Pearson - Always learning

All your resources for Economics

RSS icon Subscribe | Text size

Posts Tagged ‘ECB’

A seven-year emergency

Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.

Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.

But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.

Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.

Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.

Some indication that the ‘emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.

Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.

The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.

It would seem that the emergency continues!

Articles
QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)

ECB materials
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi

Questions

  1. What are meant by narrow and broad money?
  2. What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
  3. Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
  4. Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
  5. Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
  6. Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
  7. Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
  8. What are the disadvantages of quantitative easing?
  9. What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
Share in top social networks!

Monetary policy divergence between ECB and the Fed

The Federal Reserve chair, Janet Yellen, has been giving strong signals recently that the US central bank will probably raise interest rates at its December 16 meeting or, if not then, early in 2016. ‘Ongoing gains in the labor market’ she said, ‘coupled with my judgement that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2%.’ This, as for many other central banks, is the target rate of inflation.

In anticipation of a rise in US interest rates, the dollar has been appreciating. Its (nominal) exchange rate index has risen by 24% since April 2014 (see chart below).

In the light of the sluggish eurozone economy, the ECB president, Mario Draghi, has been taking a very different stance. He has indicated that he stands ready to cut interest rates further and increase quantitative easing. At the meeting on 3 December, the ECB did just that. It announced a further cut in the deposit rate, from –0.2 to –0.3 and an extension of the €60 billion per month QE programme from September 2016 to March 2017 (bringing the total by that time to €1.5 trillion – up from €1.1 trillion by September 2016).

Stock market investors had been expecting more, including an increase in the level of monthly asset purchases above €60 billion. Consequently stock markets fell. Both the German DAX and the French CAC 40 stock market indices fell by 3.6%. The euro also appreciated against the dollar by 2.7% on the day of the announcement. Nevertheless, since April 2014, the euro exchange rate index has fallen by 13%. Against the US dollar, the euro has depreciated by a massive 31%.

So what will be the consequences of the very different monetary policies being pursued by the Fed and the ECB? Are they simply the desirable responses to a lack of convergence of the economic performance of the US and eurozone economies? In other words, will they help to bring greater convergence between the two economies?

Or will the desirable effects of convergence be offset by other undesirable effects for the USA and the eurozone and also for the rest of the world?

Will huge amounts of dollar-denominated debt held by many emerging economies make it harder to service these debts with an appreciating dollar?
How much will US exporters suffer from the dollar’s rise and what will the US authorities do about it?
Will currency volatility lead to currency wars and, if so, what will be their economic effects?
Will the time lags involved in the effects of the continuing programme of QE in the eurozone eventually lead to overheating? Already euro money supply is rising, on both narrow and broad measures.

The following articles address these issues.

Articles
The Fed and the ECB: when monetary policy diverges The Guardian, Mohamed El-Erian (2/12/15)
European stocks slide after ECB dashes hopes of major QE expansion The Guardian, Heather Stewart and Graeme Wearden (3/12/15)
Mario Draghi riles Germany with QE overkill The Telegraph, Ambrose Evans-Pritchard (3/12/15)
How the eurozone missed its shot at a recovery The Telegraph, Peter Spence (3/12/15)
Yellen Signals Economy Nearly Ready for First Interest-Rate Hike Bloomberg, Christopher Condon (3/12/15)

Exchange rate data
Effective exchange rate indices Bank for International Settlements
Exchange rates Bank of England

Questions

  1. What would be the beneficial effects to the US and eurozone economies of their respective monetary policies?
  2. Explain the exchange rate movements that have taken place between the euro and the dollar over the past 19 months. How do these relate to the various parts of the balance of payments accounts of the two economies?
  3. Is it possible for the USA to halt the rise in the dollar while at the same time raising interest rates? Explain.
  4. Why are some members of the ECB (e.g. the German and Dutch) against expanding QE? Assess their arguments.
  5. What will be the impact of US and eurozone monetary policies on emerging economies?
  6. What will be the impact of US and eurozone monetary policies on the UK?
  7. Why did the euro appreciate after the Mario Draghi’s press statement on 3 December? What has happened to the dollar/euro exchange rate since and why?
Share in top social networks!

ECB signals further monetary easing

Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.

