The monetary policy mandates of central banks have an impact on all our lives. While the terminology might not be familiar to many outside economics, their impact is, however, undeniably important. This is because they set out the objectives for the operation of monetary policy. Adjustments to interest rates or the growth of the money supply, which affect us all, reflect the mandate given to the central bank.
Since 1977 the mandate given to the Federal Reserve (the US central bank) by Congress has been to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. This mandate has become known as the dual mandate because it emphasises both employment and stable prices. Since 2012, the Federal Reserve’s Open Market Committee has issued an annual statemenent of its long-run goals. The latest was published in January 2019. Since this time, the Federal Reserve has explicitly set the ‘longer-run goal for inflation’ at 2 per cent. It has also emphasised that it would be ‘concerned’ if the inflation rate was persistently above or below this level.
In November 2018 the Federal Reserve began a review of its monetary policy strategy, its tools and how it communicates monetary policy. The review is being conducted within the guidelines that its statutory mandate gives and as well as the longer-term inflation goal of 2 per cent. However, one of the issues being addressed by the review is how the operation of monetary policy can avoid the rate of inflation frequently undershooting 2 per cent, as it has done since the financial crisis of the late 2000s and the introduction of the 2 per cent inflation rate target.
Chart 1 shows the annual rate of consumer price inflation in the US since 1998. It helps to illustrate the concern that low inflation rates can become entrenched. The chart shows that, while the average inflation rate from 1998 to 2008 was 2.7 per cent, from 2009 the average has been only 1.6 per cent. Interestingly, the average since 2012, when the explicit 2 per cent goal was introduced, to the present day is also 1.6 per cent. (Click here to download the PowerPoint chart.)
The concern going forward is that the natural or neutral rate of interest, which is the policy rate at which the rate of inflation is close to its target level and the level of output is close to its potential level, is now lower than in the recent past. Hence, when the next downturn occurs there is likely to be less room for cutting interest rates. Hence, the review is looking, in essence, to future-proof the conduct of monetary policy.
Chart 2 shows the Federal Fund rate since 1998. This is the rate at which commercial banks lend to each other the reserve balances they hold at the Federal Reserve in order to meet their reserve requirements. The Federal Reserve can affect this rate through buying or selling government securities. If it wants to drive up rates, it can sell holdings of government securities and reduce the money supply. If it wants to drive rates down, it can buy government securities and increase the money supply. The effects then ripple through to other interest rates and, in turn, aggregate demand and inflation. (Click here to download a copy of the PowerPoint chart.)
We can see from Chart 2 the dramatic cuts made by the Federal Reserve to interest rates as the financial crisis unfolded. The subsequent ‘normalisation’ of the Federal Funds rate in the 2010s saw the Federal Funds Rate rise to no higher than between 2.25 and 2.5 per cent. Then in 2019 the Federal Reserve began to cut rates again. This was despite historically-low unemployment rates. In November 2019 the unemployment rate fell to 3.5 per cent, its lowest since 1969. This has helped fuel the argument among some economists and financiers, which we saw earlier, that that the natural (or neutral) interest rate is now lower.
If the natural rate is lower, then this raises concerns about the effectiveness of monetary policy in future economic downturns. In this context, the review is considering ways in which the operation of monetary policy would be able to prevent the rate of inflation consistently undershooting its target. This includes a discussion of how the Fed can prevent inflationary expectations becoming anchored below 2 per cent. This is important because, should they do so, they help to anchor the actual rate of inflation below 2 per cent. One possibility being considered is an inflation make-up strategy. In other words, a period of below-target inflation rates would need to be matched by a period where inflation rates could exceed the 2 per cent target in order that the long-term average of 2 per cent is met.
An inflation make-up policy would work like forward guidance in that people and markets would know know that short-term interest rates would be kept lower for longer. This would then help to force longer-term interest rates lower as well as providing people and businesses with greater certainty that interest rates will be lower for longer. This could help to encourage spending, raise economic growth and prevent inflation from overshooting its target for any extensive period of time.
