Category Archives: Interest Rates

Zero sum game – Tax cuts v Higher interest rates.

The recent tax cuts in the US by the Trump administration are estimated to create above 4% growth each year according to Gary Cohn – Director of the National Economic Council. If the US does achieve this level of growth, tax reform is said to have little impact as long-term growth – studies have estimated that the tax bill will have an impact of between 0.4% – 0.9% on GDP.

Textbooks that cover supply-side policies tend to suggest that lower taxes on labour income should raise its supply whilst lower taxes on capital income should increase saving and investment which should then increase labour productivity and competitiveness in the market place. But there is the income and substitution effect to consider. With tax cuts people’s income increase therefore there is the chance that the substitution and income effects come into play.

Substitution effect – if wages are higher workers may forgo some of their leisure time and work longer hours. SS1 on the graph

Income effect – if wages are higher workers may reduce some of their working hours as the demand for leisure time goes up – SS2 on the graph

Most textbooks favour the substitution effect with tax cuts although research shows that neither labour-force participation nor hours worked move in response to tax changes. However reported labour income does rise in response to income tax cuts, thanks largely to less tax avoidance. Furthermore savings rates have changed little with tax cuts in fact they have decreased in the US over the past 40 years. Savings rates are important for investment purposes although the current administration believes that this shortfall will be filled by overseas investors.

Oligopolists to benefit

With the lack of competition in US industry – especially in the banking sector – it is the these companies (many whom are oligopolists) and their shareholders who will reap the benefits of tax cuts. Research has shown that a cut in corporate tax of 10% would raise long-run output output by 0.15%. National Income would raise less with much of the addition to GDP going overseas.

What about higher interest rates?

Although tax cuts (increase in demand) do help out especially when there is a lot of spare capacity in the economy this is hardly the case at the moment. The US has limited spare capacity and the Federal Reserve fearing inflation have been more contractionary in their actions by recently increased interest rates which cancels out the stimulatory tax cuts.

Tax cuts and inequality

Although the republican rhetoric has been that tax cuts will benefit all they haven’t mentioned the distributional consequences. The cuts will reduce the tax burden of the top 0.2% by an average of $278,000 by 2017. This is in contrast to the bottom 20% of earners will get an extra $10 dollar by 2017.

Where is global inflation?

The Economist had an article in its Finance and Economics section on the fact that after record low interest rates and extended quantitative easing global inflation seems stubbornly low – see graph. In order to explain this you need to consider the model that central banks use to explain inflation. There are three elements to this model:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low. See graph below showing New Zealand’s Phillips Curve

Have Central Bankers’ got it wrong?

Below is very good video from the FT – here are the main points:

  • Central Banks – by lowering interest rates they could make savings less attractive and spending more attractive
  • After GFC low interest rate and asset purchases increased lending and avoided a global depression.
  • Now the world economy is not behaving as the central bankers’ said it would
  • Their theory was that with lose credit (lower interest rates) the economy would grow and inflation would rise.
  • Inflation is stagnant (unlike the 1960’s – see graph below) and this is worrying as a little inflation is required to lubricate the economy. It allows prices to fall in real terms.
  • The missing inflation may mean that the bankers’ theories are wrong.
  • Cheap money may have encouraged high asset prices and debt levels but it may undermine the economy without doing much for growth.

Inflation Unemployment.png

Black Monday – 30 years on

Black Monday refers to Monday, October 19, 1987, when stock markets  around the world crashed, shedding a huge value in a very short time. In New Zealand and Australia it is sometimes referred to Black Tuesday because of the different time zone. By the end of October stock markets around the world fell significantly:

  • Canada – 22.5%
  • USA – 22.68%
  • UK – 26.45%
  • Spain – 31%
  • Australia – 41.8%
  • Hong Kong – 45.5%
  • New Zealand – 60%

Unlike other countries the effect of the crisis was compounded by the Reserve Bank of New Zealand’s inaction to lower interest rates and therefore reduce the value of the NZ dollar. This is in contrast to the USA, Germany and Japan whose banks loosened monetary policy to prevent a recession. Below is a video from the FT looking back at the events 30 years ago. Also a useful graph to put the crash in perspective – the two circled ares are the dot.com crash and the GFC.

Black Monday in context

Types of Macroeconomic Policies

Just been doing some revision with my CIE AS class and discovered this diagram on macro policies. Mind maps like this are very useful ways of revising topics.

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply, lending rates and interest rates and is often administered by a central bank.

Supply-side policies are mainly micro-economic policies aimed at making markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output

Macro Policies.png

Reserve Bank of Australia – Neutral Rate

An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.

Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending

How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.

Aus - Neutral rate

The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.

More saving will tend to lower interest rates
More investment will tend to increase interest rates

Debelle indicates that you can group these factors into 3 main categories:

1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.