Although the ECB at its meeting in Malta on 22 October decided to keep both interest rates and asset purchases (€60 billion per month) at current levels, Mario Draghi stated at the press conference that, at its next meeting on December 3rd, the ECB would be prepared to cut interest rates and re-examine the size, composition and duration of its quantitative easing programme. He stopped short, however, of saying that interest rates would definitely be cut or quantitative easing definitely increased. He said the following:

“The Governing Council has been closely monitoring incoming information since our meeting in early September. While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation. Most notably, the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.

In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”

Mario Draghi also argued that monetary policy should be supported by fiscal policy and structural policies (mirroring Japan’s three arrows). Structural policies should include actions to improve the business environment, including the provision of an adequate public infrastructure. This is vital to “increase productive investment, boost job creation and raise productivity”.

As far as fiscal policies are concerned, these “should support the economic recovery, while remaining in compliance with the EU’s fiscal rules”. In other words, fiscal policy should be expansionary, while staying within the limits set by the Stability and Growth Pact.

His words had immediate effects in markets. Eurozone government bond yields dropped to record lows and the euro depreciated 3% against the US dollar over the following 24 hours.

Webcasts
ECB Press Conference on YouTube, Mario Draghi (22/10/15)
Draghi reloads bazooka FT Markets, Ferdinando Guigliano (22/10/15)

Articles
Mario Draghi: ECB prepared to cut interest rates and expand QE The Guardian, Heather Stewart (22/10/15)
Draghi signals ECB ready to extend QE Financial Times, Claire Jones and Elaine Moore (22/10/15)
Dovish Mario Draghi sends bond yields to new lows Financial Times, Katie Martin (23/10/15)
What Draghi Said on QE, Policy Outlook, Global Risks and Inflation Bloomberg, Deborah Hyde (22/10/15)
ECB set to ‘re-examine’ stimulus policy at next meeting BBC News (22/10/15)
The global economy warrants a big dose of caution The Guardian, Larry Elliott (25/10/15)

ECB Press Conference
Introductory statement to the press conference (with Q&A) ECB, Mario Draghi (President of the ECB), Vítor Constâncio (Vice-President of the ECB) (22/10/15)

Questions

  1. Why is the ECB considering further expansionary monetary policy?
  2. What monetary measures can a central bank use to stimulate aggregate demand?
  3. Explain the effects of Mario Draghi’s announcement on bond and foreign exchange markets.
  4. What are the objectives of ECB monetary policy according to the its mandate?
  5. Should the ECB consider using quantitative easing to provide direct funding for infrastructure projects?
  6. What constraints does the EU’s Stability and Growth Pact impose on eurozone countries?
  7. What are the arguments for and against (a) the Bank of England and (b) the US Federal Reserve engaging in further QE?
  8. If the ECB does engage in an expanded QE programme, what will determine its effectiveness?
Share in top social networks!

Down down deeper and down, or a new Status Quo?

If you asked virtually any banker or economist a few years ago whether negative (nominal) interest rates were possible, the answer would almost certainly be no.

Negative real interest rates have been common at many points in time – whenever the rate of inflation exceeds the nominal rate of interest. People’s debts and savings are eroded by inflation as the interest due or earned does not keep pace with rising prices.

But negative nominal rates? Surely this could never happen? It was generally believed that zero (or slightly above zero) nominal rates represented a floor – ‘a zero lower bound’.

The reasoning was that if there were negative nominal rates on borrowing, you would effectively be paid by the bank to borrow. In such a case, you might as well borrow as much as you can, as you would owe less later and could pocket the difference.

A similar argument was used with savings. If nominal rates were negative, savers might as well withdraw all their savings from bank accounts and hold them as cash (perhaps needing first to buy a safe!) Given, however, that this might be inconvenient and potentially costly, some people may be prepared to pay banks for looking after their savings.

Central bank interest rates have been hovering just above zero since the financial crisis of 2008. And now, some of the rates have turned negative (see chart above). The ECB has three official rates:

The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system.
The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem.
The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.

The first of these is the most important rate and remains above zero – just. Since September 2014, it has been 0.05%. This rate is equivalent to the Bank of England’s Bank Rate (currently still 0.5%) and the Fed’s Federal Funds Rate (currently still between 0% and 0.25%).

