A trade off for monetary policy

Since the global financial crisis interest rates in the UK (and the US, Europe and Japan) have been at record lows. The aim was to boost Aggregate Demand and avoid prolonged recession and promote faster recovery. An interesting trade-off has been highlighted as a result of this policy.

The low interest rates have indeed maintained UK output, according to a Bank of England economist, but the low rates have meant firms that should have ceased operations have been able to survive. Around 1.5 million jobs have been protected according to Andrew Haldane.

Of course saving jobs was exactly what the Bank of England were trying to do when they lowered rates. The unintended consequence of this action was that it reduced the costs of poorly performing firms. Those who were not efficient enough to earn the profits necessary to repay loans at 'normal' rates of interest have been able to survive ('Zombie firms' according to Haldane).

The impact has been to allow low productivity jobs to survive and this has led to poor improvements in productivity overall, because the productivity figures reported are an average over the whole economy.

Productivity is a measure of efficiency. It records how many inputs are required to produce a given level of output. For economic growth to deliver higher standards of living a rise in productivity year on year is crucial. The UK has a very poor productivity record generally and the low interest rates since 2008 have allowed this to get worse.

Haldane says that he is happy to have seen 1.5 million jobs saved rather than 2% productivity growth. At least 1.5 million people and their families will be agreeing with him.

The BBC article is here

As this is an article about the UK as an example it is directly useful to IB students. However VCE students can see the example of how all policy has trade-offs and policy actions often have unintended consequences, such as supporting inefficiency to reduce unemployment.

The Fed tries to keep 'ahead of the game'

Eddie George, the former Governor of the Bank of England, described the role of Monetary Policy as 'keeping ahead of the game'. By this he meant central banks have to act early, in anticipation of movements in the economy.

The Federal Reserve Bank of the USA (the Fed) has raised its base interest rate from 0.75% to 1. The base (or benchmark) interest rate is important because all other interest rates in an economy are like rafts to the base rates tide. When the tide comes in all the rafts go up. All US commercial interest rates (like personal loans, savings rates and mortgage rates) will rise as a result.

The article points out that the US, like the UK and EU, has an inflation target of 2%. In all three inflation is around that level, but only the Fed is raising rates. This is where Eddie George's phrase becomes relevant. Monetary policy has 'long and variable lags' and takes up to two years to take full effect. The Fed is anticipating changes in the US economy and setting higher rates for what will happen in the future.

This is a very good topic for a Macro IA and you should follow the interest rate changes in major economies. (Note the 'analysis' section of the BBC story below makes this an unsuitable article for an IA, because it is doing the job you need to do in the IA, but there are lots of other reports.)

The BBC article is here

While this is about UK monetary policy the basics of monetary policy are the same in Australia, so useful for both VCE and IB students.

Eddie George was an almost fanatical player of Bridge. He attributed his initil success at the Bank of England to playing with various important people!

Is Quantitative Easing working in Europe?

The European Central Bank has been fighting the danger of deflation in the Euro Area. Deflation is a sustained fall in the general price level so that the purchasing power of money rises.

The purchasing power of money rising sounds good! However it is generally caused by low demand and so low growth, or even falling output. The most recent period of prolonged deflation occured during the Great Depression, and nobody wants to go back to that. When prices are falling consumers will wait to buy good and services as they expect them to become cheaper. The result is a downward spiral of prices and output.

The ECB has been using conventional expansionary monetary policy, interest rates are now 0%, and unconventional monetary policy, they are printing Euros through Quantitative Easing, in order to boost Aggregate Demand (AD) and so economic growth.

The report below suggests that this is now having some effect, but it is far from certain that a sustained upswing in output, wages and prices has yet been achieved, so they will continue the policy. (Note the difference in headline and core inflation which indicates that there is still some way to go before there is a sustained recovery.)

The BBC cover the story here

A danger for Australia's economy

The ABC today report that the level of Australian household debt has reached 187% of disposable income. This is, they say, the highest in the world.

The problem is that this means that many households are close to not being able to afford to pay their debts (and interest) and buy the goods and services they need. If there was a rise in interest rates, or rise in unemployment this would see more and more households 'running out of money'.