“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle

QE unwind? Yeah right

Another very informative clip from the FT. Some of the salient points include:

  • Since the global financial crisis the Bank of England, US Fed, Bank of Japan and European Central Bank have bought assets and printed US$12 trillion.
  • Can interest rates return to what has been normal in the past – say 5% instead of close to 0%.
  • US Fed plans to shrink its balance sheet later this year – monthly reduction US$6bn in its assets. But this is a very small amount when you consider that the Fed holds US$4.5 trillion
  • But this is not happening elsewhere. Bank of Japan and European Central Bank are still printing money and buying assets. With Brexit the Bank of England faces huge uncertainties regarding their balance sheets.
  • Interest rates will remain low partly due to: ageing population, low productivity growth and a savings glut. This has reduced the attractiveness of capital spending.

DW Documentary – "The Money Deluge"

Below is a recent documentary from Deutsche Welle (DW – Germany’s international broadcaster) on the impact of exploding real estate prices, zero interest rate (see graph below) and a rising stock market. The higher income groups are benefiting greatly from these conditions but how does it effect middle income earners especially those in retirement. The DW documentary addresses these issues and explains how money deals have become detached from the real economy. Worth a look.

For years, the world’s central banks have been pursuing a policy of cheap money. The first and foremost is the ECB (European Central Bank), which buys bad stocks and bonds to save banks, tries to fuel economic growth and props up states that are in debt. But what relieves state budgets to the tune of hundreds of billions annoys savers: interest rates are close to zero.

The fiscal policies of the central banks are causing an uncontrolled global deluge of money. Experts are warning of new bubbles. In real estate, for example: it’s not just in German cities that prices are shooting up. In London, a one-bed apartment can easily cost more than a million Euro. More and more money is moving away from the real economy and into the speculative field. Highly complex financial bets are taking place in the global casino – gambling without checks and balances. The winners are set from the start: in Germany and around the world, the rich just get richer. Professor Max Otte says: “This flood of money has caused a dangerous redistribution.

ECB Rates.png

Those who have, get more.” But with low interest rates, any money in savings accounts just melts away. Those with debts can be happy. But big companies that want to swallow up others are also happy: they can borrow cheap money for their acquisitions. Coupled with the liberalization of the financial markets, money deals have become detached from the real economy. But it’s not just the banks that need a constant source of new, cheap money today. So do states. They need it to keep a grip on their mountains of debt. It’s a kind of snowball system. What happens to our money? Is a new crisis looming? The film ‘The Money Deluge’ casts a new and surprising light on our money in these times of zero interest rates.

When the NZ Official Cash Rate exceeds the US Fed Rate.

With Janet Yellen increasing the US Fed Rates to 1 – 1.25% and Graeme Wheeler keeping the OCR at 1.75% it is anticipated that the US Fed Rate will eventually become higher than the OCR. What impact might this have on the New Zealand dollar?

With higher rates (or expected higher rates) in the US money flows will be attracted into the US with higher interest rate returns. This is referred to as ‘Hot Money’ and for international investors there are significant amounts of money to be made.

A higher interest rate in the US would mean a higher return from saving in a US bank. Therefore, New Zealand investors may sell NZ dollars and buy US dollars so that they can gain more interest from their savings. This increased demand for US dollars will push up the value of the US dollar against the NZ dollar.

RBNZ v Fed Rates.png

However it is not just interest rates that influence Hot Money. In 2011the Swiss Franc appreciated on the back off the turmoil in the Eurozone as investors saw the currency as a safe haven. The NZ dollar and the AUS dollar appreciated for similar reasons post the Global Financial Crisis.

Problems of hot money flows

Hot money flows can be destabilising. A rapid rise in the currency can harm a countries with exports become more expensive and imports becoming cheaper. However the latter might be favorable depending on the import content.

Hot money flows can create excess liquidity fuelling a future asset boom and creating more long-term problems.

Trump’s tax cuts likely to have limited impact on growth

Donald Trump has indicated that the US economy needs a big tax cut to stimulate some growth and aggregate demand –  C+I+G+(X-M). His rationale is that with consumers having greater income they will spend consume more (C) and businesses keeping more of their profits will invest more (I). He is even so confident that the tax cuts won’t put a dent in the overall tax revenue of the government. However economists are suggesting that the US economy is already growing as fast as it can and in order to improve its growth rate it needs to investment in productivity.

D Pull Inflation.jpegNevertheless, US tax cuts in the 1980’s under Ronald Reagan proved to be very effective in stimulating aggregate demand but the economic environment then was different to that of today. The 1980’s was an era of stagflation with the US experiencing 10% unemployment and inflation reaching 15%. Since the GFC in 2007 growth has been positive and unlike the 1980’s unemployment has been falling  – from 10% in Oct 2009 to 4.4% in April 20178. Tax cuts are all very well when you have high unemployment but with the rate falling to under 5% companies may find it difficult to respond to the greater demand for goods and services by taking on workers to increase supply. Tax cuts would then lead to an increase in inflationary pressure (see graph) which is turn would prompt the US Fed to increase interest rates.

ProductivityTrump’s plan would also increase the Federal deficit and borrowing from the government. This would put upward pressure on interest rates for the private sector which reduces the potential for further growth. As noted earlier the area that needs to be addressed is productivity, with a shift of the LRAS curve to the right – see graph.