The third of the ECB’s rates is currently 0.3%, but the second – the rate on overnight deposits in the ECB by banks in the eurozone – is currently –0.2%. In other words, banks have to pay the ECB for making these overnight deposits (deposits that can be continuously rolled over). The idea has been to encourage banks to lend rather than simply keeping unused liquidity.

In Nordic countries, the experiment with negative rates has gone further. With plenty of slack in the Swedish economy, negative inflation and an appreciating krona, the Swedish central bank – the Riksbank – cut its rates below zero.

Many City analysts believe that the Riksbank will continue cutting, reducing its key interest rate to minus 0.5% by the end of the year [it is currently 0.35%]. Switzerland’s is already deeper still, at minus 0.75%, while Denmark and the eurozone have joined them as members of the negative zone.

But the nominal interest rate on holding cash is, by definition, zero. If deposit rates are pushed below zero, then will more and more people hold cash instead? The hope is that negative nominal interest rates on bank accounts will encourage people to spend. It might, however, merely encourage them to hoard cash.

The article below from The Telegraph looks at some of the implications of an era of negative rates. The demand for holding cash has been increasing in many countries and, along with it, the supply of banknotes, as the chart in the article shows. Here negative interest are less effective. In Nordic countries, however, the use of cash is virtually disappearing. Here negative interest rates are likely to be more effective in boosting aggregate demand.

Article
How Sweden’s negative interest rates experiment has turned economics on its head The Telegraph, Peter Spence (27/9/15)

Data
Central bank and monetary authority websites Bank for International Settlements
Central banks – summary of current interest rates global-rates.com

Questions

  1. Distinguish between negative real and negative nominal interest rates.
  2. What is the opportunity cost of holding cash – the real or the nominal interest rate forgone by not holding it in a bank?
  3. Are there any dangers of central banks setting negative interest rates?
  4. Why may negative interest rates be more effective in Sweden than in the UK?
  5. ‘Andy Haldane, a member of the Monetary Policy Committee (MPC) … suggested that to achieve properly negative rates, the abolition of cash itself might be necessary.’ Why?
  6. Why does Switzerland have notes of SF1000 and the eurozone of €500? Should the UK have notes of £100 or even £500?
  7. Why do some banks charge zero interest rates on credit cards for a period of time to people who transfer their balances from another card? Is there any incentive for banks to cut interest rates on credit cards below zero?
Share in top social networks!

A deus ex machina at last?

It was argued in an earlier blog on the Greek debt crisis that a deus ex machina was needed to find a resolution to the impasse between Greece and its creditors. The most likely candidate for such as role was the IMF.

Three days before the Greek referendum on whether or not to accept the Troika’s proposals, the IMF has stepped onto the stage. To the undoubted surprise of the other two partners in the Troika (the European Commission and the ECB), the IMF argues that Greece’s debts are unsustainable and that much more is needed than a mere bailout (which simply rolls over the debt).

According to the IMF, Greece needs €52bn of extra funds between October 2015 and December 2018, large-scale debt relief, a 20-year grace period before making any debt repayments and then debt repayments spread over the following 20 years. In return, Greece should commit to supply-side reforms to cut out waste, reduce bureaucracy, improve tax collection methods and generally improve the efficiency of the economic system.

It would also have to agree to the previously proposed primary budget surplus (i.e. the budget surplus excluding debt repayments) of 1 per cent of GDP this year, rising to 3.5 per cent in 2018.

So it this what commentators have been waiting for? What will be the reaction of the Greeks and the other two partners in the Troika? We shall see.

Articles
IMF says Greece needs extra €50bn in funds and debt relief The Guardian. Phillip Inman, Larry Elliott and Alberto Nardelli (2/7/15)
IMF: 3rd Greek bailout would cost €52bn. Or more? Financial Times, Peter Spiegel (2/7/15)
IMF: Greece needs to reform for sustainable debt, financing needs rising CNBC, Everett Rosenfeld (2/7/15)
The IMF has made an obvious point about Greece’s huge debt. Here’s why it still matters Quartz, Jason Karaian (3/7/15)
Greece: when is it time to forgive debt? The Conversation, Jagjit Chadha (2/7/15)

