Tag Archives: Monetary Policy

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

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

A2 Revision – New Classical to Extreme Keynesian

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

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

Monetary policy – not too tight in New Zealand?

Brian Fallow of the New Zealand Herald wrote a very informative article on the inflationary target that the Reserve Bank of New Zealand keeps missing – the CPI has been below the bottom of the bank’s 1 to 3% target band. Some will say that the RBNZ has been too tight with its monetary policy stance – maintaining high interest rates for too long. Assistant Governor John McDermott has defended the bank’s position for the following reasons:

  1. Nearly half the CPI consists of tradables where the price of goods is impacted by competition from outside New Zealand. For the last four years the global economy has been in a disinflationary environment caused by excess supply and in particular low commodity prices especially oil. Year ending September 2016 Tradables = -2.1%. This offset almost all of the +2.1% rise in non-tradables prices. See graph below.
  2. The recovery form the GFC has been quite weak and with the NZ$ strengthening (imports cheaper) accompanied by lower world prices has meant that import prices have been very low.
  3. The growth of the supply-side of the economy has been particularly prevalent which again has led to less scarcity and lower prices.
  4. Recent years has seen immigration boost the demand side of the economy but because the age composition is between 15-29 rather than 30-40 in previous years, the former has a much less impact on demand as they don’t tend to have the accumulated cash for spending.
  5. The RBNZ reckon that the output gap is now in positive territory (actual growth being higher than potential growth) which will start to put pressure on prices as capacity constraints become more prominent.
  6. Statistically with a weak inflation rate in the December 2015 quarter the December 2016 quarter is most likely to be higher as the percentage change is taken on the CPI of the previous year.

nz-cpi-2004-2016

The spectre of deflation hitting the New Zealand economy does not seem to be a concern at this stage especially with the longer-term inflationary expectations being in the mid range of the target bank i.e. 2%.