An inflation make-up strategy would, in part, help to cement the idea that the inflation target is effectively symmetrical and that 2 per cent is not an upper limit for the inflation rate. But, it would do more than that: it would allow the Fed to deliberately exceed the 2 per cent target.
An inflation make-up strategy does raise issues. For example, how would the Fed determine the magnitude of any inflation make-up and for how long would a looser monetary stance be allowed to operate? In other words, would an inflation make-up strategy be determined by a specific rule or formula? Or, would the principle be applied flexibly? Finally, could a simpler alternative be to raise the target rate itself, given the tendency to undershoot the 2 per cent target rate? If so, what should that the rate be?
We should know by the end of 2020 whether the Federal Reserve will adopt, when necessary, an inflation make-up monetary policy.
Articles
Questions
- What do you understand by the monetary policy mandate of a central bank?
- Explain the ways in which the monetary policy mandate of the central bank affects our everyday lives.
- Why are inflation-rate expectations important in determining actual inflation rates?
- Why is the Federal Reserve concerned about its ability to use monetary policy effectively during future economic downturns?
- Discuss the economic arguments for and against central banks operating strict inflation-rate targets.
- Does the case for adopting an inflation make-up monetary policy mandate show that the argument for inflation-rate targeting has been lost?
- What do you understand by the idea of a natural or neutral policy interest rate? Would the actual rate be expected to be above or below this if the rate of inflation was below its target level?
The Institute of Fiscal Studies (IFS) has just published its annual ‘Green Budget‘. This is, in effect, a pre-Budget report (or a substitute for a government ‘Green Paper’) and is published ahead of the government’s actual Budget.
The Green Budget examines the state of the UK economy, likely economic developments and the implications for macroeconomic policy. This latest Green Budget is written in the context of Brexit and the growing likelihood of a hard Brexit (i.e. a no-deal Brexit). It argues that the outlook for the public finances has deteriorated substantially and that the economy is facing recession if the UK leaves the EU without a deal.
It predicts that:
Government borrowing is set to be over £50 billion next year (2.3% of national income), more than double what the OBR forecast in March. This results mainly from a combination of spending increases, a (welcome) change in the accounting treatment of student loans, a correction to corporation tax revenues and a weakening economy. Borrowing of this level would breach the 2% of national income ceiling imposed by the government’s own fiscal mandate, with which the Chancellor has said he is complying.
A no-deal Brexit would worsen this scenario. The IFS predicts that annual government borrowing would approach £100 billion or 4% of GDP. National debt (public-sector debt) would rise to around 90% of GDP, the highest for over 50 years. This would leave very little scope for the use of fiscal policy to combat the likely recession.
The Chancellor, Sajid Javid, pledged to increase public spending by £13.4bn for 2020/21 in September’s Spending Review. This was to meet the Prime Minister’s pledges on increased spending on police and schools. This should go some way to offset the dampening effect on aggregate demand of a no-deal Brexit. The government has also stated that it wishes to cut various taxes, such as increasing the threshold at which people start paying the 40% rate of income tax from £50 000 to £80 000. But even with a ‘substantial’ fiscal boost, the IFS expects little or no growth for the two years following Brexit.
But can fiscal policy be used over the longer term to offset the downward shock of Brexit, and especially a no-deal Brexit? The problem is that, if the government wishes to prevent government borrowing from soaring, it would then have to start reining in public spending again. Another period of austerity would be likely.
There are many uncertainties in the IFS predictions. The nature of Brexit is the obvious one: deal, no deal, a referendum and a remain outcome – these are all possibilities. But other major uncertainties include business and consumer sentiment. They also include the state of the global economy, which may see a decline in growth if trade wars increase or if monetary easing is ineffective (see the blog: Is looser monetary policy enough to stave off global recession?).
Articles
IFS Report
Data
Questions
- Why would a hard Brexit reduce UK economic growth?
- To what extent can expansionary fiscal policy stave off the effects of a hard Brexit?
- Does it matter if national debt (public-sector debt) rises to 90% or even 100% of GDP? Explain.
