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David Blanchflower argues in this interview on the Radio 4 Today programme that the Bank of England acted too late during the financial crisis and may be on the threshold of making similar errors in setting policy rates in 2010. he suggests that the MPC is not fit for purpose and that a change in target is called for. But he doesn’t explain clearly what should take its place. So students will get something from this piece but are left unfulfilled. John Humphries should have pressed Blanchflower further.
Statistics about the speed of China’s development never cease to be amazing, no matter how many times you read them. Here is another one; in the dark days of 2009 the Chinese economy grew by yet another 8.7% (10.7% in the final quarter of the year) so that it is now set to overtake Japan, which probably shrank by 6% over the same period, to be the world’s second largest economy. And yet, according to Ma Jiantang, head of the National Bureau of Statistics, there are still 150 million people in China living on $1 a day and so poor according to the UN’s standard rating. This gives a remarkable contrast as the world’s second or third largest economy is also a developing nation with enormous conflicts and trade-offs in macroeconomic policy to resolve. Mr Ma also referred to the concerns about inflation in China - he said price rises were “mild and under control”, but over recent days the government has tried to limit the amount of loans made by the country’s banks in order to avoid a ‘domestic bubble’ of growth. This is the focus of the Times’ report, which highlights expectations that there may be a rise in interest rates in China in the next two months.read more...»
1/ BBC news video - UK interest rates could stay low for five years - One of the UK’s best known economists, Roger Bootle, predicts that interest rates will stay below 1% for the next five years
2/ Telegraph - Economists question success of Bank of England’s £200bn money-printing plan - Economists have cast doubt on whether the Bank of England’s £200bn quantitative easing (QE) programme is working
3/ Telegraph - Why the Bank of England will raise interest rates as deflationary threat melts away - despite massive amounts of Quantitative Easing (QE) in both the US and UK. It is surely only a matter of time before short-term rates follow suit. Or so you would assume
4/ Guardian - Too dangerous to raise interest rates yet - Setting interest rates is a dangerous game - and one that could choke off recovery
5/ The Times - Profile of Willem Buiter - Maverick laughs all the way to the bank - More booms and busts lie in wait, economist Willem Buiter predicts.
This revised and extended revision presentation on monetary policy is designed for AS students
This hints that the transmission mechanism of monetary policy might have broken down. When ultra-low interest rates appear to be ineffective in restoring confidence and spending, this is known as the liquidity trap. For the exam you need to explain how a reduction in policy interest rates can stimulate household and business sector demand and also (through the exchange rate) providing a stimulus to export s. But we do not live in normal times! There are grounds for thinking that – in the short term at least – the impact of monetary policy may have been reduced. Here are some reasons:read more...»
Many thanks to Geoff for updating his popular revision presentation for AS students on Aggregate Demand
Week in Westminster today featured a fascinating discussion about the impact of a hung parliament - the outcome of an indecisive election which results in no clear majority for any party. There is a view that this may be the outcome of the General Election which is due by June next year, and asking around my A2 students, is something which they see as a real possibility, as they struggle to evaluate the policies of the three main parties. It is well worth listening to and analysing with students who are in the midst of examining the macroeconomic indicators and fiscal policy, and perhaps asking them to suggest what they would do, if elected as Chancellor early next summer, in order to deal with the aftermath of the enormous fiscal stimulus injected to the economy over the last year and the probable fragile recovery from the UK’s longest recession. The link to the BBC i-player is here - listen to Lord David Steel and Roy Hattersley discussing how best to deal with the lack of a majority, then move forward to 15 minutes into the programme to hear the statements of each of the party leaders on fiscal stimulus, deficit and economic policy followed by analysis from columnists Larry Elliott of The Guardian and Liam Halligan of The Sunday Telegraph.
This new revision presentation examines the causes and effects of deflation and the possible economic policy responses.
Launch interactive presentation on deflation
Some say that “words have meaning and names have power”. Well when Mervyn King speaks, markets listen. And sell the pound too.read more...»
This revision presentation examines recent data on the extent of saving in the UK economy.
