8 per cent by March 2018 and further to 11.1 per cent by September 2018.”

In the Financial Stability Report published in June 2017, the RBI had said: “Under the baseline scenario, the average GNPA ratio of all scheduled commercial banks may increase from 9.6 per cent in March 2017 to 10.2 per cent by March 2018.”

In June 2017, the RBI expected the bad loans figure in March 2018 to be at 10.2 per cent. Now it expects it to be at 10.8 per cent. This is an increase of 60 basis points. This revision of forecasts had been happening for a while now. This is a problem that needed to be corrected. The bad loans of Indian banks need to be recognised properly, once and for all. The farce of the bad loans increasing with no end in sight, needs to end.

Earlier this week, the RBI did what it should have done a while back. But, as they say, it is better late than never. India’s central bank has done away with half a dozen loan restructuring arrangements that were in place and which allowed banks to keep postponing the recognition of their bad loans as bad loans.

As per a notification issued on February 12, 2018, a bank has to start insolvency proceedings against a defaulter with a default of Rs 2,000 crore or more, if a resolution plan is not implemented within 180 days of the initial default. The banks will have to file an insolvency application, singly or jointly (depending on how many banks, the borrower owes money to), under the Insolvency and Bankruptcy Code 2016 (IBC) within 15 days from the expiry of 180 days from the initial default.

The resolution plan can be anything from lowering of interest rate, to converting a part of the loan into equity or increasing the repayment period of the loan. The banks have a period of 180 days to figure out whether the plan is working or not. If it is not working, then insolvency proceedings need to be initiated.

This particular change will not allow banks to keep postponing the recognition of bad loans, as they have been up until now. One impact of this move will be that the bad loans of public sector banks will shoot up fast in the near future. While that is the bad part, the good part is that now we will have a better understanding of how bad the bad loans problem of Indian banks really is. The farce of every increasing bad loans is likely to end quickly.

In addition to this, the notification has also asked the banks to report to the Central Repository of Information on Large Credits (CRILC), all details of borrowers who have defaulted and have a loan exposure of Rs 5 crore or more. This has to be done weekly, every Friday. This will give the RBI a better understanding of the bad loans problem. And with more information at its disposal, it will also be in a position to see, whether banks are recognising bad loans as bad loans, or not.

While this is a good move, it does not solve the basic problem of the public sector banks i.e. they are public sector banks. With these changes made by the RBI, the real extent of the bad loans problem is expected to come out. With more bad loans, more capital will have to be written off in the days to come. This means that the government, as the major owner of public sector banks, will have to infuse more capital into these banks, if it wants to maintain its share of ownership in these banks. And from the looks of it, there is no reason to suggest otherwise. This means that the taxpayer funded bailout of public sector banks, is likely to get bigger in the days to come.

As we have been saying for a while, the government only has so much money going around, and if the taxpayer funded bailouts of public sector banks bailout are likely to get bigger, that money has to come from somewhere.

Where will that money come from? The money will come from lesser government spending on agriculture, education, health etc. That is something which has been happening for the last few years. It will also come from more farcical decisions like LIC buying shares in other public sector enterprises, and companies like ONGC having to borrow money to buy a big stake, in companies like HPCL, with the overall government ownership not changing at all.

As we like to say very often, the more things change, the more they remain the same.

The column was originally published on Equitymaster on February 14, 2018.

India’s Investment Conundrum

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The Economic Survey released by the ministry of finance every year before the budget is by far the best document on the ‘real’ state of the Indian economy. The latest Economic Survey released in late January, discusses the poor state of investment in India in great detail.

The investment to gross domestic product (GDP) ratio (a measure what part of the overall economy does investment form) peaked in 2007 at 35.6%. It has been falling ever since and in 2017, it had stood at 26.4%. No other country in the world has gone through such a huge investment bust, during the same period, the Survey suggests.

Further, the Survey remains pessimistic about whether India will be able to bounce back from here. For one, India’s investment slowdown is not yet over. As the Survey puts it: “Cross -country evidence indicates a notable absence of automatic bounce-backs from investment slowdowns. The deeper the slowdown, the slower and shallower the recovery.”

Evidence from other countries which have gone through a similar investment slowdown seems to suggest that a full recovery rarely happens. Further, a fall in private investment accounts for a bulk of the investment decline. This is something that can be seen from the fact that new projects announcement in the period of three months ending December 2017, came in at a 13-year low (as per data from Centre for Monitoring Indian Economy).

A fall in the investment to GDP ratio also suggests that enough jobs and employment opportunities are not be created. A recent estimate made by the Centre for Monitoring Indian Economy suggests that in 2017, two million jobs were created for 11.5 million Indians who joined the labour force during the year.

With sufficient jobs and employment opportunities not going around, it has impacted the earning capacity of many Indians, especially, the one million Indians entering the workforce every month.