- Find out the levels of national debt as a percentage of GDP of the G7 countries. How has Japan managed to sustain such a high national debt as a percentage of GDP?
- How can an expansionary monetary policy make it easier to finance the public-sector debt?
- How has investment in the UK been affected by the Brexit vote in 2016? Explain.
Confidence figures suggest that sentiment weakened across several sectors in June with significant falls recorded in retail and construction. This is consistent with the monthly GDP estimates from the ONS which suggest that output declined in March and April by 0.1 per cent and 0.4 per cent respectively. The confidence data point to further weakness in growth down the line. Furthermore, it poses the risk of fuelling a snowball effect with low growth being amplified and sustained by low confidence.
Chart 1 shows the confidence balances reported by the European Commission each month since 2007. It highlights the collapse in confidence across all sectors around the time of the financial crisis before a strong and sustained recovery in the 2010s. However, in recent months confidence indicators have eased significantly, undoubtedly reflecting the heightened uncertainty around Brexit. (Click here to download a PowerPoint copy of the chart.)
Between June 2016 and June 2019, the confidence balances have fallen by at least 8 percentage points. In the case of the construction the fall is 14 points while in the important service sector, which contributes about 80 per cent of the economy’s national income, the fall is as much as 15 points.
Changes in confidence are thought, in part, to reflect levels of economic uncertainty. In particular, they may reflect the confidence around future income streams with greater uncertainty pulling confidence down. This is pertinent because of the uncertainty around the UK’s future trading relationships following the 2016 referendum which saw the UK vote to leave the EU. In simple terms, uncertainty reduces the confidence people and businesses have when forming expectations of what they can expect to earn in the future.
Greater uncertainty and, hence, lower confidence tend to make people and businesses more prudent. The caution that comes from prudence counteracts the inherent tendency of many of us to be impatient. This impatience generates an impulse to spend now. On the other hand, prudence encourages us to take actions to increase net worth, i.e. wealth. This may be through reducing our exposure to debt, perhaps by looking to repay debts or choosing to borrow smaller sums than we may have otherwise done. Another option may be to increase levels of saving. In either case, the effect of greater prudence is the postponement of spending. Therefore, in times of high uncertainty, like those of present, people and businesses would be expected to want to have greater financial resilience because they are less confident about what the future holds.
To this point, the saving ratio – the proportion of disposable income saved by households – has remained historically low. In Q1 2019 the saving ratio was 4.4 per cent, well below its 60-year average of 8.5 per cent. This appears to contradict the idea that households respond to uncertainty by increasing saving. However, at least in part, the squeeze seen over many years following the financial crisis on real earnings, i.e. inflation-adjusted earnings, restricted the ability of many to increase saving. With real earnings having risen again over the past year or so, though still below pre-crisis levels, households may have taken this opportunity to use earnings growth to support spending levels rather than, as we shall see shortly, looking to borrow.
Another way in which the desire for greater financial resilience can affect behaviour is through the appetite to borrow. In the case of consumers, it could reduce borrowing for consumption, while in the case of firms it could reduce borrowing for investment, i.e. spending on capital, such as that on buildings and machinery. The reduced appetite for borrowing may also be mirrored by a tightening of credit conditions by financial institutions if they perceive lending to be riskier or want to increase their own financial capacity to absorb future shocks.
Chart 2 shows consumer confidence alongside the annual rate of growth of consumer credit (net of repayments) to individuals by banks and building societies. Consumer credit is borrowing by individuals to finance current expenditure on goods and services and it comprises borrowing through credit cards, overdraft facilities and other loans and advances, for example those financing the purchase of cars or other large ticket items. (Click here to download a PowerPoint copy of the chart.)
The chart allows us to view the confidence-borrowing relationship for the past 25 years or so. It suggests a fairly close association between consumer confidence and consumer credit growth. Whether changes in confidence occur ahead of changes in borrowing is debatable. However, the easing of confidence following the outcome of the EU referendum vote in June 2016 does appear to have led subsequently to an easing in the annual growth of consumer credit. From its peak of 10.9 per cent in the autumn of 2016, the annual growth rate of consumer credit dropped to 5.6 per cent in May 2019.