The BBC carries this interesting video discussion with De Anne Julius about the impact of the Bank’s Quantitative Easing programme designed to support demand and lending in the UK economy. She emphasises the importance of gradually withdrawing the QE programme and she argues that the main effect of QE so far has been to hold down the interest rate on government debt (gilts) but that there is little evidence so far that QE has enabled a rise in lending to consumers and small businesses. The Indy’s Big Question looks at QE in their edition today.read more...»
Here is a summary of four reports posted on the Business and Economics sections of the BBC News website over the last few days. Be warned - none of them are particularly hopeful, the green shoots of summer giving way to autumn mists.
I do recommend this 4-minute interview to help explore the reasons for the weakness of sterling and whether it is helping the UK economy. Mark Thompson , a dealer at Moneycorp, was interviewed on Radio 5’s ‘Breakfast’ programme, and explained the shocks to the economy caused by the use of Quantitative Easing and the negative bank deposit rate (which means that if banks choose to hold money on deposit with the Bank of England it actually costs them money, rather than gaining them a return as interest). He sees these as strong statements that had been deliberately used to depress the value of the pound on the currency markets, thus encouraging exports and raising the price of imports, so that there is a substitution effect towards home-produced goods, which we can see is reducing the negative trade balance and so helping to raise the level of AD.
The link here will take you to the Friday 25th September episode of the programme, and should remain live until the end of this week; I think that after that it will be unavailable. Once you have opened the i-player page, use the scroll bar below the ‘control panel’ to move forward through the programme to 1 hour 48 minutes, which is the start of the interview.
This useful article from the BBC looks at debt, repayments and savings for individuals in the UK. In July UK households actually paid back more debt than they took out for the first time since the Bank of England started recording this data 16 years ago in 1993. At the end of that month total household savings amounted to £1.1 trillion, and total outstanding lending to individuals stood at £1.46 trillion (which is almost a trillion more than in 1993). Of this, £1.23 trillion was mortgage debt and £231m was other forms of consumer credit. Households are now starting to get the message about repaying that debt, with the average individual paying back £10 more than they borrowed in July – but the average personal debt standing at £24,000 is going to take an awful long time to pay back at £10 a month.read more...»
CPI inflation has fallen to 1.6%, and RPI inflation started to recover to -1.3%, in the measure of the annual rate to August. Is this good news?
For CPI, it means that the rate is moving further away from the target of 2%, which would be a concern if it was to continue on that trend, but the RPI measure indicates a slightly lower level of deflation, which should be a welcome sign. However, in both cases, it depends upon the reason as well as the expectation of what happens next. In a speech to the Treasury Select Committee, Mervyn King suggested that inflation is likely to be volatile over the next year, and focusing on GDP, he said that there were signs of a recovery to positive growth in the third quarter of the year.
But he remains very cautious; although the European Commission forecast the UK to grow 0.2% between July and September, this is less than in France or Germany, and Mervyn King suggested three factors, or headwinds, against which UK growth would have to struggle in order to become positive.read more...»
As the US effectively prints more money, Chinese officials are expressing concern over the impact that this will have on their economyread more...»
I am cross-posting Jon’s excellent blog on Keynes and the multiplier over at his excellent IB Blog that flags up some handy recent articles on this important macro policy concept:
In its simplest form Keynesianism argues that governments should be proactive during economic downturns rather than relying upon the power of the markets and interest rate cuts. Proactive in the sense that the government should borrow money and start spending. The doctrine lost favour in the 1970s as monetarist theory gained popularity. As you will be well aware Keynes has returned in earnest over the past 18 months as governments across the globe have pumped billions into the spluttering economies in the hope of restarting them. Although early days there are tentative signs that Keynes may have be right once again.
Key to his argument of the effectiveness of pumping money into an economy is that of the multpier. Conway provides an excellent overview of the multiplier in his piece today:
Say the US government orders a $10bn (£6bn) aircraft carrier. You might assume the effect of this would be merely to pump $10bn into the US economy. Under the multiplier argument, the actual effect would be bigger. The shipbuilder takes on more employees and generates more profits; its workers spend more on consumer goods. Depending on the average consumer’s “propensity to consume”, this could raise total economic output by far more than the amount of public money actually injected.