The effect this will have on Australia is that Consumer spending would fall, leading to a lower level of Aggregate Demand (AD). This would put downward pressure on economic growth and could push Australia into its first recession since 1981.

Admittedly this is the 'disaster' scenario. There are other factors that simultaneously affect the economy. However it provides a constraint on the Reserve Banks ability to raise interest rates and should warn the government that further budget cuts and tax rises could combine to cause the recession everyone seeks to avoid.

Debt is a fact of life. It makes sense to borrow to buy a house. There is, however, a limit to the amount of debt a household can take on - the amount they can repay. If banks think households have reached their ability to pay then new loans will start to dry up and consumer spending will fall, leading to that fall in AD we feared. In that situation monetary policy becomes less effective, because lowering interest rates won't help much.

This is an important piece of background to Australia's current economic situation.

OECD data suggests Australia has high household debt, but not the highest

The ABC covers the story here

German trade surplus and another mad Trump claim

Germany has posted a record trade surplus on its current account. This really means that Germany has exported more than it imported. It should be noted that both exports and import values grew, but export values grew faster.

Trade surpluses are not 'good' and deficits are not 'bad'. There should be a broad balance over time on the current account. If there are persistent deficits this suggests that a country will build up foreign debt and isn't competitive. A persistent surplus means that the Aggregate Demand in the economy is being boosted, leading to inflationary pressures and demand for the currency, to buy the exports, will force up the exchange rate.

Trump's trade advisor has accused Germany of using the weak value of the Euro to boost its exports. This bizarre claim is just another conspiracy theory. The value of the Euro is determined by the market and the European Central Bank (ECB) is independent of governments in setting monetary policy.

The claim does however allow us to realise that Germany is concerned to reduce its trade deficit because of the effect it has on the domestic economy. As pointed out in the article Germany has taken steps to boost domestic demand in order to stimulate demand for imports. Some of the measures are detailed in the article.

Not for the first time though the article demonstrates that the Trump administration is just batshit crazy.

The size of Germany's Current Account surplus compared to GDP for the last ten years, shows a growing issue.

The BBC article is here

This article is primarily of use to IB students in its detail. However the effects of a trade surplus and the effect of currency value is important knowledge for VCE students.

Australian interest rates stay at record low

As expected the Reserve Bank of Australia (RBA) kept interest rates on hold at their meeting yesterday. They remain at the record low of 1.5%.

The RBA forecast that the Australian economy would continue to grow at about 3% in 2017, but that inflation remains below target. Therefore the RBA wishes to encourage the economy to grow faster by keeping it cheap to borrow and so encouraging consumer spending and investment, both components of Aggregate Demand.

Australian interest rates may stay the same for a while. The pressure to raise them might come from higher growth and a rapidly rising housing market. However the pressure to put them down will come from a rising exchange rate (based on events in the USA where interest rates will rise).

Monetary policy is a very important tool in managing the economy and works by affecting the total level of demand in the economy.

Australia's policy interest rate since 2014

Below are two links. The ABC one is for Year 12, the Channel Nine one for Year 11.

The ABC article is here

The Channel Nine article is here

VCE students must be able to explain policy decisions and economic events in Australia over the previous two years prior to their examination. Interest rate decisions (monetary policy) is one of the areas they must be familiar with and be able to explain why policy decisions (change interest rates etc) we made.

IB students can use this as an example of monetary policy too.

US raises interest rates

The US Central Bank, The Federal Reserve Bank, (the Fed) has raised interest rates in the US from 0.5% to 0.75%.

This may not seem like much, but for the fact this is only the second rise in ten years. (Note that 0.25% is the usual change in rates around the world.) It reflects the recovery of the US economy from the deep problems caused by 'The Great Recession' and signs that Aggregate Demand  and economic growth is picking up.

Note the factors which the Fed have cited as reasons for the rise. Clearly not everything is going really well, but AD is rising. They also seem to be taking account of the fiscal boost President-elect Trump is proposing.

Why should the Fed act now when inflation is so low (below target) and Trump has yet to unleash his 'hope for the best' economic policies on the USA and the world? The answer lies in the 'long and variable' lags in monetary policy. It will take at least 18 months for this interest rate rise to have full effect, and possibly two years. 