IMF Analysis
Greece: Preliminary Draft Debt Sustainability Analysis IMF (2/7/15)
Preliminary Debt Sustainability Analysis for Greece IMF (25/6/15)

Questions

  1. To which organisations is Greece indebted? What form to the debts take?
  2. To what extent is Greece’s current debt burden the result of design faults of the euro?
  3. What are the proposals of the IMF? What effect will they have on the Greek economy if accepted?
  4. How would the IMF proposals affect aggregate demand (a) directly; (b) compared with the proposals previously on the table that Greece rejected on 26 June?
  5. What would be the effects of Greek exit from the euro (a) for Greece; (b) for other eurozone countries?
  6. What bargaining chips can Greece deploy in the negotiations?
  7. Explain what is meant by ‘moral hazard’. Where in possible outcomes to the negotiations may there be moral hazard?
  8. What has been the impact of Greek austerity measures on the distribution of income and wealth in Greece?
  9. What are the practicalities of pursuing supply-side policies in Greece without further dampening aggregate demand?
Share in top social networks!

Wanted: a Deus ex Machina for Greece

With talks ongoing about resolving the Greek debt crisis, it is clear that there is no agreement that will satisfy both sides – the Greek government and the troika of lenders (the IMF, the ECB and the European Commission). Their current negotiating positions are irreconcilable. What is needed is something more fundamental to provide a long-term solution. What is needed is a ‘deus ex machina‘.

A deus ex machina, which is Latin for ‘god from a machine’, was a device used in Greek tragedy to solve an impossible situation. A god would appear from above, lowered by a crane, or from below through a trap door, and would put everything right. The tragedy would then be given a happy ending.

So what possible happy ending could be brought to the current Greek tragedy and who could be the deus ex machina?

The negotiations between Greece and the troika currently centre on extending credit by €7.2bn when existing debts come up for repayment. There are repayments currently due to the IMF, or by the end of June, of €1.5bn and more in July, September and December (another €3.2bn). There are also €6.7bn of Greek bonds held by the ECB, as part of the 2010 bailout programme, that are due for repayment in July and August. Without the €7.2 billion bailout, Greece will be unable to meet these debt repayments, which also include Treasury bills.

But the troika will only release the funds in return for harsh austerity measures, which involve further cuts to pensions and public expenditure. Greece would be required to run a substantial budget surplus for many years.

Greece could refuse, but then it would end up defaulting on debt and be forced out of the euro. The result would probably be a substantial depreciation of a newly restored drachma, rising inflation and many Greeks suffering even greater hardship – at least for a period of time.

So what is the possible deus ex machina? If you’re looking for a ‘god’ then it is best, perhaps, to look beyond the current actors. Perhaps the Americans could play the role in finding a solution to the impasse. Perhaps a small group of independent experts or politicians, or both, could find one. In either case, the politics of the situation would have to be addressed as well as the economics and finance.

And what would be the ‘fix’ to satisfy both sides? Ultimately, this has to allow Greek debt to be sustainable without further depressing demand and undermining the fabric of Greek society. This would almost certainly have to involve a large measure of debt forgiveness (i.e. debts being written off). It also has to avoid creating a moral hazard, whereby if the Greeks are seen as being ‘let off lightly’, this might encourage other indebted eurozone countries to be less willing to reduce their debts and make demands for forgiveness too.

Ultimately, the issue is a political one, not an economic one. This will require clever negotiation and, if there is a deus ex machina, clever mediation too.

Videos
Greek PM Tsipras warns lenders bailout plans ‘not realistic’ BBC News, Jim Reynolds (5/6/25)
Greece defers IMF payment until end of June BBC News, Chris Morris (5/6/15)
Greek debt talks: Empty shops and divided societies BBC News, Chris Morris (10/6/15)
Potential Grexit effects Deutsche Welle (13/6/15)

