Tag Archives: Monetary Policy

RNBZ can’t seriously be thinking about reducing the OCR

Today’s labour market data showed a drop in unemployment from 4.4% to 3.9% and an employment rate of 68.3% the highest since the HLFS survey was first reported in 1986. The
unemployment rate of 3.9% is the lowest since June 2008 and towards the lowest bound of the RBNZs estimated 4% to 5.5% range for the Non-Accelerating Inflation Rate of Unemployment (NAIRU). See graph below:

Tomorrow the RBNZ present their November Monetary Policy Statement (MPS) and these figures give them limited time to change any policy direction. Remember that the RBNZ is now tasked “supporting maximum sustainable employment within the economy” alongside its price stability mandate of 1-3% CPI with a target of 2%. However these figures seem to suggest that further easing is not required to meet employment objectives.

What is the Natural Rate of Unemployment?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

Source: economicshelp.org

The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

Source: BNZ – Economy Watch – 7th November 2018

Questions about the next recession.

Ryan Avent of ‘The Economist’ considers how the next recession might happen — he asks the following questions:

  1. When will the next recession be?
  2. Where will it begin?
  3. Is the world prepared for a recession?
  4. What are the obstacles?
  5. What should governments do?

Very good viewing for macro policies – Unit 4 and 5 of the CIE A2 Economics course.

With the downturn in an economy, cutting interest rates has been the favoured policy of central banks. But the use of quantitative easing (QE) might mean the end of conventional monetary policy with rates already at record low levels – by pushing rates into negative territory they are actually encouraging a deflationary environment, stronger currencies and slower growth. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Liquidity Trap

Economic Consequences of Trump

Very good video from Project Syndicate looking at the recovery of the US economy and if it is sustainable. Also was Trump responsible for the growth or Obama? Maybe Janet Yellen and central bankers with such low interest rates for a long period of time. However if there is another downturn do governments have the tools to grow the economy again? It seems that central banks have run out of ammunition i.e. no room to cut interest rates further. There is agreement that the levels of employment are not sustainable in the future and the focus should be on assisting low wage work and help people prepare for and keep work- ‘reward work’.

  • Features Nobel laureates Angus Deaton and Edmund Phelps, along with Barry Eichengreen,
  • Rana Foroohar author of ‘Makers and Takers’
  • Glenn Hubbard Dean of Columbia Business School

Global Monetary Policy – why are US rates on the rise?

With the A2 mock exam next week here is a post on the theory and applied aspects of monetary policy. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. See  mind map of Monetary Policy below.

What have caused US interest rates to increase?

The US economy has been at the forefront of the global upswing in the last couple of years and compared to other countries they are imposing a contractionary monetary policy – see graph.

The central bank in the USA, the Federal Reserve, are confident that the economy is nearly at full capacity and that inflationary pressures are starting to become evident. The main factors behind this are as follows and they all point towards an increase in aggregate demand.

  • Higher GDP growth
  • Rising investment in oil and gas industry
  • Strong consumer spending
  • Tax cuts
  • Strong employment growth
  • Tight labour market
  • Higher wages

The US is the only major economy to impose a significant contractionary monetary policy and the Fed has increased its interest rate six times in the last two years, and four more rate hikes are expected over the next 12 months. The UK and Canada have raised their policy rates tentatively, while Europe and Japan are still in the midst of unconventional easing programmes and interest rate hikes are a distant prospect. Whilst the Reserve Bank in New Zealand don’t expect rates to rise until early 2020.

New Zealand’s Neutral Rate of Interest

A speech delivered last July by John McDermott (Assistant Governor and Head of Economics at the RBNZ) talked about the neutral rate of interest. Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy

The RBNZ’s last published estimate of the neutral OCR was in June 2017 at 3.5%, with a range of estimates around that between 2.6% to 4.6%. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

Since the GFC neutral rates around the world have been falling which reflects the following:

  1.  Lower expectations about growth in the economy = reduces the return to investment
  2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
  3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
  4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

Source: BNZ – Interest Rate Research – 14th June 2018

Why negative interest rates are justified.

The Free Exchange column in The Economist referred to negative interest rates as neither unfair of unnatural. Irving Fischer used the metaphor of the world’s oldest ship’s biscuits from a voyage back in 1852. Known as hardtack these biscuits were renowned for their longer storage life and therefore making them an important source of nutrition for sailors.

