The US Fed currently have an interesting problem which other central bank would be happy to have. They have a dual mandate of Price Stability – 2% inflation and Full Employment – 5% unemployment. The current unemployment rate is 5.8%, the lowest level since 2008, and if it drops below 5% there could be labour shortages which will help to put pressure on wages and ultimately inflation. However the current inflation rate is only 1.3% and it is heading below 1% next year. There are two main reasons for this:
* The significant drop oil prices and
* A stronger US$ making imports cheaper
The concern for the US Fed is that inflation over the next couple of years stays well below the 2% threshold and interest rates remain close to 0%. As pointed out by The Economist the problem will be when the next recession rears its ugly head and Fed has no room to cut rates further as they cannot fall below 0%, since savers would simply convert their deposits into cash.
An option might be to let unemployment fall below 5% which make the labour supply more scarce bidding up wages and prices – with inflation reaching the target of 2%. Furthermore higher wages should entice workers back into the labour force. The risk is that with close to 0% interest rates inflation could rebound suddenly forcing the Fed to raise interest rates. How the Fed cope with the dual mandate next year will be interesting although the safe option could be to increase rates in the June this year. Below is a clip from Paul Solmon of PBS which explains the concern that the Fed have. It also stars Merle Hazard with a song about the dual mandate.
Following on from Merle Hazard’s Dual Mandate song, here is a report from Paul Solman of PBS looking at the role of the Federal Reserve with the end of its QE money creation programmes. The US economy is still in recovery mode and the role of the Federal Reserve is being debated. While most central banks have one mandate – price stability – the US Fed has two:
1. Maintaining stable prices
2. Full employment
Paul Krugman doesn’t think the Fed is achieving either of their mandates and would have liked to have seen them continue their bond buying last longer since employment rates and wages are still depressed.
Another video by Paul Solman in which he discusses how the NYSE record high doesn’t reflect the fundamentals of the US economy. With interest rates at virtually 0% the US Federal Reserve is trying to lower unemployment by stimulating the economy. But, by doing so there has been a tendency for it to overstimulating the stock market in the process. And also lending to stock investors, whose margin debt to buy shares on credit has been hitting record highs. Last week the Dow ended above 16000, another record for the headline index of 30 major companies.
The last record was set in 2007, a few months before the Dow’s previous high watermark.But for all the talk of the Fed’s role there’s an alternative way to understand a record Dow and higher profits: a shift of power from workers to owners. The stock market would actually be much higher if the unemployment was much lower. I think the economy is still really fundamentally weak, and that slack that’s in the economy right now, with all the unemployed people, all the unemployed businesses, would actually bring up the stock market even further.
With near zero interest rates in the US and the promise of them to remain until 2015 those that are living off the interest on savings, mainly the retired, are finding their incomes squeezed. According to The Economist personal interest income has plummeted by 30% which equates to a $432bn annually and more than 4% of disposable income. Former IMF chief economist Raghuram Rajan describes the Fed’s policy as:
“expropriating responsible savers in favour of irresponsible banks”
How should lower interest rates work according to the textbook?
However today it seems that even with these really low interest rates businesses and consumers don’t want to borrow or cannot qualify due to the more stringent requirements required. Furthermore with less consumption in the circular flow you would think that there is less need to fuel anymore investment spending.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Nobel Laureate Joseph Stiglitz came out strongly against the recent QE3 by the US Fed and the ECB’s announcement that it would buy government bonds of indebted eurozone member countries. With this announcement stock prices in the US reached post-recession highs although some worried about future inflation and significant government spending. According to Stiglitz these concerns are unwarranted as there is so much underutilisation and no serious risk of inflation. But the US Fed and the ECB sent three clear messages:
1. Previous actions didn’t work – ie QE1 and 2 2. The US Fed announcement that it will keep rates low until 2015 and buy $40bn worth of mortgage backed securities suggested the recovery is not going to take place soon. 3. The Fed and the ECB are saying that the markets won’t restore full employment soon – fiscal stimulus is needed.
In textbook economics increased liquidity means more lending, mostly to investors thereby shifting the AD curve to the right and thereby increasing demand and employment. But if you consider Spain an increase in liquidity will be cancelled out by an austerity package.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending. Joseph Stiglitz
Here is a great graphic from the BNZ showing how the NZ dollar performed in September. You could say that it strengthened on the back of notably QE3 from the US Fed and the improving global growth sentiment. Furthermore the NZ economy has performed well under trying circumstances.
June quarter GDP accounts revealed the NZ economy finished Q2 1.6% bigger than where it began the year. That is solid economic growth under ordinary circumstances. But given the ongoing challenging and uncertain global economic environment we should not under sell this achievement. It is the strongest six month expansion we have seen in the past five years. Source: BNZ
Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index
It is the US Fed’s intention to buy volumes of mortgage backed securities and keep borrowing rates at near zero (0-0.25%) until the job market and broader economy pick up. Basically they are going to print money until there is some improvement in unemployment figures. Unemployment is at 8.1% and the Fed estimate that it will fall no lower than 7.6% in 2013 and 6.7 in 2014. Inflation is forecast to remain at or below 2% until 2015.
How does it work?
The Fed will buy $40 billion a month in mortgages and will keep doing this until unemployment starts to fall. This will have a couple of effects:
1. It might lower mortgages rates by another 0.25% (already quite low). The 30-year mortgage rate is 3.5% and could go down to 3.25%
2. When mortgage rates go down, the price of houses tends to go up which is beneficial even if you are not refinancing a mortgage
3. Investors tend to move out of low interest earning investments and put their money into stocks. The DJIA closed up more than 200 points and was 625 points off its all-time high.
Impact on NZ$
With the flood of US$ into the market this has put downward pressure on the US$ which will make its export market more competitive and imports more expensive. However risk currencies like the NZ$ and AUS$ have rallied. Looking at the NZ$, this has appreciated considerably against the US$ and will make NZ exports more expensive and NZ imports cheaper. This will not only hurt the export industry as the price of goods become more expensive but the domestic sector have now got to compete with cheaper imports. The NZ$ reached US$0.84 yesterday.