Articles
It’s time to end the pretence: Greece will never fully repay its bailout loan The Guardian, Andrew Farlow (9/6/15)
Greek exit would trigger eurozone collapse, says Alexis Tsipras The Guardian, Phillip Inman, Helena Smith and Graeme Wearden (9/6/15)
The eurozone was a dream of unity. Now Europe has turned upon itself The Guardian, Business leader (14/6/15)
Greece bailout talks: an intractable crisis with three possible outcomes The Guardian, Larry Elliott (2/6/15)
Greece needs an economic defibrillator and a debt write-off Financial Times letters, Ray Kinsella (25/3/15)
Greece’s new debt restructuring plan Times of Change, Peter Spiegel (5/6/15)
Eurozone still in denial about Greece BBC News, Robert Peston (3/6/15)
Greece bailout talks – the main actors in a modern-day epic The Guardian, Phillip Inman, Ian Traynor and Helena Smith (9/6/15)
Greece isn’t any old troubled debtor BBC News, Robert Peston (15/6/15)
Greece in default if debt deadline missed, says Lagarde BBC News (18/6/15)
Burden of debt to IMF and European neighbours proves too much for Greece The Guardian, Heather Stewart (17/6/15)

Paper
Ending the Greek Crisis: Debt Management and Investment led Growth Greek government

Questions

  1. To which organisations is Greece indebted? What form to the debts take?
  2. To what extent is Greece’s current debt burden the result of design faults of the euro?
  3. Would it be possible to restructure debts in ways that make it easier for Greece to service them?
  4. Should Greece be treated by the IMF the same way it treated the highly indebted poor countries (HIPCs) and granted substantial debt relief?
  5. What would be the effects of Greek exit from the euro (a) for Greece; (b) for other eurozone countries?
  6. What bargaining chips can Greece deploy in the negotiations?
  7. Explain what is meant by ‘moral hazard’. Where in possible outcomes to the negotiations may there be moral hazard?
  8. What has been the impact of Greek austerity measures on the distribution of income and wealth in Greece?
  9. What are the practicalities of pursuing supply-side policies in Greece without further dampening aggregate demand?
Share in top social networks!

No instruments left to play

Let’s say that the world slides back into recession, or at least, the eurozone, the USA and other major economies. This is not unthinkable, given the determination of many countries to reduce public-sector deficits and debt, concerns about slowing growth in China and other major developing countries, and worries about various geo-political developments, such as conflict in the Middle East and the possible exit of Greece from the euro and the shock waves this might send. If it happened, what could governments and central banks do to stimulate aggregate demand? The problem is, according to the linked articles below, the world has largely run out of policy instruments.

In normal times, the main policy instruments for stimulating aggregate demand are cuts in interest rates (monetary policy) and increases in government expenditure and/or tax cuts (fiscal policy). But with interest rates currently at virtually zero, there is little scope for further cuts. And with governments attempting to ‘repair’ their balance sheets by cutting deficits, there is little appetite for increasing deficits again.

It is possible that central banks could engage in further quantitative easing. Indeed, the ECB is only just starting its large QE programme, involving monthly bond purchases of €60bn until at least September 2016 (totalling €1.14tr at that point). But QE leads to market distortions, such as increased asset prices (e.g. share and house prices), made higher and more unstable by speculation. By providing ‘cheap money’, it also encourages potentially risky investments.

The articles below considers the dilemma and looks at six possible options for policy makers suggested by Stephen King, chief economist at HSBC. But are they realistic? Read the articles and then consider the questions.

Financial crisis fixes leave policymakers short of ammo for next recession The Guardian, Larry Elliott (31/5/15)
How to get the economy working for us Guardian Letters, Mary Mellor; Colin Hines; Martin London; William Dixon and David Wilson (2/6/15)
HSBC’s Stephen King Outlines “Economic Nightmare” ValueWalk (14/5/15)
HSBC: Central Banks Are Running Low on Ammunition Bloomberg, Julie Verhage (13/5/15)
If the US economy is signalling an iceberg, bad news: we’re out of lifeboats The Guardian, Nils Pratley (13/5/15)
Policy makers lack the firepower to fight another US recession Financial Times, Stephen King (18/5/15)
The new surrealism Global Economics Quarterly, Stephen King (Q2, 2015)

Questions

  1. What are the risks to global recovery?
  2. Why has recovery from the 2008/9 recession been slower than that from previous recessions?
  3. What are the traditional instruments for combatting a recession?
  4. Why might central banks be wary of engaging in further rounds of quantitative easing?
  5. What is meant by ‘helicopter money’? Would this be a better solution to a recession than quantitative easing?
  6. Go through the other five policy options identified by Stephen King and discuss the suitability of each one.
Share in top social networks!