If the $10bn increase caused total United States economic output to rise by $5bn, the multiplier would be 0.5; if it rose by $15bn, the multiplier would be 1.5.
The article also provides some good points that students could use when being critical of fiscal policy (these were particuarly prevalent when monetarists were arguing against Keynesianism in the 1970s):
One of their main arguments was that governments cannot “fine-tune” an economy by regularly adjusting fiscal and monetary policy to keep employment high. There is simply too long a time lag between recognising the need for such a policy (tax cuts, say) and the policy taking effect. Even if policy-makers speedily identify the problem, it takes time for laws to be drafted and passed, and more time still for the tax cuts actually to drip through the wider economy.
There are a couple of recently published books on Keynes that you may want to get your teeth into:
Keynes: Return of the Master by R Skidelsky
This week the UK Treasury will release details of the embryonic macro-prudential policy - a policy designed to prevent the asset price bubbles that have plagued the UK at regular intervals over the years. Robert Peston has a blog on this here and portrays it as a victory for the Bank of England. We will learn more in the coming days and weeks of the technical detail behind macro-prudential policy.
I was reminded reading Robert’s blog of the policy prescription put forward by John Calverley in his most recent book “When Bubbles Burst” - will the Macro Prudential Policy Committee operate in a similar vein to an Asset Valuation Committee?
“John Calverley floats the idea of an independent Asset Valuation Committee whose job would be to improve the flow of financial information available to stock market and property investors, alerting us to when asset prices were either dangerously over-valued or under-priced in the market and perhaps giving people a stronger base on which to reallocate their portfolios and achieve better long term returns. An Asset Valuation Committee might act as a set of Wise Elders to the herd many of whom have spent much of the last two decades stampeding from one asset class to another – from internet shares to buy-to-let property – without stopping to calculate in the cold light of day the risks of the decisions they have taken.”
The Bank of England has released its latest health check on the stability (or otherwise) of the UK financial system.
Without a recovery in financial sector balance sheets and a return of an appetite to lend and unfreeze the supply of credit, any recovery will be delayed and weak.
Banks continue to de-leverage aggressively and I have met several owners of profitable and well managed smaller businesses in recent weeks who have complained that their banks are getting in touch directly to change the conditions of their credit facilities. In some cases the banks are adding 1 or 2 per cent to the rates charged for overdrafts and loans - which themselves are already a high multiple of the policy interest rate. It is the banking equivalent of the rip-off extra charges for people flying with the lower-cost airlines.read more...»
Both the Chancellor of the Exchequer and the Governor of the Bank of England gave their Mansion House speeches to the City yesterday, and both addressed the issue of regulation of the banking system. But while the Chancellor emphasised that he had no plans to fundamentally change the regulation system, the Governor called for more powers for the Bank to intervene and prevent excessive risk taking. This is at odds with the approach outlined by Alastair Darling, who referred instead to encouraging a change of management culture in the banks which would encourage bankers to manage themselves more effectively, being “rewarded for long-term success, not for failure”. He seems to suggest that the solution lies more in ensuring that banks are led by Boards of Directors with “the right people of the right skills and the right experience …. and they need to be equipped to ask the right questions.” He also called for an end to short-termism: “Their focus must be on long-term wealth creation and not short-term profits.”read more...»
Revision notes on aspects of the EU single currency - is the UK economy better off outside of the Euro?read more...»
Professor David (Danny) Blanchflower predicts an age of austerity for the UK in this Radio 4 interview (1st June) as he reflects on a three year stint as a member of the Monetary Policy Committee.read more...»
One of the paradoxes of this recession is that savers - who by and large have been as far removed from causing the crisis as it is possible to be - have seen rates of return on individual accounts collapse.
With policy interest rates dropping close to the floor and likely to stay below 1% for possibly a year or more, the rate of return on liquid savings accounts is desperately poor. Indeed the real interest rate is negative. Bank of England figures show that the average interest rate on instant access accounts - including current accounts - was 0.15% at the end of April. Hence the need for savers to think long term about their savings options and search for better long term accounts offering a better fixed rate of interest.