Ultimately, enough jobs and employment opportunities not being created has translated itself into a lack of growth on the consumer demand front. This can be seen in the capacity utilisation of manufacturing firms which has varied between 70-72% for a while now. This lack of consumer demand has finally translated into falling corporate profits, over the last decade.

Take a look at Figure 1.

Figure 1:
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Source: Economic Survey 2017-2018.

Figure 1 plots the corporate profits as a proportion of the GDP since 2008. The Indian profits are represented by the blue line, which has gone down. As the Economic Survey points out: “India’s current corporate earnings/GDP ratio has been sliding… falling to just 3½ percent.” Indian corporate profits have halved since 2008. This is a clear impact of a falling investment to GDP ratio.

Of course, no relationship in economics can be totally linear.

A falling investment rate leads to fewer jobs and employment opportunities, in turn leading to lower consumer demand and lower corporate profits.

Lower consumer demand obviously has a negative impact on the investment rate, which again has an impact on jobs, employment opportunities and corporates profits. And so the cycle works.

John Maynard Keynes, in the aftermath of the Great Depression of 1929, had suggested that when the private sector is not investing, the government needs to step in, up the ante, spend money and create consumer demand.

One of the best sectors to invest in, in order to create demand is housing. The sector has many forward and backward linkages, which can have a huge multiplier effect. As the finance minister Arun Jaitley said in his budget speech: “Under Prime Minister Awas Scheme Rural, 51 lakhs houses in year 2017-18 and 51 lakh houses during 2018-19 which is more than one crore houses will be constructed exclusively in rural areas. In urban areas the assistance has been sanctioned to construct 37 lakh houses.” A few months back, the government had announced a huge road building programme as well.

These programmes will definitely help. But the government can only do so much, given the fact that India’s investment to GDP ratio has been falling for more than a decade. The government doesn’t have access to an unlimited amount of money, and the private sector needs to start investing if the investment rate has to revive.

The private sector won’t do so, at least not immediately, because of a lack of consumer demand and also because it is just coming out of a huge borrowing binge. The government can only facilitate this situation by pushing through ease of doing business at every level.

As Jaitley said in his speech: “To carry the business reforms for ease of doing business deeper and in every State of India, the Government of India has identified 372 specific business reform actions.” These reforms need to be quickly implemented, if there has to be any hope of breaking India’s investment conundrum.

The column originally appeared in Daily News and Analysis on February 13, 2018.

Is Federal Reserve Getting Ready for an ‘Easy Money’ Confrontation with Donald Trump?

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We were at the Taj Mahal Hotel in Mumbai, attending the Equitymaster conference over the last two days. Overlooking the dark waters of the Arabian Sea and the Gateway of India, as we ate, talked and heard, we also sat back and thought about how the end of the easy money era would play out.

As we heard Marc Faber and Ajit Dayal lay out their ideas, we got more ideas. And we came to an old conclusion, all over again: forecasting, especially about the future, is a difficult business. But then someone’s got to take a shot at it. Everyone in the investing world cannot be cautiously optimistic. We have clearly have had enough of that term.

So how is this end of the era of easy money, likely to play out? The Federal Reserve of the United States, the American central bank, has started shrinking its massive balance sheet from October 2017 onwards. Between October 3, 2017 and January 29, 2018, the Federal Reserve has shrunk its balance sheet by around $40 billion, we can see that from the Fed documents. But there is still a long way to go, given that the size of the Federal Reserve’s balance sheet is still more than $4.4 trillion.

In the aftermath of the financial crisis that started in September 2008, once the Lehman Brothers, the fourth largest investment bank on Wall Street went bust, and many other financial institutions in the Western world almost went down with it, the Federal Reserve decided to print a lot of money. But just printing money wasn’t enough, this money, had to be pumped into the financial system as well.

This printed money (or rather created digitally) was pumped into the financial system by buying American treasury bonds and mortgage backed securities. American treasury bonds are bonds issued by the American government in order to finance its fiscal deficit, or the difference between what it earns and what it spends.

Mortgage backed securities are essentially securitised financial securities which are derived from mortgages (i.e. home loans). As of September 1, 2008, the Federal Reserve had assets worth $905 billion. As it got around to buying treasury bonds and mortgaged backed securities, it expanded its balance sheet very quickly. The size of Federal Reserve’s balance sheet peaked at $4.51 trillion, towards the end of December 2016.

The idea was that all this money floating around in the financial system would drive interest rates low and keep them there. This happened. Over and above this, the hope was that the companies would use low interest rates as an opportunity to borrow, invest and expand. This would create jobs and employment, would lead to spending and create faster economic growth.

The companies didn’t quite behave the way they were expected to. Yes, they did borrow. But they borrowed to buyback their shares and reduce the number of outstanding shares, and hence, pushed up their earnings per share.