The easing of credit growth helps put something of a brake on consumer spending. It is, however, unlikely to affect all categories of spending equally. Indeed, the ONS figures for May on retail sales shows a mixed picture for the retail sector. Across the sector as a whole, the 3 month-on-3 month growth rate for the volume of purchases stood at 1.6 per cent, having fallen as low as 0.1 percent in December of last year. However, the 3 month-on-3 month growth rate for spending volumes in department stores, which might be especially vulnerable to a slowdown in credit, fell for the ninth consecutive month.
Going forward, the falls in confidence might be expected to lead to further efforts by the household sector, as well as by businesses, to ensure their financial resilience. The vulnerability of households, despite the slowdown in credit growth, so soon after the financial crisis poses a risk for a hard landing for the sector. After falls in national output in March and April, the next monthly GDP figures to be released on 10 July will be eagerly anticipated.
Articles
Questions
- Which of the following statements is likely to be more accurate: (a) Confidence drives economic activity or (b) Economic activity drives confidence?
- Explain the difference between confidence as a source of economic volatility as compared to an amplifier of volatility?
- Discuss the links between confidence, economic uncertainty and financial resilience.
- Discuss the ways in which people and businesses could improve their financial resilience to adverse shocks.
- What are the potential dangers to the economy of various sectors being financially distressed or exposed?
Latest data from the UK banking trade association, UK Finance, show that cash payments have continued to decline, while contactless and mobile payments have risen dramatically. In 2018, cash payments fell 16% to 11.0 billion payments and constituted just 28% of total payments; the compares with 60% in 2008 and a mere 9% projected for 2028. By contrast, in 2018, debit card payments increased 14% to 15.1 billion payments. Credit card payments increased 4% to stand at 3.2 billion payments. Mobile payments though media such as Apple Pay, Google Pay and Samsung Pay, although still a relatively small percentage, have also increased rapidly, with 16% of the adult population registered for mobile payments, compared with just 2% in 2016.
But what are the implications of this ‘dash from cash’? On the plus side, clearly there are advantages to consumers. A contactless payment is often more convenient than cash and does not require periodic visits to a cash machine (ATM) – machines that are diminishing in number and may be some distance away if you live in the countryside. What is more, card payments allow purchasing online – a form of shopping that continues to grow. Also, if a card is stolen or lost, you can cancel it; if cash is stolen or lost, you cannot cancel that.
Then there are benefits to vendors. Cashing up is time consuming and brings little or no benefit in terms of bank charges. These are typically around 0.75% for cash deposits and roughly the same for handling debit card payments (around 0.7%). What is more, with the closure of many bank branches, it is becoming harder for many businesses to deposit cash.
Finally, there is the problem that many illegal activities involve cash payments. What is more, cash payments can be used as a means of avoiding tax as they can be ‘kept off the books’.
But there are also dangers in the dash from cash. Although the majority of people now use cards for at least some of their transactions, many older people and people on low incomes rely on cash and do not use online banking. With bank branches and ATMs closing, this group is becoming further disadvantaged. As the Access to Cash Review, Final Report states:
Millions of people could potentially be left out of the economy, and face increased risks of isolation, exploitation, debt and rising costs.
Then there is the danger of fraud. As the Financial Times article below states:
The proliferation of new types of payment method has raised concerns over security. Criminals stole £1.2bn in 2018, according to previous data from UK Finance, up from £967m in 2017. This included a rise in fraudsters illegally accessing customers’ accounts and cards.
Complaints about banking scams reached a record high in the past financial year, according to figures in May from the UK’s Financial Ombudsman Service.
One of the biggest dangers, however, of the move to card payments, and especially contactless payments, is that people may be less restrained in their spending. They may be more likely to rack up debt with little concern at the time of spending about repayment. As the Forbes article below states:
Because items purchased with a credit card have been decoupled from emotion, shoppers can focus on the benefits of the purchase instead of the cost. Thus, paying with a credit card makes it more difficult to focus on the cost or complete a more rational cost–benefit analysis. For example, if a person had to count out $0.99 to purchase an app, they might be less inclined to buy it. However, since we can quickly buy apps with our credit card, the cost seems negligible, and we can focus on the momentary happiness of the purchase.