It involves sacificing liquidity for a higher rate of return. In this sense, nothing has changed because there has always been an inverse relationship between liquidity and interest rates - but the problem facing millions of savers, many of whom risk falling into relative poverty because of the collapse in income from interest-bearing accounts is highlighted in this BBC article.
Most of us at some time in our lives need to borrow money to finance spending. From taking out a mortgage to making frequent use of bank credit cards, borrowing is a normal feature of life and not necessarily something to be worries about. What matter is whether building up debt is sustainable – in other words, can those who rely on debt pay it back? Credit means being able to buy now and pay later. The credit market for individuals is complex at the best of times and there is plenty of scope for individuals to end up in trouble if they borrow irresponsibly or are subject to mis-selling of loan products from the financial services industry.read more...»
The optimist - the new member of the MPC Professor David Miles who spoke at our economics society recently and is decidedly bullish in this article in the Western Daily Mail about the impact of the huge macro policy stimulus.
“Economic history teaches us that a combination of tax cuts, running large fiscal deficits, substantial cuts in interests rates and more quantitative easing is likely, with a certain time lag, to have a substantial impact on demand in the economy and it may well be that the worst of the recession may well be behind us.”
On the other hand, the IMF - “The current recession is likely to be unusually long and severe and the recovery sluggish,” the IMF said in releasing two chapters from its twice-yearly World Economic Outlook (WEO). Have a read here
This summer you can expect many column inches devoted to searching for green shoots of economic recovery. There must come a time when the unprecedented policy stimulus applied to the UK economy will start to bear fruit and evidence emerges of a turning point in the business cycle.read more...»
A quick heads up on a brief profile of David Miles in The Times this morning
This brief “Industry Speak Explainer” from the Guardian provides a vsimple explanation of how the government borrows money by selling gilts. It explains how the Bank of England’s policy of quantitative easing, which involves buying up to £75bn of gilts in an attempt to drive up their price and push down the yield, is an attempt to avoid crowding out by persuading investors to sell gilts back to the Bank and spend the cash on other assets instead, helping to drive up their prices, reduce the cost of borrowing, and stoke new demand across the economy.read more...»
Sailing very close to what is allowed under the terms of Bank of England independence, the Governor of the Bank Mervyn King has made a dramatic statement about how much scope the government has to launch a fresh fiscal stimulus when the delayed Budget is announced on the 22nd of April.read more...»
Some good news today ... David Miles, one of the City’s finest economists and a real expert on housing finance and the broader workings of the economy, has been appointed onto the Monetary Policy Committee. He starts his tenure in June.read more...»
The Financial Times reports today that the Swiss Central Bank has started to intervene in the currency markets to lower the value of the Swiss Franc because they fear that a rapidly appreciating currency will worsen their economic slowdown.read more...»
I have attached some notes from an excellent seminar given last night by Stephen King, Chief Global Economist of HSBC to a large group of keen AS and A2 economists. The Egerton Room at Eton College was pretty packed to hear Mr King give a really clear overview of the risks facing the world economy. There are so many moving parts at the moment that no one country can fix the problems - this demands a coordinated response. And there is a real sense that macro-economic policy has lost control. With it the risk of a descent into economic nationalism and a reversal of globalisation can become acute.
Q&A: Why when base rates change does it cause other interest rates to also change?
The concise answer is that the Bank of England acts as the nation’s central bank and it can use its daily operations in the money markets to nudge other interest rates higher or lower.read more...»
There is much in the press this morning about the fact that the Bank of England has asked Alistair Darling if it can begin the process of ‘quantitative easing’ (many refer to it as ‘printing money’). What does this actually mean though? There is an excellent graphic in today’s Times that makes it all a little clearer.
There was also a good blog from the BBC’s Economics editor Stephanie Flanders yesterday on quantitative easing.
Heather Stewart is also on good form this morning with a good Q & A piece in today’s Guardian.
The conditions under which investor flight might happen for the UK is something we have discussed in our recent A2 lessons on exchange rates and macroeconomic policy and it forms the basis for a short article in the Financial Times today…read more...»
The Bank of England’s Monetary Policy Committee (MPC) has lowered the Bank Rate by 50bps to 1.00%.read more...»
