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Posts Tagged ‘monetary policy’

Relaxing the inflation target

The Bank of England’s monetary policy is aimed at achieving an inflation rate of 2% CPI inflation ‘within a reasonable time period’, typically within 24 months. But speaking in Nottingham in one of the ‘Future Forum‘ events on 14 October, the Bank’s Governor, Mark Carney, said that the Bank would be willing to accept inflation above the target in order to protect growth in the economy.

“We’re willing to tolerate a bit of an overshoot in inflation over the course of the next few years in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible.”

But why should the Bank be willing to relax its target – a target set by the government? In practice, a temporary rise above 2% can still be consistent with the target if inflation is predicted to return to 2% within ‘a reasonable time period’.

But if even if the forecast rate of inflation were above 2% in two years’ time, there would still be some logic in the Bank not tightening monetary policy – by raising Bank Rate or ending, or even reversing, quantitative easing. This would be the case when there was, or forecast to be, stagflation, whether actual or as a result of monetary policy.

The aim of an inflation target of 2% is to help create a growth in aggregate demand consistent with the economy operating with a zero output gap: i.e. with no excess or deficient demand. But when inflation is caused by rising costs, such as that caused by a depreciation in the exchange rate, inflation could still rise even though the output gap were negative.

A rise in interest rates in these circumstances could cause the negative output gap to widen. The economy could slip into stagflation: rising prices and falling output. Hopefully, if the exchange rate stopped falling, inflation would fall back once the effects of the lower exchange rate had fed through. But that might take longer than 24 months or a ‘reasonable period of time’.

So even if not raising interest rates in a situation of stagflation where the inflation rate is forecast to be above 2% in 24 months’ time is not in the ‘letter’ of the policy, it is within the ‘spirit’.

But what of exchange rates? Mark Carney also said that “Our job is not to target the exchange rate, our job is to target inflation. But that doesn’t mean we’re indifferent to the level of sterling. It does matter, ultimately, for inflation and over the course of two to three years out. So it matters to the conduct of monetary policy.”

But not tightening monetary policy if inflation is forecast to go above 2% could cause the exchange rate to fall further. It seems as if trying to arrest the fall in sterling and prevent a fall into recession are conflicting aims when the policy instrument for both is the rate of interest.

Articles
BoE’s Carney says not indifferent to sterling level, boosts pound Reuters, Andy Bruce and Peter Hobson (14/10/16)
Bank governor Mark Carney says inflation will rise BBC News, Kamal Ahmed (14/10/16)
Stagflation Risk May Mean Carney Has Little Love for Marmite Bloomberg, Simon Kennedy (14/10/16)
Bank can ‘let inflation go a bit’ to protect economy from Brexit, says Carney – but sterling will be a factor for interest rates This is Money, Adrian Lowery (14/10/16)
UK gilt yields soar on ‘hard Brexit’ and inflation fears Financial Times, Michael Mackenzie and Mehreen Khan (14/10/16)
Brexit latest: Life will ‘get difficult’ for the poor due to inflation says Mark Carney Independent, Ben Chu (14/10/16)
Prices to continue rising, warns Bank of England governor The Guardian, Katie Allen (14/10/16)

Bank of England
Monetary Policy Bank of England
Monetary Policy Framework Bank of England
How does monetary policy work? Bank of England
Future Forum 2016 Bank of England

Questions

  1. Explain the difference between cost-push and demand-pull inflation.
  2. If inflation rises as a result of rising costs, what can we say about the rate of increase in these costs? Is it likely that cost-push inflation would persist beyond the effects of a supply-side shock working through the economy?
  3. Can interest rates be used to control both inflation and the exchange rate? Explain why or why not.
  4. What is the possible role of fiscal policy in the current situation of a falling exchange rate and rising inflation?
  5. Why does the Bank of England target the rate of inflation in 24 months’ time and not the rate today? (After all, the Governor has to write a letter to the Chancellor explaining why inflation in any month is more than 1 percentage point above or below the target of 2%.)
  6. What is meant by a zero output gap? Is this the same as a situation of (a) full employment, (b) operating at full capacity? Explain.
  7. Why have UK gilt yields soared in the light of a possible ‘hard Brexit’, a falling exchange rate and rising inflation?
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Sterling’s slide

The pound has fallen to its lowest rate against the euro since July 2013 and the lowest rate against the US dollar since 1985. Since August 2015, the pound has depreciated by 23.4% against the euro and 22.2% against the dollar. And since the referendum of 23 June, it has depreciated by 15.6% against the euro and 17.6% against the dollar.

On Sunday 2 October, at the start of the Conservative Party conference, the Prime Minister announced that Article 50, which triggers the Brexit process, would be invoked by the end of March 2017. Worries about what the terms of Brexit would look like put further pressure on the pound: the next day it fell by around 1% and the next day by a further 0.5%.

Then, on 6 October, it was reported that President Hollande was demanding tough Brexit negotiations and the pound dropped significantly further. By 7 October, it was trading at around €1.10 and $1.22. At airports, currency exchange agencies were offering less than €1 per £ (see picture).

With the government implying that Brexit might involve leaving the Single Market, the pound continued falling. On 12 October, the trade-weighted index reached its lowest level since the index was introduced in 1980: below its trough in the depth of the 2008 financial crisis and below the 1993 trough following Britain’s ejection from the European Exchange Rate Mechanism in September 1992.

So just why has the pound fallen so much, both before and after the Brexit vote? (Click here for a PowerPoint of the chart.) And what are the implications for the economy?

