It is apparent that business cycles aren’t those smooth ups and downs as depicted in a lot of textbooks but more volatile with booms and busts. Central banks appear to play their part in this process with the low cost of borrowing feeding the boom phase of the cycle. Instead of economic stability regulated by market forces, monetary intervention creates long-term instability for the sake of short-term stability.
Bubbles (financial manias) unfold in several stages, an observation that is backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically, four phases can be identified:
Stealth – emerging opportunity for future prize appreciations of investments. Investors have better access to information and understand the wider economic context that would trigger asset inflation. Prices tend to increase but are unnoticed by the general public.
Awareness – many investors start to notice the momentum so money starts to push prices higher. There can be sell-offs but the smart money takes this opportunity to reinforce its existing positions. The media start to notice that this boom benefits the economy.
Mania – the public see prices going up and see this a great opportunity to invest with the expectations about future appreciation. This stage is not so much about reasoning but psychology as money pours into the market creating greater expectations and pushing prices up. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. At some point, statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
Blow-off – everyone roughly at the same time realises that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Many try to unload their assets, but takers are few; everyone is expecting further price declines. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. This is the time when the smart money starts acquiring assets at low prices.
Japan is top of the table in accumulating government debt and with a record stimulus to cushion the impact of COVID-19 it is approaching debt levels of 250% of GDP. So how does Japan manage to keep its government bond yields so low (see graph below) and investor confidence high that it can avoid default?
To finance this debt, the Japanese government issues bonds known as JGBs. These are snapped up in enormous volumes by the Bank of Japan (BoJ), the country’s central bank that is officially independent but in practice closely co-ordinates economic policy with the government.
Bond Prices vs Yield
Like any investment the buyer of the bond wants to get the greatest return. Bond prices and interest rates (yield) move in opposite directions and an easy way to consider this is zero-coupon bonds. Here the interest is derived by the difference between the purchase price of the bond and the value of the bond on maturity. Bond price $920 – Maturity value $1000. The bond’s rate of return = (1000-80 ÷ 920) x 100 = 8.7% return. However a lot depends on what else is happening in the bond market. If interest were to increase and newly issued bonds were giving a return of 10% the 8.7% return is no longer attractive. To match the 10% the original bond price would have to decrease to $909. The bond’s rate of return = (1000-909 ÷ 909) x 100 = 10% return
Reasons for low rates on JGB’s
Japanese Government Bond (JGB) is a bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.
The BoJ has recently been buying up billions dollars of Japanese government bonds keeping interest rates around 0% in the hope of increasing the inflation rate to its 2% target. Therefore any rise in bond yields triggers a buy action from the BoJ. As of 2019, the central bank owns over 40% of Japanese government bonds. The BOJ’s government bond holdings rose 3.4% from a year ago to 486 trillion yen ($4.5 trillion) as of March 2020, roughly 90% the size of the country’s economy, according to the central bank’s earnings report for the previous fiscal year.
Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.
Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money V = Income Velocity of Circulation P = Average Price level T = Volume of Transactions or Output
Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.
Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.
Secular stagnation Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro
Central bankers around the world have been toying with the idea of going into negative territory with interest rates. The economic indicators influencing their decision tend to focus on the inflation rate and the amount of spare capacity – output gaps. Some research has suggested that interest rates needed to go as low as -6.5% (UK in 2013) and -3% ( USA in 2014) to stimulate growth.
Negative interest rates does encourage people to take money out of their bank accounts and store in safe deposit boxes or under the mattress, the latter being vulnerable to theft. This makes the process of buying goods/services difficult – do you carry a lot of cash as electronic transfer is no longer used? Additionally online transactions would disappear with people holding cash. According to The Economist central bankers face three important questions.
The technical feasibility – rates could be pushed lower by getting rid of high-denomination banknotes and impose fees on large transfers might raise the cost of hoarding cash by enough to allow rates to be cut further.
Hurting growth – negative interest rates can weaken demand rather than boosting it. As commercial banks have to keep reserves at the central bank negative interest rates means that they are losing money. However the commercial banks may not want to pass these costs onto customers so their profits are squeezed. This is especially a concern for less profitable banks that may limit their lending and ultimately investment and growth.
Is it worth it? Is the easing of interest rates into negative territory enough to make the difference between a strong recovery or a weak one. Also will people still borrow when rates are negative. Even with the low rates today borrowing levels are not significant and even if rates went negative would it make any difference? Consumers are worried about taking on debt with job security a concern therefore borrowing is not a top priority.
In order to kick start the economy there needs to be more fiscal expansion. Giving people money with a wage subsidy or just crediting their bank accounts would be more effective in achieving more economic activity.
Source: The Economist – Should the Fed cut rates below zero? 23rd May 2020
Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen
Video from CNBC looking at why central banks became independent and if it still should be the case – very informative and they use the Phillips Curve in their explanation. WIth the ongoing inflation problems in the 1970’s and 80’s it was thought that giving central banks independence of government control should be implemented. It was argued that policy makers would struggle to convince the public they were serious about containing inflation if politicians retained a say on setting interest rates. In 1989 New Zealand become the first country to introduce an independent bank with the 1989 – Reserve Bank Act. The mandate was to keep inflation between 0-2% but later changed to 1-3%.
With the GFC in 2008 it was central banks who slashed interest rates and implemented several rounds of quantitative easing to stimulate demand. However the GFC could have been prevented if central banks intervened to stop the biggest asset-bubble in history instead of focusing purely on keeping inflation low. Furthermore the European Central Bank were slow to act and the recovery was stymied. The fact that Germany is under the threat of deflation means that the ECB have cut interest into negative territory and are relaunch another round of quantitative easing – they are running out of options. Economists are focusing on fiscal stimulus – tax cuts and government spending. Therefore monetary and fiscal policy should be working together. According to Larry Elliott of The Guardian. central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay.
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,
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.
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
The FT had an excellent article back in April last year that covered many concepts which are a part of Unit 4 of the CIE A2 Economics course. It covers the liquidity trap, deflation, MV=PT, circular flow, Monetary Policy, Quantitative Easing etc.
The article focuses on the liquidity trap with Monetary Policy being the favoured policy of central banks. However 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.
Normally lower interest rates lead to:
savers spending more
capital being moved into riskier investments
cheaper borrowing costs for business and consumers
a weaker currency which encourages exports
But when interest rates go negative the speed at which money goes around the circular flow (Velocity of Circulation) slows which adds to deflationary problems. Policymakers pump more money into the circular flow to try to stimulate growth but as price fall consumer delay purchases, reducing consumption and growth.
The article concludes by saying Monetary Policy addresses cyclical economic problems, not structural ones. Click below to read the article.