I am discussing the macroeconomic effects of exchange rate movements with my AS students this week.
The suddeness and severity of the recent depreciation of sterling, both against the US dollar and the Euro as well as on a trade weighted basis provides plenty of ammunition for a good lesson which seeks to develop their understanding of the transmission mechanism of exchange rate fluctuations together with a chance to develop their evaluation skills. I have made the AS macro student handout available for download below - it contains up to date charts on sterling together with a short exercise for students on how different stakeholders might be impacted by a sterling depreciation.
Roger Bootle’s quarterly Deloitte Economic Review rarely disappoints and the new edition which is available here provides a timely and crystal-clear explanation of the demand and supply-side factors that might bring about price deflation in the UK economy during 2009 and into 2010.
Seven forces are raised as contributing to downward pressure on the general price level
1. The sharp fall in global food and energy prices
2. Intense competition amongst retailers such as deep-discounting to maintain cash flow and market share
3. The impact of the temporary cut in VAT from 17.5% to 15%
4. Falling housing costs including lower mortgage interest repayments (which affects RPI inflation)
5. The lagged effects of a large margin of spare capacity in the economy due to the negative output gap
6. Downward pressure on basic pay settlements and average earnings - how many people will take pay cuts this year?
7. The sustained and persistent decline in asset prices with consequences for consumer confidence and aggregate demand
For AS students - consider how these forces might be explained and illustrated using AD and SRAS analysis.
The risks of price deflation are not insignificant, indeed as Bootle points out, price deflation might have been rare during the latter part of the twentieth century but we have had plenty of instances of it in the UK in earlier ages.
What of the likely consequences of a bout of price deflation?
Some of the forces mentioned above are indeed likely to be temporary (the VAT cut is reversed in 2010) and some will have favourable effects on real income and spending power. But the consensus seems to be that deflation can have a pervasive and damaging effect on the real economy:
1. A rise in the real value of debts - personal, corporate and state
2. A change in the psychology and expectations of businesses and consumers
3. Second round effects including pressure for wages to fall and output to be cut back further
4. The possibility that the usual instruments of monetary policy become ineffective
5. Consequences for welfare benefits - will the government cut unemployment and state pensions in a world of deflation?
6. The damaging effects on the corporate sector of falling prices and profit margins
Sterling’s continued depreciation perhaps holds out the best hope of avoiding deflation this year as does a partial rebound in the price of oil and gas and other inputs. Bootle predicts that - having cut policy interest rates to the bare bones of 1.5% - the Government and Bank of England are likely to resort to further emergency measures to prevent a Japanese-style deflationary spiral.
This BBC resource has bang-up-to-date graphs and data for the performance of the macroeconomy – GDP, Unemployment, House prices, Inflation, Repossession and Interest rates – as well as some interesting regional comparisons and the opportunity to check your own personal inflation rate. It should be read by anyone studying macroeconomics, especially those taking AQA Unit 6 next week!
Normally we would expect an increase in consumer sales to shift AD to the right and so be inflationary, all other things remaining equal. However, yesterday’s forecasts suggested that significant sales last month would be one of the main drivers of a reduction in inflation when figures for CPI and RPI were released – but the reason is the heavy discounting that retailers had to offer in order to gain those increased sales, so that prices actually fell even though the volume of sales rose.read more...»
The Bank of England has cut policy interest rates to 1.5% (a reduction of 0.5%) taking them to their lowest level in the long history of the Old Lady of Threadneedle Street. Several mortgage lenders have announced whole or partial reductions in standard variable interest rates on mortgages but the majority of lenders will be reviewing carefully whether they should bring their borrowing rates down ... the reason is simple but really important ..... the debate on interest rates is moving on.read more...»
During the housing boom millions of property-owners in Britain opted to unlock some of the equity in their homes by extending their mortgage and using it as a prop for extra spending such as a new car or other big-ticket consumer durables. Housing equity loans have also been made available by some lenders for older households to maintain their spending during retirement.