The articles explore the reasons for the depreciation. Central to these are the effects on the balance of payments from a possible decline in inward investment, lower interest rates leading to a net outflow of currency on the financial account, and stimulus measures, both fiscal and monetary, leading to higher imports.

Worries about the economy were occurring before the Brexit vote and this helped to push sterling down in late 2015 and early 2016, as you can see in the chart. This article from The Telegraph of 14 June 2016 explains why.

Despite the short-run effects on the UK economy of the Brexit vote not being as bad as some had predicted, worries remain about the longer-term effects. And these worries are compounded by uncertainty over the Brexit terms.

A lower sterling exchange rate reduces the foreign currency price of UK exports and increases the sterling price of imports. Depending on price elasticities of demand, this should improve the current account of the balance of payments.

These trade effects will help to boost the economy and go some way to countering the fall in investment as businesses, uncertain over the terms of Brexit, hold back on investment in the UK.

Articles
Pound Nears Three-Decade Low as May Sets Date for Brexit Trigger Bloomberg, Netty Idayu Ismail and Charlotte Ryan (3/10/16)
Sterling near 31-year low against dollar as May sets Brexit start dat Financial Times, Michael Hunter and Roger Blitz (3/10/16)
Sterling hits three-year low against the euro over Brexit worries The Guardian, Katie Allen (3/10/16)
Pound sterling value drops as Theresa May signals ‘hard Brexit’ at Tory conference Independent, Zlata Rodionova (3/10/16)
Pound falls as Theresa May indicates Brexit date BBC News (3/10/16)
The pound bombs and stocks explode over fears of a ‘hard Brexit’ Business Insider UK, Oscar Williams-Grut (3/10/16)
Pound Will Feel Pain as Brexit Clock Ticks Faster Wall Street Journal, Richard Barley (3/10/16)
British Pound to Euro Exchange Rate’s Brexit Breakdown Slows After Positive Manufacturing PMI Halts Decline Currency Watch, Joaquin Monfort (3/10/16)
7 ways the fall in the value of the pound affects us all Independent (4/10/16)
The pound and the fury: Brexit is making Britons poorer, and meaner The Economist, ‘Timekeeper’ (11/10/16)
Is the pound headed for parity v US dollar and euro? Sydney Morning Herald, Jessica Sier (5/10/16)
Flash crash sees the pound gyrate in Asian trading BBC News (7/10/16)
Flash crash hits pound after Hollande remarks Deutsche Welle (7/10/16)
Sterling mayhem gives glimpse into future Reuters, Swaha Pattanaik (7/10/16)
Sterling takes a pounding The Economist, Buttonwood (7/10/16)
Government must commit to fundamental reform The Telegraph, Andrew Sentance (7/10/16)

Data
Interest & exchange rates data – Statistical Interactive Database Bank of England

Questions

  1. Why has sterling depreciated? Use a demand and supply diagram to illustrate your argument.
  2. What has determined the size of this depreciation?
  3. What is meant by the risk premium of holding sterling?
  4. To what extent has the weaker pound contributed to the better economic performance than was expected immediately after the Brexit vote?
  5. What factors will determine the value of sterling over the coming months?
  6. Who gain and who lose from a lower exchange rate?
  7. What is likely to happen to inflation over the coming months? Explain and consider the implications for monetary and fiscal policy.
  8. What is a ‘flash crash’. Why was there a flash crash in sterling on Asian markets on 7 October 2016? Is such a flash crash in sterling likely to occur again?
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New UK monetary policy measures – somewhat short of the kitchen sink

The Bank of England has responded to forecasts of a dramatic slowdown in the UK economy in the wake of the Brexit vote. On 4th August, it announced a substantial easing of monetary policy, but still left room for further easing later.

Its new measures are based on the forecasts in its latest 3-monthly Inflation Report. Compared with the May forecasts, the Report predicts that, even with the new measures, aggregate demand growth will slow dramatically. As a result, over the next two years cumulative GDP growth will be 2.5% lower than it would have been with a Remain vote and unemployment will rise from 4.9% to around 5.5%.

What is more, the slower growth in aggregate demand will impact on aggregate supply. As the Governor said in his opening remarks at the Inflation Report press conference:

“The weakness in demand will itself weigh on supply as a period of low investment restrains growth in the capital stock and productivity.

There could also be more direct implications for supply from the decision to leave the European Union. The UK’s trading relationships are likely to change, but precisely how will be unclear for some time. If companies are uncertain about the future impact of this on their businesses, they could delay decisions about building supply capacity or entering new markets.”

Three main measures were announced.

•  A cut in Bank Rate from 0.5% to 0.25%. This is the first time Bank Rate has been changed since March 2009. The Bank hopes that banks will pass this on to customers in terms of lower borrowing rates.
•  A new ‘Term Funding Scheme (TFS)’. “Compared to the old Funding for Lending Scheme, the TFS is a pure monetary policy instrument that is likely to be more stimulative pound-for-pound.” The scheme makes £100bn of central bank reserves available as loans to banks and building societies. These will be at ultra-low interest rates to enable banks to pass on the new lower Bank Rate to customers in all forms of lending. What is more, banks will be charged a penalty if they do not lend this money.
•  An expansion of the quantitative easing programme beyond the previous £375 billion of gilt (government bond) purchases. This will consist of an extra £60bn of gilt purchases and the purchase of up to £10bn of UK corporate bonds.

The Bank recognises that there is a limit to what monetary policy can do and that there is also a role to play for fiscal policy. The new Chancellor, Philip Hammond, is considering what fiscal measures can be taken, including spending on infrastructure projects. These are likely to have relative high multiplier effects and would also increase aggregate supply at the same time. But we will have to wait for the Autumn Statement to see what measures will be taken.

