Stephen King savages rigid inflation targets
Stephen King, Chief Global Economist at HSBC is brilliant in today’s Independent - attacking the rigid adherence to an inflation target based solely on the rate of change of consumer prices and ignoring asset price deflation. One of the best comment pieces on macroeconomic policy that I have read in a long time.
“The rigid adherence to an inflation target in a world of constant external shocks may sometimes be more a source of instability than of tranquillity. With sizeable relative price shocks stemming from globalisation, the risks of instability are all the greater. Even worse, if the public thinks that price stability is the only litmus test of economic health, the achievement of low inflation may encourage excessive risk-taking which, in turn, could undermine the achievement of broader economic objectives.”
A revolution at the Fed?
The current edition of Business Week has a special on Ben Bernanke’s leadership of the US Fed Reserve. As he drives real official policy interest rates into negative territory, this set of articles is good background reading for students in the UK who want to understand a little more some of the differences in approach between the Fed Reserve and our own Bank of England. How big a risk is the Fed taking that its enormous efforts to inject liquidity into the US financial markets and bolster confidence with aggressive rate cuts, will create further problems down the line?
Fed opts to leave a little powder left
It is a sign of the times when a decision to cut (slash) official short term interest rates by 0,75% (taking US rates to 2.25%) comes in below market expectations! The US Fed Reserve has cut the cost of borrowing in a fresh bid to limit the downside risks for the real economy as financial turbulence threatens to dent a huge hole in prospects for the US economy in the coming months. Loads of comment available on this one from virtually every commentator. Evan Davis, the former Economics editor of the BBC was on good form on TV this morning - explaining that cuts in interest rates from the central banks is not really where the problem lies for most consumers. It is the interest rate charged on the lending and borrowing that the banks do between each other which then feeds through into the market for mortgage and other retail loans.
One of the keys to coming out of this crisis will be for banks to recapitalise and improve their own block of funding before they start lending out again. In short, the banks need to attract fresh injections of capital - perhaps from encouraging more of us to save and also from external sources such as the petro-dollars being held by the sovereign wealth funds. Confidence in the different pieces of the financial system is ebbing away - stabilising the markets is the immediate issue and the problem.
Data charts on US and UK interest rates
US_Rate_Cut_March_2008.pdf
UK_Interest_Rates.pdf
Suggested links on the US rate cut
US and UK inflation
Latest data on inflation suggests price rises are dampening in the US - opening the door for further rate cuts.
But in the UK there are fears that sustained inflationary pressures will prevent the Monetary Policy Committee of the Bank of England reducing the base rate until at least the summer. Geoff looked at this in detail earlier in the week.
read more...»Adaptive expectations?
For over ten years the Bank of England has been keen to manage expectations of inflation. It knows that if people fear a return of high rates of price inflation, they will factor that into their wage demands and there is a risk that the price stability we have enjoyed for fifteen years or more might be under threat. That would make the setting of interest rates even more complicated than normal, particularly given the current economic uncertainties at home and abroad.
With that in mind, the latest quarterly survey of price expectations published by the bank does not make happy bed-time reading for the Governor. Expectations of future inflation rose to 3.3 percent in February - the highest since the Bank started to publish the survey in 1999 and (importantly) more than a percentage point above the actual rate of CPI inflation.
Perhaps this survey is an example of adaptive expectations at work. Families see the rising cost of living every time they go to the supermarket, fill their car with diesel or check their quarterly energy bills. More people than ever before are discovering that the official measure of inflation (the CPI) bears little resemblance to the inflation they feel. The RPI inflation rate which includes housing costs, is much closer to their day-to-day experience.
It might be that we are unduly influenced by the prices we see around us and those highlighted in news broadcasts and on the front pages of the papers. Behind the scenes, the prices of audio-visual products continues to fall, as does the retail prices of clothing and second hand cars!