Fischer wrote in ‘The Theory of Interest’ in 1930 an imaginary scenario where a group of sailors are shipwrecked and the only food they have to sustain them is hardtack. Fischer proposed the question ‘under what circumstances would sailors borrow and lend biscuits? For most people interest is the reward for saving and delayed satisfaction so negative interest rates would seem to be unjust. In the case of shipwrecked sailors if one of them is prepared to lend another a biscuit the lender would want more than one biscuit in return and the more hungry they are the higher the interest rate. However Fischer pointed out that the interest rate should be zero as if it were positive it would mean that the sailor would have to take more than one hardtack biscuit to repay the loan. However no sailor would accept these terms as he could instead eat one more piece from his own supply, thereby reducing his future consumption by one hardtack biscuit. And a sailor who had already depleted his supply would be in no position to repay borrowed biscuits. If for instance the sailors were washed ashore with perishable items the interest rate would be negative – Fischer concludes that the rate of interest for any commodity should be negative not positive.

Recently banks in Japan, Switzerland, Denmark and Sweden started charging customers for saving money which asks the question why should people pay to keep their money in banks when they had already earned it? But charging customers interest is a natural occurrence when you consider that savers preserve their purchasing power without any care required to prevent any resources eroding. In 1916 economist Silvio Gesell gave his treatise in favour of negative interest rates on money. His said that storing wealth required considerable effort and ingenuity especially commodities like meat, wheat, fruit etc which are perishable. Gesell said that our goods rot, decay, break and rust. Only if money depreciated at a similar pace would people be as anxious to spend it as suppliers were to sell their perishable commodities. To keep the economy going he wanted money to rot like potatoes and rust like iron.

The negative interest rate introduced by Japan accompanied by an inflation target three years before is in effect pursuing Gesell’s dream of a currency that rots and rusts, albeit by only 2% a year.

Source: The Economist – Free Exchange – 3rd February 2018

Fed might tighten but emerging markets could ease.

From the Espresso app by The Economist I came across a useful graph showing inflation figures in emerging economies. I used this with my NCEA Level 2 class when we discussed inflation and how if the inflation rate is below the target rate there may be room to loosen monetary policy and cut interest rates. This should stimulate demand in the economy and increase output and employment.

In America investors are experiencing the novelty of an inflation scare. But in many emerging economies, including several of the biggest, price pressures are at unusual lows. In China and Indonesia inflation is below target. In Brazil, for the first time this century, it has remained under 3% for seven straight months. And in Russia, where the central bank is meeting today, prices are rising at their slowest pace since the fall of the Soviet Union. This lack of inflationary pressure gives central bankers some welcome room for monetary manoeuvre. Even if America’s Federal Reserve turns hawkish, emerging markets need not slavishly follow its lead.

Eurozone growth faster than US but not in good shape for the long-term.

According to the OECD the rate of growth in the eurozone has surpassed that of the US, UK and Japan and has surprised many with its resilience. However is the EU in a position of strength to cope with the challenges of another recession? The Economist ‘Free Exchange’ looked into this issue and identified some shortcomings. The crisis in the EU was severe and the impact financially was was around €1.4trn as this would have been the amount of GDP lost since 2007, assuming that most economies grow at 2% per year.

The damage was compounded by the fact that the EU’s monetary policy which has 3 main weaknesses:

1. Within the EU the printing of money is centralised through the European Central Bank in Frankfurt. Therefore countries who wanted to print more money to bail themselves out and stimulate the economy could no longer do it. Furthermore as there is no central fiscal budget it meant that individual countries were responsible for their own fiscal solvency. So if they ran up big deficits the risk of default was great and made markets react negatively to any concerning news on a country’s fiscal prudence. In reacting to this scenario the ECB said, as a last resort, that it would step in and buy government bonds to help ailing economies. On this news bond yields dropped as the ECB has brought about some stability.

2. In 2014 the EU was still struggling but was constrained by its inflation mandate. When economies go through major economic downturns they loosen monetary and fiscal policy – cut interest rates and increase government spending respectively to make up for the lost private spending. Although the ECB cut interest rates to 0% and government increased spending there was the problem of its mandate. The ECB was curbed by the 2% inflation ceiling unlike the 2% target for most other countries and by the fact that its strongest economy, Germany, was paranoid about inflation – memories of the post-war hyperinflation years. Only with the threat of deflation did stimulatory asset purchases start to happen.

3. This is the mismatch between the scope of its economic institutions and its political ones. No European institution enjoys the democratic legitimacy of a national government. The crisis meant greater reform in the financial sector but also led to increased authority of unelected institutions like the ECB. The frustration has been that countries in the eurozone have suffered significant amounts of pain by unaccountable European politicians. Countries don’t want to lose their sovereignty but it seems that any further integration is a catalyst to its demise.

The return to improving growth levels has been brought about by increasing export volumes – with a weaker euro. With consumer spending and investment on the decline foreign consumers have been the saviour of the EU. However this is dependent on global growth which cannot last forever and the euro area needs to be prepared politically to get through the next recession.

Source: The Economist – Free Exchange – The second chance. 2nd December 2017