But despite the limits to monetary policy, there is more the Bank of England could do. It already recognises that there may have to be a further cut in Bank Rate, perhaps to 0.1% or even to 0% (the ECB has a 0% rate). There could also be additional quantitative easing or additional term funding to banks.

Some economists argue that the Bank should go further still and, in conjunction with the Treasury, provide new money directly to fund infrastructure spending or tax cuts, or even as cash handouts to households. This extra money provided to the government would not increase government borrowing.

We discussed the use of this version of ‘helicopter money’ in the blogs, A flawed model of monetary policy, Global warning and People’s quantitative easing. Some of the articles below also consider the potential for this type of monetary policy. In a letter to The Guardian 35 economists advocate:

A fiscal stimulus financed by central bank money creation [which] could be used to fund essential investment in infrastructure projects – boosting the incomes of businesses and households, and increasing the public sector’s productive assets in the process. Alternatively, the money could be used to fund either a tax cut or direct cash transfers to households, resulting in an immediate increase of household disposable incomes.

Webcasts and podcasts
Inflation Report Press Conference Bank of England, Mark Carney (4/8/16)
Bank spells out chance of further rate cut this year BBC Radio 4 Today Programme, Ben Broadbent, Deputy Governor of the Bank of England (5/8/16)
Broadbent Ready to Back Another BOE Rate Cut Amid Slowdown Bloomberg, Chris Wyllie (5/8/16)
What’s Top of Mind? ‘Helicopter Money’ Goldman Sachs Macroeconomic Insights, Allison Nathan (April 2016)

Articles
Bank of England measures
Interest rate cut: What did the Bank of England announce today and how will it affect you? Independent, Ben Chu (5/8/16)
This is the Bank of England’s all-action response to Brexit The Guardian, Larry Elliott (4/8/16)
Bank of England unveils four-pronged stimulus package in bid to avoid Brexit recession The Telegraph, Szu Ping Chan (4/8/16)
Record-breaking Bank of England Financial Times, Robin Wigglesworth (4/8/16)
The Bank of England has delivered – now for a fiscal response Financial Times (4/8/16)
Bank of England Cuts Interest Rate to Historic Low, Citing Economic Pressures New York Times, Chad Bray (4/8/16)
Sledgehammer? This is more like the small tool to fix a fence The Telegraph, Andrew Sentance (5/8/16)
All eyes are on Hammond as Bank runs low on options The Telegraph, Tom Stevenson (6/8/16)
Bank of England’s stimulus package has bought the chancellor some time The Guardian, Larry Elliott (7/8/16)

Helicopter money
A post-Brexit economic policy reset for the UK is essential Guardian letters, 35 economists (3/8/16)
Cash handouts are best way to boost British growth, say economists The Guardian, Larry Elliott (4/8/16)
Helicopter money: if not now, when? Financial Times, Martin Sandbu (2/8/16)
The helicopters fly on for now, but one day they will crash The Telegraph, Tom Stevenson (23/7/16)
Is the concept of ‘helicopter money’ set for a resurgence? The Conversation, Phil Lewis (2/8/16)
Helicopter money talk takes flight as Bank of Japan runs out of runway Reuters, Stanley White (30/7/16)
Helicopters 101: your guide to monetary financing Deutsche Bank Research, George Saravelos, Daniel Brehon and Robin Winkler (15/4/16)
Helicopter money is back in the air The Guardian, Robert Skidelsky (22/9/16)

Bank of England publications
Inflation Report, August 2016 Bank of England (4/8/16)
Inflation Report Press Conference: Opening Remarks by the Governor Bank of England, Mark Carney (4/8/16)
Inflation Report Q&A Bank of England Press Conference (4/8/16)
Inflation Report, August 2016: Landing page Bank of England (4/8/16)

Questions

  1. Find out the details of the previous Funding for Lending (FLS) scheme. How does the new Term Funding Scheme (TFS) differ from it? Why does the Bank of England feel that TFS is likely to be more effective than FLS in expanding lending?
  2. What is the transmission mechanism between asset purchases and real aggregate demand?
  3. What factors determine the level of borrowing in the economy? How is cutting Bank Rate from 0.5% to 0.25% likely to affect borrowing?
  4. If the Bank of England’s latest forecast is for a significant reduction in economic growth from its previous forecast, why did the Bank not introduce stronger measures, such as larger asset purchases or a cut in Bank Rate to 0.1%?
  5. What are the advantages and disadvantages of helicopter money in the current circumstances? If helicopter money were used, would it be better to use it for funding public-sector infrastructure projects or for cash handouts to households, either directly or in the form of tax cuts?
  6. How does the Bank of England’s measures of 4 August compare with those announced by the Japanese central bank on 29 July?
  7. What effects can changes in aggregate demand have on aggregate supply?
  8. What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
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Falling sterling – bad for some; good for others

Since the Brexit vote in the referendum, sterling has been falling. It is now at a 31-year low against the US dollar. From 23 June to 6 July it depreciated by 12.9% against the US dollar, 10.7% against the euro and 17.0% against the yen. The trade-weighted sterling exchange rate index depreciated by 11.6%.

Why has this happened? Partly it reflects a decline in confidence in the UK economy by investors; partly it is in response to policy measures, actual and anticipated, by the Bank of England.

As far as investors are concerned, the anticipation is that there will be net direct investment outflows from the UK. This is because some companies in the UK are considering relocating part or all of their business from the UK to elsewhere in Europe. For example, EasyJet is drawing up plans to move its headquarters to continental Europe. It is also because investors believe that foreign direct investment in the UK is likely to fall as companies prefer to invest elsewhere, such as Ireland or Germany.