Whatever the cause, the reality is that rising expectations of inflation will make it more difficult for the MPC to sanction aggressive cuts in interest rates if and when the economy moves into a sharper than expected slowdown.
The most powerful law in the world?
We are studying information failure this week and at one point during the lesson today I was tempted to spurt out that the biggest information failure of all was the failure of people to understand the law of compound interest. That was going to be in the context of discussing why people often leave it so late to start saving money when a small pot earning interest on a compound basis over a large time period can grow very quickly if it invested for long enough. Just small changes in the annual return - say from 2.5% pa to 3.0% pa can have an enormous effect on the final value of a pension fund. MindYourFinances has a good example to use by way of illustration.
I will leave that discussion until the next lesson ... but tonight I picked up a piece by John Kay which will appear in the FT tomorrow on the wealth of Warren Buffett newly crowned as the world’s richest man. Kay reinforces the power of compound interest in shaping the value of the Buffett Foundation.
“Albert Einstein supposedly observed that the most powerful force in the universe is compound interest, and Mr Buffett’s frugality has enabled compound interest to work its magic. During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world.”
Read the rest of John’s piece here
UK base rates held at 5.25% in March
The Bank of England held official short term interest rates at 5.25% at the end of the March meeting of the MPC. I will be streaming the March edition of The UK Economy in Charts later on this evening.
Freeconomics
Mark Boyle is no ordinary man. He is a self-styled ‘community pilgrim’ and he hit the news over the weekend after setting out to walk from Bristol to India - without using money.
“Most of the problems in the world such as greed, fear and insecurity, manifest themselves in money,” he is says, “so I’m going out and instead putting my trust in the universe.”
read more...»Would you credit it?
I must be one of the few adults of working age in this country not to possess a credit card? I now have one debit card, several more for hole in the wall withdrawals from savings accounts and no mortgage. My bank didn’t send me a replacement credit card last year and I haven’t missed it one little bit. But the rest of the world seems to have been going credit crazy over the last ten years and this series of clear charts from Foreign Policy magazine for their March/April edition is remarkable for showing the explosive growth in the demand for and supply of consumer credit. Now that we are firmly in the grip of a credirt crunch, perhaps the numbers will start to turnaround?
All of the charts and the remainder of the article are here.
8-1
Getting personal regarding the rules?
If a fretful Gordon Brown was watching on Wednesday as the Bank of England unveiled its latest strategy for the British economy, the Prime Minister may well have wondered whether he might end up feeling much the same way over his decision last month to hand Mervyn King a second term as Governor of the Bank.
Mr King’s flinty and uncompromising message on Britain’s economic prospects was bleak enough to leave any occupant of No 10 wringing his hands over the likely evaporation of the country’s “feelgood factor”.
read more...»Cheaper base rates but credit stays expensive
Base interest rates might be falling in the UK but it would be a mistake to assume that the cost of servicing credit cards and other unsecured loans has become any cheaper - if anything, the price of borrowing money has edged even higher in the last few weeks. That is the inevitable result of the ongoing credit crunch which has caused lenders to tighten the hurdles borrowers must jump over before being granted loan finance.
read more...»Minus one quarter of one percent
As expected, the MPC has cut the UK base rate from 5.50% to 5.25% today. In the context of rising energy and food prices, this sends a mixed message to observers. Why would the Bank allow an expansionary monetary policy in the context of rising inflationary pressure?
read more...»Time Lags
With attention focused on changes in base rate today, Hamish McRae , writing in The Independent, looks at longer-term prospects for the world economy.
He argues that growth from BRIC and similar economies will maintain growth this year, but the real test for the world economy in coping with slowing demand in Europe and the USA will come in 2009.
Only another 30 minutes to the base rate decision - which appears to already be a foregone conclusion?
Interest rate cuts do work!