Eurozone: positive inflation

The eurozone has been suffering from deflation: that is, negative inflation. But, the latest data show an increase in the rate of inflation in April from 0% to 0.3%. This is still a very low rate, with a return to deflation remaining a possibility (though perhaps unlikely); but certainly an improvement.

The eurozone economy has been stagnant for some time but the actions of the European Central Bank (ECB) finally appear to be working. Prices across the eurozone have risen, including services up by 1.3%, food and drink up by 1.2% and energy prices, albeit still falling, but at a slower rate. All of this has helped to push the annual inflation rate above 0%. For many, this increase was bigger than expected. Howard Archer, Chief European Economist at HIS Global Insight said:

“Renewed dips into deflation for the eurozone are looking increasingly unlikely with the risks diluted by a firming in oil prices from their January lows, the weakness of the euro and improved eurozone economic activity.”

Economic policy in the eurozone has focused on stimulating the economy, with interest rates remaining low and a €1.1 trillion bond-buying programme by the ECB. But, why is deflation such a concern? We know that one of the main macroeconomic objectives of a nation is low and stable inflation. If prices are low (or even falling) is it really as bad as economists and policy-makers suggest?

The problem of deflation occurs when people expect prices to continue falling and thus delay spending on durables, hoping to get the products cheaper later on. As such, consumption falls and this puts downward pressure on aggregate demand. This decision by consumers to put off spending will cause aggregate demand to shift to the left, thus pushing national income down, creating higher unemployment and adding to problems of economic stagnation. If this expectation continues, then so will the inward shifts in AD. In the eurozone, this has been a key problem, but it now appears that aggregate demand has stopped falling and is now slowly recovering, together with the economy.

It is important to note how interdependent all aspects of an economy are. The euro responded as news of better inflation data emerged, together with expectations of a Greek deal being reached. Enrique Diaz-Alvarez, chief risk officer at Ebury said:

“The move [rise in euro] got going with the big upside surprise in eurozone inflation data — especially core inflation, which bounced up from 0.6 per cent to 0.9 per cent. This is exactly what the ECB wants to see, as it is proof that QE is having the desired effect and removes the threat of deflation in the eurozone from the foreseeable future.”

One of the key factors that has kept inflation down in the eurozone (and also the UK) is falling oil prices. It is for this reason that many have been suggesting that this type of deflation is not bad deflation. With oil prices recovering, the general price level will also recover and so economies will follow suit. The following articles consider the fortunes of the eurozone.

Eurozone inflation shouldn’t shift ECB’s QE focus Wall Street Journal, Richard Barley (2/6/15)
Eurozone deflation threat recedes Financial Times, Claire Jones (2/6/15)
Eurozone inflation rate rises to 0.3% in May BBC News (2/6/15)
Eurozone back to inflation as May prices beat forecast Reuters, Jan Strupczewski (2/6/15)
Boost for ECB as Eurozone prices turn positive in May Guardian, Phillip Inman (2/6/15)
Eurozone inflation higher than expected due to quantitative easing International Business Times, Bauke Schram (2/6/15)
Euro lifted by Greek deal hopes and firmer inflation data Financial Times, Roger Blitz and Michael Hunter (2/6/15)

Questions

  1. What is the difference between the 0.3% and 0.9% figures quoted for inflation in the eurozone?
  2. What is deflation and why is it such a concern?
  3. Illustrate the impact of falling consumer demand in an AD/AS diagram.
  4. How has the ECB’s QE policy helped to tackle the problem of deflation? Do you think that this programme needs to continue or now the economy has begun to improve, should the programme end?
  5. To what extent is the economic stagnation in the eurozone a cause for concern to countries such as the UK and USA? Explain your answer.
  6. Why has the euro risen, following news of this positive inflation data?
Share in top social networks!

The ECB takes the plunge – at last

After promises made back in July 2012 that the ECB will ‘do whatever it takes’ to protect the eurozone economy, the ECB has at last done just that. It has launched a large-scale quantitative easing programme. It will create new money to buy €60 billion of assets every month in the secondary market.