Thus although the effect of net direct investment outflows (or reductions in net inflows) will be on the long-term investment part of the financial account of the balance of payments, the immediate effect is felt on the short-term financial flows part of the account as investors anticipate such moves and the consequent fall in sterling.

As far as monetary policy is concerned, the fall in sterling is in response to four things announced or signalled by Mark Carney at recent news conferences (see Monetary and fiscal policies – a U-turn or keeping the economy on track?).

First is the anticipated fall in Bank Rate at the next meeting of the Monetary Policy Committee on 13/14 July. Second is the possibility of further quantitative easing (QE). Third is an additional £250bn of liquidity that the Bank is prepared to provide through its normal open-market operations. Fourth is the easing of capital requirements on banks (reducing the countercyclical buffer from 0.5% to 0%), which would allow additional lending by banks of up to £150bn.

Lower interest rates, additional liquidity and further QE would all increase the supply of sterling on the foreign exchange markets. The anticipation of this, plus the anticipation of lower interest rates, would decrease the demand for sterling. The effect of these supply and demand changes is a fall in the exchange rate.

But is a fall in the exchange rate a ‘good thing’? As far as consumers are concerned, the answer is no. Imports will be more expensive, as will foreign holidays. People’s pounds will buy less of things priced in foreign currency and thus people will be poorer.

As far as exporters are concerned, however, the foreign currency they earn will exchange into more pounds than before. Their sterling revenues, therefore, are likely to increase. They might also choose to reduce the foreign currency price of exports, thereby increasing the quantity sold – the amount depending on the price elasticity of demand. The increase in exports and reduction in imports will help to reduce the current account deficit and also boost aggregate demand.

Articles
Pound slumps to 31-year low following Brexit vote The Guardian, Katie Allen , Jill Treanor and Simon Goodley (24/6/16)
Sterling’s post-Brexit fall is biggest loss in a hard currency Reuters, Jamie McGeever (7/7/16)
Brexit Accelerates the British Pound’s 100 Years of Debasement Bloomberg, Simon Kennedy and Lukanyo Mnyanda (5/7/16)
Pound sterling falls below $1.31 hitting new 31-year low Independent, Hazel Sheffield (5/7/16)
Viewpoints: How low will sterling go? BBC News, Leisha Chi (6/7/16)
How low will the pound fall? Financial Times (7/7/16)
Allianz’s El-Erian says UK must urgently get its act together or dollar parity could beckon Reuters, Guy Faulconbridge (7/7/16)
What does a falling pound mean for the British economy? The Telegraph, Peter Spence (6/7/16)

Data
Spot exchange rates: Statistical Interactive Database – interest & exchange rates data Bank of England

Questions

  1. What determines how much the exchange rate depreciates for a given shift in the demand for sterling or the supply of sterling?
  2. Why might the short-term effects on exchange rates of the Brexit vote be different from the long-term effects?
  3. Why has the pound depreciated by different amounts against different currencies?
  4. What are likely to be the effects on the financial and current accounts of the balance of payments of the Bank of England’s measures?
  5. Find out what has happened to business confidence since the Brexit vote. What effect does the level of confidence have on the exchange rate and why?
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Monetary and fiscal policies – a U-turn or keeping the economy on track?

What have been, and will be, the monetary and fiscal responses to the Brexit vote in the referendum of 23 June 2016? This question has been addressed in speeches by Mark Carney, Governor of the Bank of England, and by George Osborne, Chancellor the Exchequer. Both recognise that the vote will cause a negative shock to the economy, which will require some stimulus to aggregate demand to avoid a recession, or at least minimise its depth.

Mark Carney stated that:

The Bank of England stands ready to provide more than £250bn of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required.

In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses.

This could mean that at its the next meeting, scheduled for 13/14 July, the Monetary Policy Committee will consider reducing Bank Rate from its current level of 0.5% and introducing further quantitative easing.

In a speech on 30 June, he went further:

I can assure you that in the coming months the Bank can be expected to take whatever action is needed to support growth subject to inflation being projected to return to the target over an appropriate horizon, and inflation expectations remaining well anchored.

Then in a speech on 5 July, introducing the latest Financial Stability Report, he said that the Bank of England’s Financial Policy Committee is lowering the required capital ratio of banks, thereby freeing up capital for lending to customers. The part being lowered is the ‘countercyclical capital buffer’ – the element that can be varied according to the state of the economy. Mark Carney said:

The FPC is today reducing the countercyclical capital buffer on banks’ UK exposures from 0.5% to 0% with immediate effect. This is a major change. It means that three quarters of UK banks, accounting for 90% of the stock of UK lending, will immediately have greater flexibility to supply credit to UK households and firms.

Specifically, the FPC’s action immediately reduces regulatory capital buffers by £5.7 billion and therefore raises banks’ capacity to lend to UK businesses and households by up to £150 billion. For comparison, last year with a fully functioning banking system and one of the fastest growing economies in the G7, total net lending in the UK was £60 billion.

Thus although there may be changes to interest rates and narrow money in response to economic reactions to the Brexit vote, the monetary policy framework remains unchanged. This is to achieve a target rate of CPI inflation of 2% at the 24-month time horizon.

But what of fiscal policy?

In its Charter for Budget Responsibility, updated in the Summer 2015 Budget, the government states its Fiscal Mandate:

3.2 In normal times, once a headline surplus has been achieved, the Treasury’s mandate for fiscal policy is:
   a target for a surplus on public-sector net borrowing in each subsequent year.