The Bank of England’s estimate of mortgage equity withdrawal (MEW) is intended to measure that part of consumer borrowing from mortgage lenders that is not invested in the housing market. It takes the increase in housing finance (net mortgage lending and capital grants) and subtracts households’ investment in housing (purchases of new houses and houses from other sectors, improvements to property, and the transactions costs of moving house).
But as the housing recession deepens and prices fall at an annual rate of more than ten per cent, the pattern of equity borrowing has reversed. For the second quarter in succession, people invested nearly £6 billion into housing equity - in effect thousands of people have taken the decision to scale back on equity loans and focus instead on repaying some of the outstanding mortgage debt as and when funds allow.
This change in borrowing psychology has been accompanied by tighter lending criteria being used by lenders making it more difficult and expensive for people to extend their mortgage. Just as the days of the 95% - 100% mortgage have gone for now, so the steady flow of equity release marketing coming through letter boxes has dried up completely. It is all part of the complex process of de-leveraging - an attempt by financial institutions to cut their lending and rebuild their balance sheets.
For the best part of a decade the booming housing market was a significant crutch for domestic consumer spending. Now that equity withdrawal has gone into reverse and with unemployment expected to rise by up to one million over the next year, there are two major drivers of household spending pointing firmly in a downwards direction. The collapse in equity withdrawal is evidence of greater caution among consumers but is yet more bad news for retailers.
The BBC covers the latest data in this article
Britain stands on the brink of one of the deepest recessions since the end of World War Two. Real GDP in the UK fell by its highest amount for eighteen years in the 3rd quarter of 2008 and this marks only the early stages of the downward slide. Most of the really bad economic news - such as the banking collapses and the carnage on the high street in the weeks before Christmas - happened in the final quarter.
2009 will be the first downturn that the vast majority of students will ever have experienced and for many, the direct consequences of a sharp fall in output, profits, jobs and spending will be clear to see.
Naturally for economics students and teachers, the fall out from the global credit crunch and financial crisis will be an incredibly interesting time - the era of the Great Stability has come abruptly to an end and all bets seem to be off regarding the extent and depth of the next stage of the economic cycle. Expect the word recession to be increasingly replaced by the word slump as the forthcoming year unfolds. Indeed the R word may be swapped for the D word if the contraction becomes embedded.read more...»
Hamish McRae has a thoughtful piece in his column in the Independent on the risk that sterling’s fall will make it harder for the UK government to finance their budget deficit. It is a good example of how, in the current climate, the effects of monetary policy and fiscal policy decisions are becoming blurred.read more...»
The continued depreciation of sterling - most notably against the Euro - continues to dominate the economic headlines. One Euro now buys 95 pence and parity is much more likely than I thought when I wrote about the exchange rate last week.
For your exams remember that you need to have a clear handle on
Why the currency is falling (causation)
What the main demand and supply-side effects of this are (consequences)
The possible policy responses (intervention)
With the latter keep in mind that the government and the central bank does not have a target for the external value of the pound although they recognise that it plays an important role in influencing the components of aggregate demand (C+I+G+X-M and also changes in short run aggregate supply (SRAS) e.g. through movements in the prices of imported goods and services.
Another approach for critical analysis of the exchange rate’s fall is to use the acronym PMD
P - plusses - i.e. what are the main advantages of a fall in the currency?
M - minuses - what are the negative effects for the UK economy at this time and for different agents (businesses and consumers)
D - depends - “it depends on” is one of the best evaluation phrases you can use - sterling has fallen by more than 20 per cent (on a trade weighted basis) over the last year. This is a significant depreciation - but the effects DEPEND on many factors - here are a few:
Do exporters reduce their overseas prices or choose instead to keep prices the same and make a higher profit margin?
Do foreign consumers switch their demand to UK exports if and when our exports become more price competitive?
Will the negative real income effect of a global economic downturn offset the competitive advantage from having a lower exchange rate?
Will higher import prices help to prevent deflation in the UK next year?
“Stephen Jen, currency chief at Morgan Stanley, said sterling is a “high-beta” currency, meaning that it is highly-geared to the global economic cycle. It shoots up during good times and plunges during bad times. It should return to health if and when the world emerges from economic winter.”