Finally, there is the issue of our privacy. Card payments enable companies, and possibly other agencies, to track our spending. This may have the benefits of allowing us to receive tailored advertising, but it may be used as a way of driving sales and encouraging us to take on more debt as well as giving companies a window on our behaviour.
Articles
- Millions choose a cashless lifestyle
BBC News, Kevin Peachey (6/6/19)
- The decline of cash in the UK – in charts
BBC News (7/6/19)
- One in 10 adults in UK have gone ‘cashless’, data shows
The Guardian, Rupert Jones (6/6/19)
- Going contactless is gloriously convenient – for all the wrong people
The Guardian, Peter Ormerod (7/3/19)
- Mobile banking and contactless cards continue to surge in popularity
Financial Times, James Pickford (6/6/19)
- Is a cashless society in Britain near? Banking data suggests just 9% of all payments will be cash by 2028
This is Money, George Nixon (6/6/19)
- Older and poorer communities are left behind by the decline of cash
The Conversation, Daniel Tischer, Jamie Evans and Sara Davies (16/5/19)
- As cash declines, research shows the most deprived communities are left behind
University of Bristol Press Release (16/5/19)
- Do People Really Spend More With Credit Cards?
Forbes, Bill Hardekopf (16/7/18)
- Why Cash Is Quickly Disappearing From China’s Economy—Data Sheet
Fortune, Aaron Pressman and Clay Chandler (5/6/19)
Cashless in China: Why It Matters CNA Insider on YouTube, Joshua Lim (28/10/17)
Reports
Questions
- Summarise the main findings of the UK Payments Market Report 2019
- What are the relative merits of using (a) cash; (b) debit cards; (c) mobile payment?
- Find out what has happened to consumer debt in a country of your choice over the past five years. What are the main determinants of the level of consumer debt?
- How has UK money supply changed over the past five years? To what extent does this reflect changes in the ways people access money in their accounts?
- Why and how is China going ‘cashless’? Does this create any problems?
- Make out a case for and against increasing the £30 limit for contactless payments in the UK.
It is perhaps timely given the ongoing uncertainty around Brexit to revisit and update our blog Desperately seeking confidence written back in January. Consumer and business confidence reflects the sentiment, emotion, or anxiety of consumers and businesses. Confidence surveys therefore try to capture these feelings of optimism or pessimism. They may then provide us with timely information for the short-term prospects for private-sector spending. For example, declining levels of confidence might be expected to play a part in weakening the growth of consumption and investment spending.
Attempts are made to measure confidence through the use of surveys. One long-standing survey is that conducted for the European Commission. Each month consumers and firms across the European Union are asked a series of questions, the answers to which are used to compile indicators of consumer and business confidence. For instance, consumers are asked about how they expect their financial position to change. They are offered various options such as ‘get a lot better, ‘get a lot worse’ and balances are then calculated on the basis of positive and negative replies.
The chart plots confidence in the UK for consumers and different sectors of business since the mid 1990s. The chart captures the volatility of confidence. This volatility is generally greater amongst businesses than consumers, and especially so in the construction sector. (Click here to download a PowerPoint copy of the chart.)
Confidence measures rebounded across all sectors during the 2010s, with positive balances being recorded consistently from 2013 to 2016 in services, retail and industry. Subsequently, confidence indicators became more erratic though often remaining at above-average levels. However, confidence indicators have eased across the board in recent months. In some cases the easing has been stark. For example, the confidence balance in the service sector, which contributes about 80 per cent of the economy’s national income, fell from +10.9 in February 2018 to -16.2 in February 2019, though recovering slightly to -9.2 in March 2019.