3.3 For the period outside normal times from 2015-16, the Treasury’s mandate for fiscal policy is:
   a target for a surplus on public-sector net borrowing by the end of 2019-20.

3.4 For this period until 2019-20, the Treasury’s mandate for fiscal policy is supplemented by:
   a target for public-sector net debt as a percentage of GDP to be falling in each year.

The target of a PSNB surplus by 2019-20 has been the cornerstone of recent fiscal policy. In order to stick to it, the Chancellor warned before the referendum that a slowdown in the economy as a result of a Brexit vote would force him to introduce an emergency Budget, which would involve cuts in government expenditure and increases in taxes.

However, since the vote he is now saying that the slowdown would force him to extend the time for reaching a surplus beyond 2019-20 to avoid dampening the economy further. But does this mean he is abandoning his fiscal target and resorting to discretionary expansionary fiscal policy?

George Osborne’s answer to this question is no. He argues that extending the deadline for a surplus is consistent with paragraph 3.5 of the Charter, which reads:

3.5 These targets apply unless and until the Office for Budget Responsibility (OBR) assess, as part of their economic and fiscal forecast, that there is a significant negative shock to the UK. A significant negative shock is defined as real GDP growth of less than 1% on a rolling 4 quarter-on-4 quarter basis. If the OBR assess that a significant negative shock:

occurred in the most recent 4 quarter period;
is occurring at the time the assessment is being made; or
will occur during the forecast period

then:

  if the normal times surplus rule in 3.2 is in force, the target for a surplus each year is suspended (regardless of future data revisions). The Treasury must set out a plan to return to surplus. This plan must include appropriate fiscal targets, which will be assessed by the OBR. The plan, including fiscal targets, must be presented by the Chancellor of the Exchequer to Parliament at or before the first financial report after the shock. The new fiscal targets must be approved by a vote in the House of Commons.
  if the shock occurs outside normal times, the Treasury will review the appropriateness of its fiscal targets for the period until the public finances return to surplus. Any changes to the targets must be approved by a vote in the House of Commons.
  once the budget is in surplus, the target set out in 3.2 above applies.

In other words, if the OBR forecasts that the Brexit vote will result in GDP growing by less than 1%, the Chancellor can delay reaching the surplus and thus not have to introduce tougher austerity measures. This, in effect, is what he is now saying and maintaining that, because of paragraph 3.5, it does not break the Fiscal Mandate. The nature of the next Budget, probably in the autumn, will depend on OBR forecasts.

A few days later, George Osborne announced that he plans to cut corporation tax from the current 20% to less than 15% – below the rate of 17% previously scheduled for 2019-20. His aim is not just to stimulate the economy, but to attract inward investment, as the rate would below that of any major economy and close the rate of 12.5% in Ireland. His hope would also be to halt the outflow of investment as companies seek to relocate in the EU.

Videos and podcasts
Statement from the Governor of the Bank of England following the EU referendum result Bank of England (24/6/16)
Uncertainty, the economy and policy – speech by Mark Carney Bank of England (30/6/16)
Introduction to Financial Stability Report, July 2016 Bank of England (5/7/16)
Osborne: Life will not be ‘economically rosy’ outside EU BBC News (28/6/16)
Osborne takes ‘realistic’ view over surplus target BBC News (1/7/16)
Why has George Osborne abandoned a key economic target? BBC News (1/7/16)

Articles
Mark Carney says Bank of England ready to inject £250bn into economy to keep UK afloat after EU referendum Independent, Zlata Rodionova (24/6/16)
Carney Signals Rate Cuts as Brexit Chaos Engulfs Political Class Bloomberg, Scott Hamilton (30/6/16)
Bank of England hints at UK interest rate cuts over coming months to ease Brexit woes International Business Times, Gaurav Sharma (30/6/16)
Carney prepares for ‘economic post-traumatic stress’ Financial Times, Emily Cadman (30/6/16)
Bank of England warns Brexit risks beginning to crystallise BBC News (5/7/16)
Bank of England tells banks to cut buffer to boost lending Financial Times, Caroline Binham and Chris Giles (5/7/16)
George Osborne puts corporation tax cut at heart of Brexit recovery plan Financial Times (3/7/16)
George Osborne corporation tax cut is the wrong way to start EU negotiations, former WTO boss says Independent, Hazel Sheffield (5/7/16)
George Osborne abandons 2020 UK surplus target Financial Times, Emily Cadman and Gemma Tetlow (1/7/16)
George Osborne scraps 2020 budget surplus plan The Guardian, Jill Treanor and Katie Allen (1/7/16)
Osborne abandons 2020 budget surplus target BBC News (1/7/16)
Brexit and the easing of austerity BBC News, Kamal Ahmed (1/7/16)
Osborne Follows Carney in Signaling Stimulus After Brexit Bloomberg, Simon Kennedy (1/7/16)

Questions

  1. Explain the measures taken by the Bank of England directly after the Brexit vote.
  2. What will determine whether the Bank of England engages in further quantitative easing beyond the current £385bn of asset purchases?
  3. How does monetary policy easing (or the expectation of it) affect the exchange rate? Explain.
  4. How effective is monetary policy for expanding aggregate demand? Is it more or less effective than using monetary policy to reduce aggregate demand?
  5. Explain what is meant by (a) capital adequacy ratios (tier 1 and tier 2); (b) countercyclical buffers. (See, for example, Economics 9th edition, page 533–7 and Figure 16.2))
  6. To what extent does increasing the supply of credit result in that credit being taken up by businesses and consumers?
  7. Distinguish between rules-based and discretionary fiscal policy. How would you describe paragraph 3.5 in the Charter for Budget Responsibility?
  8. Would you describe George Osborne’s proposed fiscal measures as expansionary or merely as less contractionary?
  9. Why is the WTO unhappy with George Osborne’s proposals about corporation tax?
  10. What is the Nash equilibrium of countries seeking to undercut each other’s corporation tax rates?
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Brexit: the economic consequences

The UK has voted to leave the EU by 17 410 742 votes (51.9% or 37.4% of the electorate) to 16 141 241 votes (48.1% or 34.7% of the electorate). But what will be the economic consequences of the vote?