In all likelihood the Bank of England will cut interest rates today at the end of the monthly meeting. The MPC has not been as proactive as the United States Federal Reserve in aggressively easing monetary policy but a reduction in the cost of borrowed money will act as a stabilizer for confidence and demand as the economy softens. It is at times like this that we need to remind ourselves of how cuts in interest rates work their way through the economy. And also to remember that base rate changes do work even if, this time around, the policy-makers may have to do a little more than in the past to smooth the extent of cyclical volatility. Monetary policy is not yet impotent!
read more...»11 Year High for Australian Interest Rates
Many central banks around the world have been cutting interest rates in a bid to soften the blow of a global economic slowdown - the US Fed Reserve being the obvious example - but in Australia, official policy rates have risen to an eleven year high with the news that the Reserve Bank of Australia has increased rates to seven per cent.
read more...»The Wrong Kind of Inflation?
Invited as the obligatory economist to my institution’s Salaries Committee, I spent lunchtime today discussing what sort of pay rise we deserve (huge, of course) and the sort of pay rise we might receive (rather less than huge, we suspect). I filled a happy half hour being questioned by my colleagues on the difference between RPI, CPI, RPIX, the CBI, the FBI, and even the CIA.
read more...»Another cut in US interest rates
The United States Federal Reserve has once more moved to lower interest rates in an aggressive move to bolster confidence and demand in their flagging economy. This BBC news audio-visual clip looks at the immediate market reaction. Just about every macroeconomic policy lever is now being pulled in terms of monetary and fiscal policy and it will be fascinating to see what impact the loosening of macroeconomic policy has on the economy.
Ben Bernanke has indicated that he is prepared to cut rates even further if necessary, a stark contrast to the inactivity at the Bank of England. The fact is that the drivers of monetary policy decisions in the United States tend to err on the side of economic growth whereas the sober bankers on the Monetary Policy Committee take a sterner line on inflation risks. Whose side are you on?
read more...»
Differences between the Fed and the BoE
The Fed was in the news last week with a dramatic relaxation of monetary policy as official short term interest rates were cut by 0.75%. Gary Duncan has produced another of his regular briefings on aspects of monetary policy as part of the Times / Bank of England TwoPointZero competition. Today he looks at the differences in the handling of interest rate policy between the United States Federal Reserve and the Bank of England. One difference is that the Fed has a ‘dual mandate’ explained here
‘The key difference between the two central banks is their remits from government. While Britain’s MPC has one chief goal, to meet the 2 per cent inflation target set each year by the Chancellor, the Fed’s far broader brief, set in law by the US Congress, is to maintain stable prices while seeking to foster growth and maximise US employment. This is the Fed’s “dual mandate”.’
The rest of the article can be found here
Fears of a 30’s style liquidity trap
Fears of a 1930’s style “liquidity trap”
Will big cuts in interest rates avert the threat of recession for the United States? Interest rate reductions ought normally to provide a monetary stimulus to the economy supporting confidence and encouraging consumer spending and business investment. A well-judged relaxation of monetary policy should help to stabilise demand, output and jobs helping to reduce the risk of a painful economic slump.
But the Nobel-prize winning economist Joe Stiglitz has claimed that the United States may be on the verge of a 1930s-style “liquidity trap” which may make monetary policy decisions impotent. His argument is based on the divergent movement in long term and short term interest rates. Last week the US Federal Reserve cut short term interest rates by 0.75% (the largest single reduction in nearly a quarter of a century) - thus bringing down short term official interest rates. Stiglitz believes that longer-term interest rates such as rates on government and corporate bonds and mortgage rates will not come down as easily and it is this that might act as a depressant on the real economy. The credit crunch has driven up long term interest rates and bond yields are also being edged upwards by fears of rising global inflation, for example caused by persistently high fuel and energy prices and the end of a decade or more of cheap food.