Chart 2 shows how the recent easing of consumer confidence has seen the confidence balance fall below its long-term (median) average of -7. In March 2019 the balance stood at -11.7 the lowest figure since November 2013. To put the easing into further perspective, the consumer confidence balance had been as high as +8.2 in September 2015. (Click here to download a PowerPoint copy of the chart.)
Changes in confidence are used frequently as an example of a demand shock. In reality changes in consumer confidence are often likely to be an amplifier of shocks rather than the source. For example, the collapse in aggregate demand in 2007/8 that followed the ‘credit crunch’, the severe tightening of credit conditions and financial distress of many sectors of the economy is likely to have been amplified by the collapse in consumer confidence. The weakening of confidence since 2016 is perhaps a purer example of a ‘confidence shock’. Nonetheless, falls in confidence, whether they amplify existing shocks or are the source of shocks, are often a signal of greater economic uncertainty.
Greater uncertainty is likely to go and hand in hand with lower confidence and is likely to reflect greater uncertainty about future income streams. The result is that people and businesses become more prudent. In the context of households this implies a greater willingness to engage in self-insurance through increased saving. This is known as buffer stock or precautionary saving. Alternatively, people may reducing levels of borrowing. In uncertain times prudence can dominate our impatience that encourages us to spend.
Chart 3 plots the paths of the UK household-sector saving ratio and consumer confidence. The saving ratio approximates the proportion of disposable income saved by the household sector. What we might expect to see, if greater uncertainty induces buffer-stock saving, is for falls in confidence to lead to a rise in the saving ratio. Conversely, less uncertainty as proxied by a rise in confidence would lead to a fall in the saving ratio. (Click here to download a PowerPoint of the chart.)
The chart provides some evidence of this. The early 1990s and late 2000s coincided with both waning confidence and a rising saving ratio, whilst the rising confidence seen in the late 1990s coincided with a fall in the saving ratio. However, the easing of confidence since 2016 has coincided with a period where the saving ratio has been historically low. In the first quarter of 2017 the saving ratio was just 3.3 per cent. Although the saving ratio has ticked up a little, in the final quarter of 2018 it remained historically low at just 4.9 per cent. Hence, the available data on the saving ratio does not provide clear evidence of the more cautious behaviour we might expect with waning confidence.
Consider now patterns in the consumer confidence balance alongside the annual rate of growth of consumer credit (net of repayments) to individuals by banks and building societies. Consumer credit is borrowing by individuals to finance current expenditure on goods and services.
Data on consumer credit is more timely than that for the saving ratio. Therefore, Chart 4 shows the relationship between consumer confidence and consumer credit into 2019. We observe a reasonably close association consumer credit growth and consumer confidence. Certainty, the recent easing in confidence is mirrored by an easing in the annual growth of net consumer credit. (Click here to download a PowerPoint of the chart.)
The year-to-year growth in net consumer credit has eased considerably since the peak of 10.9 per cent in November 2016. In February 2019 the annual growth rate of net consumer credit had fallen back to 6.3 per cent, its lowest rate since September 2014. As we noted in our recent blog Riding the consumer credit cycle (again) it is hard to look much past the effect of Brexit in acting as a lid on the growth in consumer credit. Therefore, while the recent falls in consumer confidence have yet to markedly affect the saving ratio they may instead be driving the slowdown in consumer credit. The effect will be to weaken the growth of consumer spending.
Articles
Questions
- Draw up a series of factors that you think might affect both consumer and business confidence. How similar are both these lists?
- Which of the following statements is likely to be more accurate: (a) Confidence drives economic activity or (b) Economic activity drives confidence?
- What macroeconomic indicators would those compiling the consumer and business confidence indicators expect each indicator to predict?
- What is meant by the concept of ‘prudence’ in the context of spending? What factors might determine the level of prudence
- How might prudence be expected to affect spending behaviour?
- How might we distinguish between confidence ‘shocks’ and confidence as a ‘propagator’ of shocks?
- What is meant by buffer stock or precautionary saving? Draw up a list of factors that are likely to affect levels of buffer stock saving.
- If economic uncertainty is perceived to have increased how could this affect the consumption, saving and borrowing decisions of people?