To leave the EU, Article 50 must be invoked, which starts the process of negotiating the new relationship with the EU. This, according to David Cameron, will happen when a new Conservative Prime Minister is chosen. Once Article 50 has been invoked, negotiations must be completed within two years and then the remaining 27 countries will decide on the new terms on which the UK can trade with the EU. As explained in the blog, The UK’s EU referendum: the economic arguments, there are various forms the new arrangements could take. These include:

‘The Norwegian model’, where Britain leaves the EU, but joins the European Economic Area, giving access to the single market, but removing regulation in some key areas, such as fisheries and home affairs. Another possibility is ‘the Swiss model’, where the UK would negotiate trade deals on an individual basis. Another would be ‘the Turkish model’ where the UK forms a customs union with the EU. At the extreme, the UK could make a complete break from the EU and simply use its membership of the WTO to make trade agreements.

The long-term economic effects would thus depend on which model is adopted. In the Norwegian model, the UK would remain in the single market, which would involve free trade with the EU, the free movement of labour between the UK and member states and contributions to the EU budget. The UK would no longer have a vote in the EU on its future direction. Such an outcome is unlikely, however, given that a central argument of the Leave camp has been for the UK to be able to control migration and not to have to pay contributions to the EU budget.

It is quite likely, then, that the UK would trade with the EU on the basis of individual trade deals. This could involve tariffs on exports to the EU and would involve being subject to EU regulations. Such negotiations could be protracted and potentially extend beyond the two-year deadline under Article 50. But for this to happen, there would have to be agreement by the remaining 27 EU countries. At the end of the two-year process, when the UK exits the EU, any unresolved negotiations would default to the terms for other countries outside the EU. EU treaties would cease to apply to the UK.

It is quite likely, then, that the UK would face trade restrictions on its exports to the EU, which would adversely affect firms for whom the EU is a significant market. Where practical, some firms may thus choose to relocate from the UK to the EU or move business and staff from UK offices to offices within the EU. This is particularly relevant to the financial services sector. As the second Economist article explains:

In the longer run … Britain’s financial industry could face severe difficulties. It thrives on the EU’s ‘passport’ rules, under which banks, asset managers and other financial firms in one member state may serve customers in the other 27 without setting up local operations. …

Unless passports are renewed or replaced, they will lapse when Britain leaves. A deal is imaginable: the EU may deem Britain’s regulations as ‘equivalent’ to its own. But agreement may not come easily. French and German politicians, keen to bolster their own financial centres and facing elections next year, may drive a hard bargain. No other non-member has full passport rights.

But if long-term economic effects are hard to predict, short-term effects are happening already.

The pound fell sharply as soon as the results of the referendum became clear. By the end of the day it had depreciated by 7.7% against the dollar and 5.7% against the euro. A lower pound will make imports more expensive and hence will drive up prices and reduce the real value of sterling. On the other had, it will make exports cheaper and act as a boost to exports.

If inflation rises, then the Bank of England may raise interest rates. This could have a dampening effect on the economy, which in turn would reduce tax revenues. The government, if it sticks to its fiscal target of achieving a public-sector net surplus by 2020 (the Fiscal Mandate), may then feel the need to cut government expenditure and/or raise taxes. Indeed, the Chancellor argued before the vote that such an austerity budget may be necessary following a vote to leave.

Higher interest rates could also dampen house prices as mortgages became more expensive or harder to obtain. The exception could be the top end of the market where a large proportion are buyers from outside the UK whose demand would be boosted by the depreciation of sterling.

But given that the Bank of England’s remit is to target inflation in 24 month’s time, it is possible that any spike in inflation is temporary and this may give the Bank of England leeway to cut Bank Rate from 0.5% to 0.25% or even 0% and/or to engage in further quantitative easing.

One major worry is that uncertainty may discourage investment by domestic companies. It could also discourage inward investment, and international companies many divert investment to the EU. Already some multinationals have indicated that they will do just this. Shares in banks plummeted when the results of the vote were announced.

Uncertainty is also likely to discourage consumption of durables and other big-ticket items. The fall in aggregate demand could result in recession, again necessitating an austerity budget if the Fiscal Mandate is to be adhered to.

We live in ‘interesting’ times. Uncertainty is rarely good for an economy. But that uncertainty could persist for some time.