Around €10 billion will be private-sector securities that are currently being purchased under the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year. The remaining €50 billion will be public-sector assets, mainly bonds of governments in the eurozone. This extended programme of asset purchases will begin in March this year and continue until at least September 2016, bringing the total of asset purchased by that time to over €1.1 trillion.

The ECB has taken several steps towards full QE over the past few months, including €400 billion of targeted long-term lending to banks, cutting interest rates to virtually zero (and below zero for the deposit rate) and the outright purchase of private-sector assets. But all these previous moves failed to convince markets that they would be enough to stimulate recovery and stave off deflation. Hence the calls for full quantitative easing became louder and it was widely anticipated that the ECB would finally embark on the purchase of government bonds – in other words, would finally adopt a programme of QE similar to those adopted in the USA (from 2008), the UK (from 2009) and Japan (from 2010).

Rather than the ECB buying the government bonds centrally, each of the 19 national central banks (NCBs), which together with the ECB constitute the Eurosystem, will buy their own nation’s bonds. The amount they will buy will depend on their capital subscriptions the eurozone. For example, the German central bank will buy German bonds amounting to 25.6% of the total bonds purchased by national central banks. France’s share will be 20.1% (i.e. French bonds constituting 20.1% of the total), Spain’s share will be 12.6% and Malta’s just 0.09%.

Central banks of countries that are still in bail-out programmes will not be eligible to purchase their countries’ assets while their compliance with the terms of the bailout is under review (as is the case currently with Greece).

The risk of government default on their bonds will be largely (80%) covered by the individual countries’ central banks, not by the central banks collectively. Only 20% of bond purchases will be subject to risk sharing between member states according to their capital subscription percentages: the ECB will directly purchase 8% of government bonds and 12% will be bonds issued by European institutions rather than countries. As the ECB explains it:

With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.

As with the QE programmes in the USA, the UK and Japan, the transmission mechanism is indirect. The assets purchased will be from financial institutions, who will thus receive the new money. The bond purchases and the purchases of assets by financial institutions with the acquired new money will drive up asset prices and hence drive down long-term interest rates. This, hopefully, will stimulate borrowing and increase aggregate demand and hence output, employment and prices.

The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money, which the institutions that sold the securities can use to buy other assets and extend credit to the real economy. In both cases, this contributes to an easing of financial conditions.

In addition, there is an exchange rate transmission mechanism. To the extent that the extra money is used to purchase non-eurozone assets, so this will drive down the euro exchange rate. This, in turn, will boost the demand for eurozone exports and reduce the demand for imports to the eurozone. This, again, represents an increase in aggregate demand.

The extent to which people will borrow more depends, of course, on confidence that the eurozone economy will expand. So far, the response of markets suggests that such confidence will be there. But we shall have to wait to see if the confidence is sustained.

But even if QE does succeed in stimulating aggregate demand, there remains the question of the competitiveness of eurozone economies. Some people are worried, especially in Germany, that the boost given by QE will reduce the pressure on countries to engage in structural reforms – reforms that some people feel are vital for long-term growth in the eurozone

The articles consider the responses to QE and assess its likely impact.

Articles
The ECB makes its mind up: The launch of euro-style QE The Economist (22/1/15)
ECB unveils massive QE boost for eurozone BBC News (22/1/15)
Eurozone boost of €1.1tn in ‘shock and awe’ plan by Central Bank The Guardian, Heather Stewart (22/1/15)
European Central Bank unleashes quantitative easing Financial Times, Claire Jones (22/1/15)
11 questions you are too embarrassed to ask about Quantitative Easing Independent, Russell Lynch (22/1/15)
What the experts say about the ECB’s latest round of QE The Guardian, Julia Kollewe (22/1/15)
Mario Draghi’s QE blitz may save southern Europe, but at the risk of losing Germany The Telegraph, Ambrose Evans-Pritchard (22/1/15)
The sad consequences of the fear of QE The Economist, Paul De Grauwe (21/1/15)
Will euro QE work? BBC News, Robert Peston (20/1/15)

ECB publications
ECB announces expanded asset purchase programme ECB Press Release (22/1/15)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi, President of the ECB (22/1/15)
Webcast of ECB press conference, Mario Draghi, President of the ECB (22/1/15)

