This podcast is from the Library of Economics and Liberty’s EconTalk site. In it, Scott Sumner of Bentley University discusses with host Russ Roberts the role of monetary policy in the USA since 2007 and whether or not it was as expansionary as many people think.
In fact, Sumner argues that monetary policy was tight in late 2008 and that this precipitated the recession. He argues that the standard indicators of the tightness or ease of monetary policy, namely the rate of interest and the growth in the money supply, were misleading.
Sumner on Monetary Policy EconTalk podcast (9/11/09)
Questions
- Why is it important to look at the velocity of circulation of money when deciding the effect of interest rate changes or changes in the monetary base? Can the Fed’s failure to take velocity sufficiently into account be seen as a cause of the recession?
- Is there evidence of a liquidity trap operating in the USA in late 2008?
- How could the Fed have pursued a more expansionary policy, given that interest rates were eventually cut to virtually zero and the monetary base was expanded substantially?
- Why does Sumner argue that monetary policy should focus on influencing the growth in aggregate demand?
- How useful is the quantity equation, MV = PT (or MV = PY) in understanding the role and effectiveness of monetary policy?
- What is the Keynesian approach to monetary policy in a recession? How does this differ from the monetarist approach? Are both approaches focusing on the demand side and thus quite different from supply-side analysis of recession?
- Why is the consumer prices index (CPI) a poor indicator of a nominal shock to the economy? Should the central bank focus on nominal GDP, rather than CPI, as an indicator of the state of the economy and as a guide to the stance of monetary policy?
- What are the strengths and weaknesses of using a Taylor rule as a guide to monetary policy? Would nominal GDP futures be a better target for monetary policy?
The Bank of England’s latest quarterly Inflation Report was published on November 11. With all the gloomy news over the past few months the report is pleasantly up-beat – certainly for the longer term. As Mervyn King, Governor of the Bank of England, states in his opening remarks to the publication of the report, “The considerable stimulus from the past easing of monetary and fiscal policy and the depreciation of sterling should lead to a recovery in economic activity.”
Nevertheless, recovery will be slow, especially at first. This means that it will be some time before output returns to pre-recession levels. “Despite a recovery in economic growth, output is unlikely, at least for a considerable period, to return to a level consistent with a continuation of its pre-crisis trend. That is in large part because the impact of the downturn on the supply capacity of the economy is expected to persist. But it is also because there is likely to be sustained weakness of demand relative to that capacity.”
There is surprisingly good news too on employment and unemployment. Although unemployment has risen sharply in recent months, the rate of increase is slowing and “There was a small increase of 6000 in the number of people in employment to 28.93 million, the first quarterly increase since May–July 2008 (see Labour market statistics, November 2009).
So should we be putting out the flags? Can the Bank of England ease off on quantitative easing (see Easing up on quantitative easing)? Or does it still need to keep on increasing money supply, especially as fiscal policy will have to get a lot tighter? The following articles consider the issues.
Mervyn King: economy remains ‘uncertain’ (video) Channel 4 News, Faisal Islam (11/11/09)
Bank of England governor dampens hopes of swift UK recovery Guardian, Graeme Wearden (11/11/09)
Recovery has only just started, warns sombre King Guardian, Heather Stewart (11/11/09)
Cautious good cheer BBC News, Stephanomics (11/11/09)
Bank of England’s Mervyn King says UK only just started on recovery road Telegraph (11/11/09)
The Bank of England’s Inflation Report is useless. Here’s why. Telegraph, Edmund Conway (11/11/09)
Bank of England raises growth and inflation forecasts: economists react (includes video) Telegraph (11/11/09)
Bank of England talks up hopes of strong recovery Times Online, Robert Lindsay (11/11/09)
Bank of England cautions on economic recovery BusinessWeek, Jane Wardell(11/11/09)
Just who benefits from quantitative easing? WalesOnline (11/11/09)
Inflation Report: Forget the fan charts, what we need is a clear economic policy Telegraph, Jeremy Warner (11/11/09)
We’ve no choice but to keep inflating Independent, Hamish McRae (11/11/09)
Is there a break in the economic gloom? (video) BBC Newsnight, Paul Mason (12/11/09)
The Bank of England Inflation Report can be found at the following site, which contains links to the full report, the Governor’s opening remarks, charts, a podcast and a webcast:
Inflation Report November 2009 Bank of England
Questions
- Explain what the three fan charts, Charts 1, 2 and 3 on pages 6, 7 and 8 of the Inflation Report, show.