Another Chairman of the Fed, William McChesney Martin famously stated that the job of the Federal Reserve is "to take away the punch bowl just as the party gets going",  recognising the long lags in policy. (That is raise interest rates early in the upward part of the business cycle and not wait until inflation is already rising.)

US Federal Funds Rate December 2005 to December 2016

The Sydney Morning Herald covers the story here

This article is about monetary policy and how decisions are made. AD/AS analysis can be applied to it and analysis of why the decision has been made can be discussed.

Monetary policy in the EU

Here is another possible IA topic. The European Central Bank (ECB) is to extend its Quantitative Easing (QE) programme by nine months, but won't buy as many bonds each month.

You will recall that QE is like printing money to expand the money supply. The ECB buys bonds from the public adding to their cash holdings. This increases liquidity in the market and forces down yields on all financial assets. The hope is that this encourages households and firms to spend money (boost AD).

The question is, will it work? The phrase 'pushing on a piece of string' is often used to suggest that under current circumstances it will have little effect. But can it do any harm?

Notice that the Euro depreciated. This may help make Euro Area exports become more competitive if that situation persists.

The BBC covers the story here 

This story is about monetary policy, but 'unconventional monetary policy'. It is a good topic for an IA. Again you may want to find other sources where the article leaves you more to say.

Unemployment figures and policy

There have been a lot of stories on unemployment recently - see my posts on Australia's unemployment figures hiding the true state of the economy for example. Below is a link to one on US unemployment.

US unemployment is falling as the economy adds jobs. This has led the US Central Bank - the Federal Reserve Bank of America - to suggest interest rates will rise. Why? Because inflationary pressures are likely to be building, monetary policy works with a long lag and a small rise now should help prevent a problem in a couple of years. (Note more rate rises will certainly be needed over the next year.

See if you can find an article that doe not do too much of the analysis for you to use as an IA source.

The BBC article is here

Headline inflation rise hides continued sluggishness

The Australian CPI figure released yesterday showed a significant jump in inflation, and for some this was great news s at least inflation headed back towards the target range of the Reserve Bank of Australia (RBA). This is almost certainly a false hope.

Looking at the figures it is clear that the massive rise in fruit and vegetable prices, largely due to massive flooding affecting supply, has made the CPI figure look more healthy than it really is. Take that out and the underlying rate of inflation actually fell.

Australia's headline and underlying inflation compared

The low inflation figures show that economic growth the Australian economy continues to slow down, and this is not good news. The end of the mining boom is severely affecting WA and the Northern Territory, but indicators don't show massive growth in the rest of Australia that will compensate.

Once again Greg Jericho in The Guardian provides excellent analysis and data of the inflation figures and considers the likely impact on monetary policy settings.

The Guardian article is here

VCE students are especially urged to understand the pressures in the economy at present - demand side pressures on policy settings. The article makes use of the Australian underlying inflation measures which are required knowledge.

IB students can use this as an example of inflation and monetary policy. The article is particularly strong at looking at how the various factors link together to give an overview of the health of the economy and the process and implementation of monetary policy.

Losing and gaining from inflation

Continuing the UK pound theme today I will look at a story on the effects of higher inflation in the UK.

Inflation has been subdued across the world in recent years despite very expansionary monetary policies being pursued by all central banks. In the UK inflation is well below the Bank of England target of 2% and in August was just 0.6% on the CPI measure. It has rocketed to 1% in September.

So far there is only anecdotal evidence that the fall in the value of the pound is responsible, but import prices will rise with the near 20% fall in the value of the pound since June. This would cause cost-push inflation and will compliment the demand-pull inflation that the Bank of England are encouraging by their recent reduction in interest rates to 0.25%.

The article, again from the BBC, looks at the effects higher inflation might have on households. It points out that when inflation reaches a rate higher than wages growth then real incomes start to fall, making people worse off. It also notes that those on benefits, many of which are frozen in value until 2020, also lose out.