Articles
Why Brexit is grim news for the world economy The Economist (24/6/16)
International banking in a London outside the European Union The Economist (24/6/16)
What happens now that Britain has voted for Brexit The Economist (24/6/16)
Britain and the EU: A tragic split The Economist (24/6/16)
Brexit in seven charts — the economic impact Financial Times, Chris Giles (21/6/16)
How will Brexit result affect France, Germany and the rest of Europe? Financial Times, Anne-Sylvaine Chassany, Stefan Wagstyl, Duncan Robinson and Richard Milne (24/6/16)
How global markets are reacting to UK’s Brexit vote Financial Times, Michael Mackenzie and Eric Platt (24/6/16)
Brexit: What happens now? BBC News (24/6/16)
How will Brexit affect your finances? BBC News, Brian Milligan (24/6/16)
Brexit: what happens when Britain leaves the EU Vox, Timothy B. Lee (25/6/16)
An expert sums up the economic consensus about Brexit. It’s bad. Vox, John Van Reenen (24/6/16)
How will the world’s policymakers respond to Brexit? The Telegraph, Peter Spence (24/6/16)
City of London could be cut off from Europe, says ECB official The Guardian, Katie Allen (25/6/16)
Multinationals warn of job cuts and lower profits after Brexit vot The Guardian, Graham Ruddick (24/6/16)
How will Brexit affect Britain’s trade with Europe? The Guardian, Dan Milmo (26/6/16)
Britain’s financial sector reels after Brexit bombshell Reuters, Sinead Cruise, Andrew MacAskill and Lawrence White (24/6/16)
How ‘Brexit’ Will Affect the Global Economy, Now and Later New York Times, Neil Irwin (24/6/16)
Brexit results: Spurned Europe wants Britain gone Sydney Morning Herald, Nick Miller (25/6/16)
Economists React to ‘Brexit’: ‘A Wave of Economic and Political Uncertainty’ The Wall Street Journal, Jeffrey Sparshott (24/6/16)
Brexit wound: UK vote makes EU decline ‘practically irreversible’, Soros says CNBC, Javier E. David (25/6/16)
One month on, what has been the impact of the Brexit vote so far? The Guardian (23/7/16)

Questions

  1. What are the main elements of a balance of payments account? Changes in which elements caused the depreciation of the pound following the Brexit vote? What elements of the account, in turn, are likely to be affected by the depreciation?
  2. What determines the size of the effect on the current account of the balance of payments of a depreciation? How might long-term effects differ from short-term ones?
  3. Is it possible for firms to have access to the single market without allowing free movement of labour?
  4. What assumptions were made by the Leave side about the economic effects of Brexit?
  5. Would it be beneficial to go for a ‘free trade’ option of abolishing all import tariffs if the UK left the EU? Would it mean that UK exports would face no tariffs from other countries?
  6. What factors are likely to drive the level of investment in the UK (a) by domestic companies trading within the UK and (b) by multinational companies over the coming months?
  7. What will determine the course of monetary policy over the coming months?
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A flawed model of monetary policy

In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.

The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.

As Joseph Stiglitz points out:

As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.

And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves. In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less

What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:

The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter money last week is a straw in the wind.

As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.

So if the model of monetary policy is indeed flawed, prepare for more unconventional measures

Articles
What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)

Questions

  1. What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
  2. In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
  3. Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
  4. Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
  5. What forms might helicopter money take?
  6. Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?
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Global warning

Project Syndicate is an organisation which produces articles on a range of economic, political and social topics written by eminent scholars, political and business leaders, policymakers and civic activists. It then makes these available to news media in more than 150 countries. Here we look at four such articles which assess the outlook for the European and global economies and even that of capitalism itself.

The general tone is one of pessimism. Despite unconventional monetary policies, such as quantitative easing (QE) and negative nominal interest rates, the global recovery is anaemic. As the Nouriel Roubini articles states:

Unconventional monetary policies – entrenched now for almost a decade – have themselves become conventional. And, in view of persistent lacklustre growth and deflation risk in most advanced economies, monetary policymakers will have to continue their lonely fight with a new set of ‘unconventional unconventional’ monetary policies.

Perhaps this will involve supplying additional money directly to consumers and/or business in a so-called ‘helicopter drop’ of money. Perhaps it will be supplying money directly to governments to finance infrastructure projects – a policy dubbed ‘people’s quantitative easing‘. Perhaps it will involve taxing the holding of cash by banks to encourage them to lend.

The Hans-Werner Sinn article looks at some of the consequences of the huge amount of money created through QE and continuing to be created in the eurozone. Although it has not boosted consumption and investment nearly as much as desired, it has caused bubbles in various asset markets. For example, the property market has soared in many countries:

Property markets in Austria, Germany, and Luxembourg have practically exploded throughout the crisis, as a result of banks chasing borrowers with offers of loans at near-zero interest rates, regardless of their creditworthiness.

The German property boom could be reined in with an appropriate jump in interest rates. But, given the ECB’s apparent determination to head in the opposite direction, the bubble will only grow. If it bursts, the effects could be dire for the euro.

The Jean Pisani-Ferry article widens the analysis of the eurozone’s problems. Like Roubini, he considers the possibility of a helicopter drop of money, which “would be functionally equivalent to a direct government transfer to households, financed by central banks’ permanent issuance of money”.

Without such drastic measures he sees consumer and business pessimism (see chart) undermining recovery and making the eurozone vulnerable to global shocks, such as further weakening in China. (Click here for a PowerPoint of the chart.)

Finally, Anatole Kaletsky takes a broad historical view. He starts by saying that “All over the world today, there is a sense of the end of an era, a deep foreboding about the disintegration of previously stable societies.” He argues that the era of ‘leaving things to the market’ is coming to an end. This was an era inspired by the monetarist and supply-side revolutions of the 1960s and 1970s that led to the privatisation and deregulation policies of Reagan, Thatcher and other world leaders.

But if the market cannot cope with the complexities of today’s world, neither can governments.

If the world is too complex and unpredictable for either markets or governments to achieve social objectives, then new systems of checks and balances must be designed so that political decision-making can constrain economic incentives and vice versa. If the world is characterized by ambiguity and unpredictability, then the economic theories of the pre-crisis period – rational expectations, efficient markets, and the neutrality of money – must be revised.