These buybacks essentially benefitted the rich Americans who owned shares. The benefits were two-fold. First, they had an opportunity to sell their shares back to the companies buying them. And second, as the stock market rallied because of improved earnings and all the money floating around, those who owned shares benefitted.
But this wasn’t really what the Federal Reserve had hoped. The consumers were also supposed to borrow and spend at low interest rates. But that didn’t quite play out the way the Federal Reserve had hoped.

What happened instead was that large financial institutions borrowed money at very low interest rates and invested them in stock and bond markets all over the world, including India. These trades are referred to as the dollar carry trade. This led to stock markets rallying all over the world, irrespective of the fact whether the earnings of the companies were improving or not.

The Federal Reserve has decided to gradually start withdrawing all the money that it has put into the global financial system. Between October and December 2017, it planned to sell treasury bonds and mortgage backed securities worth $10 billion. Between January and March 2018, this will go up to $20 billion a month. Between April and June 2018, this will go up to $30 billion a month. Between July and September 2018, the Federal Reserve plans to sell bonds worth $40 billion a month. After that the amount will rise to $50 billion a month.[i]

How does the actual evidence look like? As mentioned earlier in the piece, the Federal Reserve had managed to shrink its balance sheet by $40 billion between October 3, 2017 and January 29, 2018. From the looks of it, the Federal Reserve seems to be doing what it said it would do. Nevertheless, these are early days.

In 2018, the Federal Reserve is expected to shrink its balance sheet by $420 billion and 2019 onwards, the balance sheet is expected to shrink by $600 billion a year. With the Federal Reserve taking money out of the financial system, there will be lesser money going around, this is likely to push up interest rates. In fact, the yield (i.e. return) on the 10-year treasury bond has crossed 2.85%. This yield acts as a benchmark for other kinds of lending, simply because lending to the American government is deemed to be the safest form of lending. With interest rates expected to go up, the carry trades are expected to become unviable. This will lead money being withdrawn from stock and bond markets all over the world.

In fact, regular readers would know that we have already discussed a large part of what has been written up until now. But now comes the completely crazy part. The United States government is expected to borrow $955 billion, during the course of this year, to meet its expenses. It is further expected to borrow a trillion dollars, in each of the next two years. Basically, the American government needs to borrow close to $3 trillion between 2018 and 2020.

During the same period, the Federal Reserve is working towards withdrawing more than $1.6 trillion ($420 billion in 2018 + $600 billion in 2019 + $600 billion in 2020) from the financial system. In this scenario, when the Federal Reserve is withdrawing money from the financial system and the government needs to borrow a huge amount of money, it is but logical that the interest rates in the United States are going to go up.

This will impact the carry trades. Hence, stock markets and bond markets will have a tough time all over the world. Of course, all this comes with the assumption that the Federal Reserve will continue doing what it is. The question is will it continue to withdraw the printed money it has pumped into the financial system?

Now this is where things get really interesting. The American society as a large is a highly indebted one. The total household debt of the Americans as of September 30, 2017, stood at $12.96 trillion. The debt has been going up for 13 consecutive quarters now. This debt includes, home loans, auto loans, student loans, credit cards outstanding, etc.
Hence, rising interest rates will hurt the average American as the EMIs will go up. It will also hurt the American government which is in the process of borrowing more, in the years to come. Governments, because they borrow as much as they do, as a thumb rule, like low interest rates.

In this scenario, if the Federal Reserve continues withdrawing the printed money, it is more than likely to run into a confrontation with the American president Donald Trump. Trump has only recently chosen Jerome Powell as the Chairman of the Federal Reserve, after Janet Yellen. One school of thought seems to suggest that Powell, given that he has been appointed by Trump, is likely to bat for Trump and go easy on withdrawing money from the financial system, and allowing interest rates to go up. But it is not just up to him. The American monetary policy is decided by the Federal Monetary Policy Committee (FOMC), which has Powell and 12 other members.

In fact, even if that Powell does not bat for Trump, the FOMC might still vote to go slow on allowing interest rates to rise. Ultimately, the Federal Reserve has to ensure that the American economy continues to remain on a stable footing. If rising interest rates end up hurting the American economy, the FOMC will have to react accordingly. No Federal Reserve decisions are written in stone and can always be changed.

The question is how quickly is this likely to happen? Now that is a very difficult question to answer. But my best guess (and I use the word very very carefully here) is that during the second half of the year, the Federal Reserve might have to reverse its policy of taking out all the money that it has put into the global financial institution.

Up until then, a lot of damage will be done to the stock and bond markets around the world. The funny thing is that though the Federal Reserve is now pulling out money to let interest rates rise, the European Central Bank continues to buy bonds issued by its member governments and the 10-year government bond yields of European countries, is significantly lower than that of United States.

What does this mean in an Indian context? Unless, the American Federal Reserve reverses its current policy, the Indian stocks are going to have a tough time. That is a given. What happens next, if and when Federal Reserve changes track? Will another easy money start? On that your guess is as good as ours.
Let’s watch and wait!
[i] https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm

The column originally appeared on Equitymaster on February 12, 2018.