One group that is protected are those who receive the old age pension (that is everybody in the UK who are old enough, it is not means tested). The old age pension goes up by at least 2.5% a year, or inflation on CPI or wages growth - whichever is higher. This protects the old against an important cost of inflation.

Note the link in the article to 'winners' from inflation.

The BBC article is here

The costs and benefits of inflation is relevant to everyone. This provides a very useful survey of the issue facing people today with low inflation and the impact of rising inflation. 

Monetary Policy ineffective?

As IB students move to looking at macroeconomic policy I will provide some articles that highlight some recent issues and also help give context to the importance of understanding the theory of policy is important to understanding its use in reality.

The article below makes lots of points. It talks about how the Australian Treasurer (Finance Minister) believes that Monetary Policy has become ineffective in boosting economic activity at present. It also talks about how Fiscal and Supply-side policy must work together to achieve macroeconomic goals.

I am going to concentrate on monetary policy here. Morrison asserts that further interest rate cuts (Australian interest rates have fallen from 4.75% to 1.5% since 2012) will do nothing to stimulate the economy. This is suggesting that the transmission mechanism by which lower rates stimulate economic activity and raise the price level has stopped working.

The theory, which you will learn, suggests that lowering interest rates will raise Consumer and Investment spending and probably Net Exports, all components of Aggregate Demand. However when interest rates are very low many believe that the incentives to change behaviour cease to be significant. If coupled with lower consumer and business confidence even negative interest rates cannot help stimulate the economy on their own.

This is very much a current policy debate. Similar arguments are being had in Japan and Europe where the central banks not only set negative rates but are printing money to try to stimulate the economy.

Notice Morrison's use to the phrase 'pushing on a piece of string' - a classic term used to describe how lowering interest rates does nothing to solve a recession. The answer is more government spending and infrastructure investment. Of course that policy will be cheaper to finance when interest rates are low - so maybe low rates still have a role.

The Age covers the story here

Note that there is a lot of politics in this. Morrison, for example, refuses to acknowledge that more government spending is needed because the political priority is to cut spending to 'solve' the budget deficit. 

There are lots of articles on this argument - look for them for your IA.

Sensible words

Gordon Brown as the UK Chancellor of the Exchequer (Treasurer or Finance Minister) had a 'Golden Rule'. Balance the budget of current expenditure over the economic cycle. That is he, like all sensible governments, separate the current and capital components of the government budget.

The article below says 'maybe this is a good idea?' Well while it is rather late this is a welcome contribution to the public debate.

It is not bad to borrow to invest!

The ABC article is here

Monetary policy in the Euro Area

Like many countries around the world the interest rate is at a record low. The European Central Bank (ECB) has kept its rate at 0% this month.

The Euro Area economy is growing slowly and inflation is so low that deflation is a real possibility. The response of the ECB has been to 'print' 1 trillion Euros of money and lower interest rates to encourage spending.

The ECB has been slower than most to act, partly because it has a 25 member committee that finds it difficult to agree. They may have acted far too late, or they may just feel that with rates so low and confidence so weak that monetary policy is ineffective.

There are lots of good stories like this around the world that will make good IA's.

The BBC cover the story here

Monetary policy is impotent - RBA Governor

The article linked below is as much an opinion piece as a news article (so not that suitable for IA's). However there is an important message in it. Monetary policy alone won't work to manage the economy.

Ever since the idiot Costello conned everyone into believing a Budget surplus was the equivalent of good economic management Australian governments have not really distinguished themselves in fiscal (budgetary) policy planning and execution. The one exception was the Rudd governments textbook response to the GFC.

Glenn Stevens, the retiring Governor of the RBA, has given a clear message to th government. Stop obsessing about the deficit, it isn't the problem, start spending on infrastructure to boost demand and build capacity.

VCE students will recognise this as a question of the policy mix. IB students will see the liquidity trap and he ineffectiveness to monetary policy as well.

The SMH article is here

As above for VCE and IB interest.

RBA cuts interest rates to new record low

The Reserve Bank of Australia (RBA) has cut its cash rate to 1.5%. This means that interest rates charged and paid by banks should drop too.

The rate cut is the latest in a succession of cuts as shown by the chart below.