Previous blog posts
The fate of the eurozone (7/1/15)
Eurozone deflation risk (1/12/14)
Edging closer to full QE (6/9/14)
The ECB: tackling the threat of deflation (8/6/14)

Data
Euro area economic and financial data ECB

Questions

  1. Why has the ECB been reluctant to engage in full QE before now?
  2. How has the ECB answered the objections of strong eurozone countries, such as Germany, to taking on the risks associated with weaker countries?
  3. What determines the amount by which aggregate demand will rise following a programme of asset purchases?
  4. In what ways and to what extent will non-eurozone countries benefit or lose from the ECB’s decision?
  5. Are there any long-term dangers to the eurozone economy of the ECB’s QE programme? If so, how might they be tackled?
  6. Why did the euro plummet on the ECB’s announcement? Why had it not plummeted before the announcement, given that the introduction of full QE was widely expected?
Share in top social networks!

Eurozone deflation risk

The eurozone is made up of 18 countries (19 in January) and, besides sharing a common currency, they also seem to be sharing the trait of weak economic performance. The key macroeconomic variables across the eurozone nations have all seemingly been moving in the wrong direction and this is causing a lot of concern for policy-makers.

Some of the biggest players in the eurozone have seen economic growth on the down-turn, unemployment rising and consumer and business confidence falling once again. Germany’s economic growth has been revised down and in Italy, unemployment rose to a record of 13.2% in September and around 25% of the workforce remains out of work in Spain and Greece. A significant consequence of the sluggish growth across this 18-nation bloc of countries is the growing risk of deflation.

Whilst low and stable inflation is a macroeconomic objective across nations, there is such a thing as inflation that is too low. When inflation approaches 0%, the spectre of deflation looms large (see the blog post Deflation danger). The problem of deflation is that when people expect prices to fall, they stop spending. As such, consumption falls and this puts downward pressure on aggregate demand. After all, if you think prices will be lower next week, then you are likely to wait until next week. This decision by consumers will cause aggregate demand to shift to the left, thus pushing national income down, creating higher unemployment. If this expectation continues, then so will the inward shifts in AD. This is the problem facing the eurozone. In November, the inflation rate fell to 0.3%. One of the key causes is falling energy prices – normally good news, but not if inflation is already too low.

Jonathan Loynes, Chief European Economist at Capital Economics said:

“[the inflation and jobless data] gives the ECB yet another nudge to take urgent further action to revive the recovery and tackle the threat of deflation…We now expect the headline inflation rate to drop below zero at least briefly over the next six months and there is a clear danger of a more prolonged bout of falling prices.”

Some may see the lower prices as a positive change, with less household income being needed to buy the same basket of goods. However, the key question will be whether such low prices are seen as a temporary change or an indication of a longer-term trend. The answer to the question will have a significant effect on business decisions about investment and on the next steps to be taken by the ECB. It also has big consequences for other countries, in particular the UK. The data over the coming months across a range of macroeconomic variables may tell us a lot about what is to come throughout 2015. The following articles consider the eurozone data.

Euro area annual inflation down to 0.3% EuroStat News Release (28/11/14)
Eurozone inflation weakens again, adding pressure on ECB Nasdaq, Brian Blackstone (28/11/14)
Eurozone inflation rate falls in October BBC News (28/11/14)
Eurozone recovery fears weigh on UK plc, says report Financial Times, Alison Smith (30/11/14)
€300bn Jean-Claude Juncker Eurozone kickstarter sounds too good to be true The Guardian, Larry Elliott (26/11/14)
Eurozone area may be in ‘persistent stagnation trap’ says OECD BBC News (25/11/14)
Euro area ‘major risk to world growth’: OECD CNBC, Katy Barnato (25/11/14)
OECD sees gradual world recovery, urges ECB to do more Reuters, Ingrid Melander (25/11/14)

Questions

  1. What is deflation and why is it such a concern?
  2. Illustrate the impact of falling consumer demand in an AD/AS diagram.
  3. What policies are available to the ECB to tackle the problem of deflation? How successful are they likely to be and which factors will determine this?
  4. To what extent is the economic stagnation in the Eurozone a cause for concern to countries such as the UK and US? Explain your answer.
  5. How effective would quantitative easing be in combating the problem of deflation?
Share in top social networks!