A related piece claims that the Sterling slide is the worst since 1931
“The pound has now fallen by 23pc against a basket of other currencies, according to figures from the Bank of England. The fall is sharper than the devaluations in 1992, after leaving the Exchange Rate Mechanism, 1976, when the International Monetary Fund was forced to intervene, and 1949, when a host of countries slumped against the dollar. The devaluation is only matched by the moment in 1931 when, under Ramsay MacDonald, the UK was forced to abandon the gold standard, plunging by more than 24pc against the dollar. The parallel is significant, since many economists have attributed the gold standard exit as one of the main reasons the UK enjoyed a relatively mild depression in the 1930s, while the US suffered mass unemployment and saw its economy shrink by a third.”
The Financial Times carries an interesting interview with Charles Bean from the Bank of England. He Deputy Governor reveals how on regional visits to businesses in the UK he has been hit by the severity of the likely labour shedding in the jobs market as businesses small and large look to make immediate redundancies to reduce some of their overheads. Robert Peston reinforces this point in a recent blog post in which he argues that many businesses are turning down new orders because they cannot be confident of securing the short-term loan finance needed to buy the raw materials and components needed to fulfill customer orders.read more...»
Ground Zero for US Interest Rates
The official judges on whether the United States is or is not in a downturn (the NBER) are now saying that the USA entered a technical recession at the end of last year. It takes some time for the statistics to provide concrete proof of this – a nation’s GDP data is always three to six months behind the times.
What is clear is that the world’s biggest economy is in serious trouble as the financial crisis spreads to Main Street and millions of jobs are at serious risk. To state that that millions of jobs might go is not an under-statement. Half a million jobs were lost in November alone.
Yesterday the United States Federal Reserve pulled on the monetary policy interest rate lever one last time. It announced a reduction in the federal funds rate to a new level of ‘between zero and 0.25 per cent’ – which means in practice that the interest rate at which the Federal Reserve is prepared to lend to other financial institutions is now at the floor.
Managing confidence and demand
The main aim of lowering interest rates is simple – to drive down the cost of borrowing for consumers and businesses in an attempt to stimulate confidence and demand in the domestic economy thereby helping to stabilise output and jobs during what promises to be a deep and painful recession.
Some students wonder why – if official interest rates are zero – why it is that loans, overdrafts, credit card rates and numerous other interest costs for borrowed money remain positive – often way above the so-called ‘policy rate’.
The main answer is that most loans – be it for a mortgage or an investment project for a company – are for much longer periods of time than the overnight lending or surplus funds between the banks within the inter-bank market.
So a property-buyer or business looking for loan finance will pay a rate of interest equal to the ‘risk free’ interest on government securities (bonds) of similar duration plus a risk premium that the lender requires as an insurance against the loan going bad. In short - the greater the risk of a borrower defaulting on their loan, the higher is the rate of interest charged.
The credit crunch has made lenders more cautious about lending – risk premium spreads have risen in most financial markets. As a result, deep cuts in policy interest rates by most of the world’s central banks have done little to reduce the real cost of credit for personal and business customers. This is one reason why monetary policy can become ineffective as a tool for managing aggregate demand.
Let us head back to the decision of the Federal Reserve to cut official interest rates to zero. Does this mean that there is nowhere else for monetary policy to go to prevent a deflationary depression?
Turning on the taps
Not quite, some of you may have read about the possibility of the US Central Bank taking some highly unusual steps which boils down to effectively printing money to stimulate liquidity in the financial system. This is known as quantitative easing and the easiest way of describing it is to say that the central bank would buy directly different types of existing debt – say long term government bonds or the dodgy debt of the failed mortgage giants Freddie Mac and Fanny Mae – and print money to pay for their purchases. This injection of money into the economic system would boost the money supply and keep interest rates low.
The Federal Reserve could – in principle – buy any outstanding assets held by the private sector of the economy – and print money to pay for them. They could guarantee to buy up fresh government debt issued by the government – for example extra government borrowing to fund President-elect Obama’s fiscal policy recovery programme.