In the last four years the RBA has now halved its cash rate (3% to 1.5%). The aim of this expansionary monetary policy is to try and stimulate household consumption (C), business investment (I) and to some extent moderate the rise in the Australian dollar (AUD) to help maintain competitiveness in overseas markets. The rate cut will affect these variables via the monetary policy transmissions mechanism, although many doubt they will be that effective.

The reason that the RBA cut rates are given by their statement: extracts below.

"The global economy is continuing to grow, at a lower than average pace."
"Commodity prices are above recent lows, but this follows very substantial declines over the past couple of years. Australia's terms of trade remain much lower than they had been in recent years."
"In Australia, recent data suggest that overall growth is continuing at a moderate pace, despite a very large decline in business investment."
"Recent data confirm that inflation remains quite low. Given very subdued growth in labour costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time."

However there are some indicators that suggest that rates need not be cut. This is typical in any period and the RBA has to decide on the balance the forces to make its decision. They identify:

"Several advanced economies have recorded improved conditions over the past year..."
"Labour market indicators continue to be somewhat mixed, but are consistent with a modest pace of expansion in employment in the near term. "
"Low interest rates have been supporting domestic demand and the lower exchange rate since 2013 is helping the traded sector."

There are several concerns about monetary policy. These include will cutting rates at such low levels actually promote any change in behaviour, i.e. will cutting rates work? There is concern that the cut in rates simply shows how desperate the economic situation is and so any influence rate cuts have is overwhelmed by lower business and consumer sentiment.

There is also criticism that the RBA have badly mismanaged the situation for years and have failed to learn from other central banks. The Guardian article below explores this.

The ABC looks at the rate cut here

The Guardian discusses RBA policy here

VCE students will be interested in the conduct of monetary policy by the RBA and how this is likely to effect the Australian economy, in particular how it might work through the monetary transmission mechanism. Also the factors that are influencing Aggregate Demand in Australia are highlighted by this decision. IB students should also be interested in the RBA overall policy that is discussed in The Guardian ad how appropriate their actions have been in recent years given the time lags involved in policy and the influence of relative interest rates.

Headline inflation down, underlying inflation up

Yesterday the June quarter inflation figures showed that the CPI in Australia was running at an annual rate of 1%. That is well below the RBA target of 2- 3% on average over the business cycle. There is a wide expectation of further interest rate cuts, if not at the August meeting of the RBA certainly by the end of the year.

The figures, which are summarized below by the ABS, do disguise a rise in underlying inflation (that is with volatile items removed) has risen to 1.5% (from 1.4%). Underlying inflation does give a better picture of what is happening in the economy, but is still very low. Indeed these are the lowest recorded inflation figures for 17 years.

The question of the next move in monetary policy is dominating the press. Many argue that the RBA must lower interest rates to boost Aggregate Demand to avoid deflation and possible recession. However others, such as former RBA Board member Professor Warwick McKibbin, argues that moving rates to near zero (or zero in Japan) did nothing to help other economies as changes in rates at such low level has no significant effect on saving and investment incentives. 

The danger of very low rates lies in reducing retirement incomes and further distorting the housing market.

The ABC cover the story here

The article is of direct relevance to VCE students who must be aware of Australian inflation movements, the influences on the figures and the monetary policy response. IB students will find this useful as an example of inflationary pressures and policy response, they should also look at the use of inflation targets and pros and cons of monetary policy in a situation of low inflation/rates where 'conventional monetary policy' is ineffective.

If you needed proof confidence is important, look no further than the UK

The decision of the UK to leave the European Union (EU) was widely predicted to be an economic disaster. Therefore we shouldn't be surprised that businesses and consumers have reacted to the move based on the uncertainty this situation has created.

A survey recently published survey shows there has been a sharp slowdown in orders, which will work through the economy to mean lower output. The slowdown is the worst since the Global Financial Crisis.

Both Consumption spending and Investment spending, both components of Aggregate Demand (AD) are partly determined by household and firms confidence (sentiment). Put simply if households are worried about future income they will spend less and save more now. Firms will not invest as much if they are uncertain about future prospects. Brexit has handed out one huge dollop of uncertainty and households and firms are reacting exactly as economic theory predicts.