… It is obvious that new technology and the integration of billions of additional workers into global markets have created opportunities that should mean greater prosperity in the decades ahead than before the crisis. Yet ‘responsible’ politicians everywhere warn citizens about a ‘new normal’ of stagnant growth. No wonder voters are up in arms.

His solution has much in common with that of Roubini and Pisani-Ferry. “Money could be printed and distributed directly to citizens. Minimum wages could be raised to reduce inequality. Governments could invest much more in infrastructure and innovation at zero cost. Bank regulation could encourage lending, instead of restricting it.”

So will there be a new era of even more unconventional monetary policy and greater regulation that encourages rather than restricts investment? Read the articles and try answering the questions.

Articles
Unconventional Monetary Policy on Stilts Project Syndicate, Nouriel Roubini (1/4/16)
Europe’s Emerging Bubbles Project Syndicate, Hans-Werner Sinn (28/3/16)
Preparing for Europe’s Next Recession Project Syndicate, Jean Pisani-Ferry (31/3/16)
When Things Fall Apart Project Syndicate, Anatole Kaletsky (31/3/16)

Questions

  1. Explain how a ‘helicopter drop’ of money would work in practice.
  2. Why has growth in the eurozone been so anaemic since the recession of 2009/10?
  3. What is the relationship between tightening the regulations about capital and liquidity requirements of banks and bank lending?
  4. Explain the policies of the different eras identified by Anatole Kaletsky.
  5. Would it be fair to describe the proposals for more unconventional monetary policies as ‘Keynesian’?
  6. If quantitative easing was used to finance government infrastructure investment, what would be the effect on the public-sector deficit and debt?
  7. If the inflation of asset prices is a bubble, what could cause the bubble to burst and what would be the effect on the wider economy?
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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.
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Chinese monetary policy

In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.

The RRR is the percentage of liabilities that banks are required to hold in the form of cash reserves – money that could otherwise have been used for lending. This latest move will bring the compulsory ratio for the larger banks down from 17.5% to 17%. This may sound like only a small reduction, but it will release some ¥650bn to ¥690bn (around $100bn) of reserves that can be used for lending.

The cut from 17.5% to 17% is the fourth this year. Throughout 2014 and 2015 it was stable at 20%.

The hope is that this lending will not only help to boost economic growth but also stimulate demand for the consumption of services. The measure can thus be seen as part of a broader strategy as the authorities seek to re-balance the economy away from its reliance on basic manufacturing towards a more diversified economy. It is also hoped that the extra demand will help to boost jobs and thus provide more opportunities for people laid off from traditional manufacturing industries.

It is expected that further reductions in the RRR will be announced later in the year – perhaps a further 1.5 to 2 percentage points.

But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.

One issue that concerns both the Chinese and overseas competitors is the effect of the measure on the exchange rate. By increasing the money supply, the measure will put downward pressure on the exchange rate as it will boost the demand for imports.

The Chinese authorities have been intervening in the foreign exchange market to arrest a fall in the yuan (¥) because of worries about capital outflows from China. The yuan was devalued by 2.9% in August 2015 from approximately ¥1 = ¢16.11 to approximately ¥1 = ¢15.64 (see chart) and after a modest rally in November 2015 it began falling again, with the Chinese authorities being unwilling to support it at the November rate. By January 2016, it had fallen a further 2.8% to approximately ¢15.20 (click here for a PowerPoint file of the chart).

But despite the possible downward pressure on the yuan from the cut in the reserve requirement, it will probably put less downward pressure than a cut in interest rates. This is because an interest rate cut has a bigger effect on capital outflows as it directly reduces the return on deposits in China. The central bank had already cut its benchmark 1-year lending rate from 6% to 4.35% between November 2014 and October 2015 and seems reluctant at the current time to cut it further.

China central bank resumes easing cycle to cushion reform pain Reuters, Pete Sweeney (29/2/16)
China cuts reserve requirements for banks to boost economy PressTV (29/2/16)
China Moves to Bolster Lending by Easing Banks’ Reserve Ratio New York Times, Neil Gough (29/2/16)
Economists React: China’s ‘Surprise’ Bank Reserve Cut Wall Street Journal (29/2/16)
China Cuts Banks’ Reserve Requirement Ratio Bloomberg, Enda Curran (29/2/16)
China Reserve-Ratio Cut Signals Growth Is Priority Over Yuan Bloomberg, Andrew Lynch (29/2/16)
China reserve ratio cut not a signal of impending large-scale stimulus: Xinhua Reuters, Samuel Shen and John Ruwitch (2/3/16)
China injects cash to boost growth and counter capital outflows Financial Times, Gabriel Wildau (29/2/16)
China’s Economic Policy Akin To Pushing On A String Seeking Alpha, Bruce Wilds (2/3/16)
China cuts banks’ reserve ratio for fifth time in a year: Why and what’s next Channel NewsAsia, Tang See Kit, (1/3/16)

Questions

  1. Explain what is mean by the required reserve ratio (RRR).
  2. Explain how credit creation takes place.
  3. What will determine the amount of credit creation that will take place as a result of the $100bn of reserves in Chinese banks released for lending by the cut in the RRR from 17.5% to 17%.
  4. What prompted the recent cuts in the RRR?
  5. Why may China’s recent monetary policy measures be like pushing on a string?
  6. Is the reduction in the RRR a purely demand-side measure, or will it have supply-side consequences?
  7. Explain how different types of monetary policy affect the exchange rate.
  8. Should other countries welcome the cut in China’s RRR? Explain.
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