Added to this, Ben Bernanke at the Fed could announce that the central bank expects to keep short term interest rates at super-low levels for the foreseeable future – a strategy designed to embed into people’s minds that the nominal cost of borrowed money ought to remain minimal. One of the problems of the liquidity trap is that – when interest rates are driven to zero – our expectations are that the next move will be upwards and that this could happen swiftly. The Fed needs to avoid this expectation.
Martin Wolf discusses many of these issues in his excellent piece in the Financial Times – available here. He flags up one idea – that the central bank could simply send everyone a cheque with some money to spend – perhaps using some time limited coupons?
So in the weeks and months ahead, keep a look out for some of the key decisions of the US Federal Reserve. As students you are living through an amazing moment in nearly a hundred years of economic history.
And what will the Bank of England do in response to events both here in the UK and also overseas? Is it prepared to go the distance and reduce the BoE policy rate to zero? We will find out in early January or February.
Here are three follow up articles on the latest cut in US interest rates:
BBC news: US rates slashed to nearly zero
Guardian (Chris Payne): The Fed has waved a white flag
Independent: US slashes interest rates to new zero-0.25% range
Telegraph: UK needs negative interest rates, L&G warns
The Times (Gerard Baker): Fed throws out the rulebook
The exchange rate is big news at the moment and it is worth following closely since changes in the external value of a currency can have significant effects on prices, export and domestic demand, jobs and the rate of economic growth.
As with most topics in AS macro, think about causation, consequences and whether changes to macroeconomic policies through intervention can and should seek to make a difference.
Larry Elliott in the Guardian considers whether the devaluation of sterling against the Euro could be a saving grace for the economy. And there is a neat interactive graphic showing what has been happening to the pound’s value against the Euro Area currency.
The Times reports on sterling’s weakness and suggests that falling overseas demand for UK denominated shares is one factor driving the currency lower. Britain is expected to suffer a deeper recession than most of the leading advanced economies and this will impact on profits and dividends from UK businesses largely dependent on the health of the UK economy.
The Financial Times reports on the rise of the Euro as a reserve currency
“There are now more euros in circulation than dollars, and the euro’s role as an international reserve currency is growing. By the first half of this year, the euro accounted for 27 per cent of official foreign reserves, up from 18 per cent soon after its launch. The dollar’s share fell from 71.2 per cent to 62.5 per cent during the same period.”
Reserve currency status is an important factor driving demand for a currency – sterling seems to have lost its much vaunted safe-haven status among international investors and this is another reason behind the steep depreciation of recent weeks and months.
Will the government (through the Bank of England) intervene in the currency markets to help stabilise the value of the pound against the Euro?
Not if you believe the public statements of Treasury Minister Yvette Cooper who is reported in the Independent as saying that the value of the pound was not a top priority for the government implying that the pound would be left to find its own market level. In an interview on the BBC radio 4 Today programme she is quoted as saying:
“We’ve never had a policy of targeting the pound. Our policy is to target inflation. And that I think has been the right one.”
Regular articles on the economics of exchange rates appear on my blog here:
A couple of my students have poinetd me towards an article by Gary Duncan of the Times earlier on this week. Mr Duncan refers to some recent research by Paul Ormerod of Volterra Consulting which has looked at the history of british recession - measured by how long they lasted and also by the cumulative drop in GDP. Most post-war recessions have been relatively shortlived the worst being the downturn in 1979-82 where real national output declined by over 4 per cent. Ormerod points to the importance of the speed of any descent into recession and the impact on the ‘animal spirits’ of businesses and consumers. The more dramatic the turnaround in macroeconomic fortunes, the deeper the recession is likely to be. And when confidence disappears the traditional tools of macroeconomic stabilisation become less effective.
The fundamental problem facing the banks is a lack of capital and the refinancing options they have been faced with give them little commercial alternative but to attempt to shrink the size of their loan books (deleveraging is the jargon) and find ways of generating fresh capital in a cost effective and sustainable way. Robert Peston is at his very best in this blog article and the added bonus is an interview with Jim O’Neill the Chief Economist at Goldman Sachs which makes the case for a State Lending Bank.
This afternoon I am updating my regular chartroom presentations on the UK economy and the UK housing market. I will link to them here and make them available for downloads in other blog entries.
A hat tip to Paul Bridges for alerting me to the Peston article.