The effect is to reduce both Consumer and Investment spending and AD will fall.

 

The diagram shows the result of a fall in business and consumer confidence. Inflationary pressure is reduced and this may well lead to the Bank of England having to cut interest rates and engage in more quantitative easing as the UK inflation rate is already well below target. Also with lower output UK economic growth will falter and the possibility of recession and higher unemployment will mean the government might have to allow the budget deficit to increase. 

The Bank of England has already indicated that they will take an accommodating stance  and the new British Chancellor (Treasury minister) has said the aim of returning the government budget to balance by 2020 will be abandoned. 

The BBC report on this story here

VCE students can use this to apply their knowledge of budgetary policy and note the link to monetary policy for the 'policy mix'. For IB students this is an excellent example of fiscal and monetary policy operation using the AD/AS model to analyze the consequences and responses. Not that there will be both discretionary and automatic responses from fiscal policy.

Australian interest rates on hold for now

On Tuesday the Reserve Bank of Australia (RBA) held their cash rate at 1.75%. This wasn't a shock as they cut the rate last month from 2% and it takes a crisis for rates to move very quickly. However forecasters are saying that 1.5% is the likely rate by the end of 2016.

The RBA is setting monetary policy to an expansionary stance because inflationary pressures are low. Growth is presently 3.1% which is below trend, but still the second best in the OECD. Wage pressures are low and the investment component of Aggregate Demand is weakening. This all points to a need to help boost the demand side of the economy with lower rates.

International concerns also feature in the RBA's thinking. If Australia is the second fastest OECD economy then we cannot expect a major growth in export demand any time soon. Also commodity prices are expected to remain at around current levels for the rest of the year.  Australia needs to look to the domestic market for growth.

The reaction of the markets to the interest rate decision was to raise the price of the Australian dollar. The exchange rate has fallen since 2013, but is now fluctuating between 70c and 75c to the US dollar. The boost to Australian export competitiveness has been welcomed, but the RBA's decision to keep Australia's relatively high rates on hold a while longer has meant a move to the higher end of the current trading band.

Major countries central bank interest rates compared to Australia

Australia      1.75%
USA             0.5%
UK               0.5%
Euro area    0.0%
Japan          0.0%

The RBA's decision is reported here 

Monetary policy is a major topic in both VCE and IB. The reasons for setting interest rates is a key area of knowledge as is the impact those decisions have on the wider economy.

What should the inflation target be?

Central banks around the world have taken to adopting an official target for inflation since the 1990's. This was the result of the failure of all previous attempts to manage inflation and included exchange rate targets, fixed exchange rates and controlling the supply of money.

To the surprise of most the targeting of inflation has worked (although arguably this allowed conditions for the GFC to occur). The target adopted is met by influencing the demand for money by manipulating interest rates - the price of money. It is accepted however that there are 'long and variable' lags in such monetary policy and so most central banks try to manage the inflation rate over the next two years rather than influence the next set of inflation figures.

The policy of adopting a target that is not 0% inflation (very popular among politicians as an aim in the 1970's and 80's) is that there are benefits and costs of low and stable inflation, Most central banks have adopted a target of around 2% on the CPI measure. For example the Bank of England have a 2% target with a 1% margin either side before they must explain their failure. The Australian central bank, the RBA, has a target of 2 to 3% over the economic cycle.

The Australian target is much more flexible than the Bank of England target, but seems the same type of price stability. Enough inflation to allow changes in the economy and growth, but not so much that it threatens the efficiency of the price mechanism. All central banks know that it is price volatility that causes the greatest harm.

Presently inflation is below target in most OECD countries. This has led to some people saying that the targets are now too low and should be adjusted downwards. This is to ignore the dangers that too low an inflation rate can bring. In Australia's case the country is too at risk of price fluctuations due to volatile commodity markets and a lower target could easily lead to deflation.

In the article below the views of the Governor of the RBA are discussed on why the inflation target should not be changed.

The Financial Review article is here

This article focuses on Australian monetary policy and so is of interest to VCE students, in particular because it talks about current policy and the influences on decision making. IB students are also required to have detailed knowledge on monetary policy and examples of its workings.