If mortgage rates stay high, there will be little respite for a US housing market clearly mired in recession. Falling property prices will depress personal wealth and lead to a reduction in spending on goods and services. Negative equity may haunt many thousands of home-owners - where their property is worth less than their outstanding mortgage debt - and in this situation, lower short term interest rates e.g. on credit cards will do little to boost consumer demand. Stiglitz believes that in a liquidity trap two things can happen. Firstly that large changes in interest rates have little impact (the interest elasticity of demand drops close to zero) and also that the time lag between a relaxation of monetary policy and its eventual impact on aggregate demand lengthens. This makes it very difficult to rely solely on monetary policy as a way of managing demand. This is perhaps a cue for the size and scale of the tax rebates being pushed through by the Bush administration.
Even that may not be sufficient. Professor Stiglitz is reported in the Telegraph as saying:
“As a Keynesian, I’d say the biggest back for the buck in terms of immediate stimulus would be unemployment assistance and tax rebates for the poor. That will feed through quickly, but set against the magnitude of the problem, even a fiscal stimulus package of $150bn is not going to be enough. The (economic) distress is going to be very severe. Around 2m people have lost all their savings.”
Consumer spending accounts for over 70 per cent of aggregate demand in the US economy – a record high – and much greater than for most other advanced economies. The Stiglitz view is that the US recession is as much the result of macroeconomic mismanagement rather than a response to a series of negative external shocks.
“What we have now are the foreseeable consequences of bad economic management.”
Suggestions for further reading
Can the world stop the slide? (Time magazine)
http://www.time.com/time/magazine/article/0,9171,1706763,00.html
George Soros: Britain cannot escape US recession (The Guardian)
http://www.guardian.co.uk/business/2008/jan/24/recession.davos
A jump in wage inflation
Several factors seem to be pushing wages higher
- The rise in the rate of retail price inflation - it seems that many wage negotiations use the RPI measure of inflation as a starting poiint for pay talks.
- Increases in energy costs and food prices - both of which feed directly into the RPI and CPI of course - are highly visible and transparent to households - millions of people are now struggling to cope with sharp increases in petrol and gas prices together with real terms increases in rail fares and electricity bills
- Pay rises of 4 per cent or higher are now needed simply to keep pace with inflation so that real incomes are maintained
- With the economy weakening and business profits under pressure, the current pay round might be the last opportunity to trade unions to negotiate wages higher for a little while - it will be more difficult to bid for inflation-busting pay rises when unemployment is rising and bargaining power is on the wane
The Bank of England will be watching the acceleration of wage inflation with some worry - pay rises not matched by improving productivity will drive unit labour costs higher and make it more difficult for the Monetary Policy Committee to cut interest rates when needed as 2008 progresses.
There are now clearer signs that inflation expectations are on the rise - the key is whether people and trade unions have the collective bargaining power in the labour market to drive pay higher in response.
Background to the UK interest rate cut
The Monetary Policy Committee cut interest rates by 0.25% today. Download a presentation containing some charts relevant to the BoE’s deliberations.
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Reasons for cutting base rates
- Recent evidence points to an economy heading for a severe slowdown
- Inflationary fears remain – hints of ‘stagflation’
- But the BoE judges that the ‘balance of risks’ has altered in the last few weeks
- They need to cut rates now (and may have to again next month or early in 2008) to stop the collapse in confidence
- This is an interest rate cut designed to improve the ‘animal spirits’ of consumers and businesses alike
Recent changes in rates
Current rate 5.5
Last 5.75
Month ago 5.75
Year ago 5.0
Warning signs for the economy
Sharp fall in consumer confidence
Evidence of declines in house prices
Slowdown in construction sector output
Signs of weaker sales on the high street
Rise in the cost of lending between the banks
Reduction in the supply of funds available for mortgage finance
Raft of profits warnings from many companies
Suggestions for further reading on this
BBC news:
UK interest rates trimmed to 5.5%
Times:
The Bank better get this right (Kaletsky)
Guardian:
Independent:
Is Britain's economy heading for the perfect storm?