- Why is the Bank of England more optimistic than in its previous report (August 2009)?
- Why did the sterling exchange rate fall on the publication of the report?
- Has the policy of expansionary monetary policy proved to be beneficial and should the Bank of England continue to pursue an expansionary monetary policy?
- What determines the balance of effects of an expansionary monetary policy on (a) asset prices; (b) real output; and (c) inflation?
- How have relatively flexible labour markets affected the impact of recession on (a) wage rates; (b) unemployment?
After the November 2009 meeting of the Monetary Policy Committee, the Bank of England announced that it would keep Bank Rate on hold at 0.5%, at which rate it has been since March. It also said that it would spend a further £25 billion over the next three months on asset purchases, primarily government bonds, thereby pumping additional money into the economy: the process known as “quantitative easing“. This would bring total asset purchases under the scheme to £200bn.
But although this represents a further increase in money supply, the rate of increase is slowing down. In the previous three months, £50 billion of assets had been purchased. So does this imply that the Bank of England sees a recovery around the corner? Will money supply have been expanded enough to finance the desired increase in spending – on both consumption and investment?
A problem so far is that most of the extra money has not been spent on goods and services. Banks have been building up their reserves, with much of the money simply being re-deposited in the Bank of England as reserve balances (see Table A1.1.1 in “Bankstats). At the same time, households have been taking on very little extra debt – indeed, In July, total household debt actually fell (see “Payback time) and consumer debt (i.e. excluding mortgages) has continued to fall. If quantitative easing is to work, the money must be spent!
But with the monetary base having expanded so much, is there a danger that, once the recovery gathers pace, spending growth will return with a vengeance? Will inflation rapidly become a problem again with an overheating economy? The following articles examine the issues.
Interest rates held at 0.5 per cent (includes video) Channel 4 News (5/11/09)
Bank of England extends quantitative easing to £200bn Guardian, Larry Elliott (5/11/09)
What the economists say: Quantitative easing £25bn boost Guardian (5/11/09)
Bank of England faced with its biggest split on policy in a decade Independent, Sean O’Grady (4/11/09)
Bank of England expands money-printing programme to £200bn to fight downturn (includes video) Telegraph (5/11/09)
The one thing worse than quantitative easing would be no QE at all Telegraph, Edmund Conway (5/11/09)
BoE: It ain’t over till it’s over Telegraph, Edmund Conway blog (5/11/09)
Bank raises stimulus to £200bn to end recession Times Online, Grainne Gilmore (5/11/09)
Bank of England to inject another £25bn of stimulus money Management Today (5/11/09)
Extra £25bn to stimulate economy BBC News (5/11/09)
Quantitative easing ‘not working’ (video of DeAnne Julius: former MPC member) BBC News (5/11/09)
Boxed in BBC Stephanomics (5/11/09)
The BoE’s £25bn gambit Financial Times, Chris Giles blog (5/11/09)
US to reduce Quantitative Easing as rates kept low Telegraph, James Quinn (4/11/09)
Quantitative easing ‘unpleasant’ BBC Today Programme, Stephen Bell and Wilem Buiter (7/11/09)
Experts debate whether quantitative easing is working (video) BBC Newsnight (6/11/09)
Questions
- What has been happening to the velocity of circulation of (narrow) money in the past few months? Explain the significance of this.
- What is likely to happen to the velocity of circulation in the coming months if (a) the economy recovers quite strongly; (b) recovery is modest?
- What is the relationship between quantitative easing and the growth in broad money (i.e. M4 in the UK)? How will banks’ desire to build up their reserves affect this relationship?
- Is the UK economy in a liquidity trap? Explain.
- Why is it likely that the Bank of England may well engage in more quantitative easing next March and beyond? How is the fiscal situation likely to affect Bank of England decisions?
- Examine the argument for the Bank of England buying more private-sector debt (virtually all of the asset purchases have been of public-sector debt)?
A key determinant of the length of any phase of the business cycle is consumer confidence. If people have gloomy expectations and confidence of a recovery is low, then a recession that should have lasted 6 months ends up lasting for years. Companies don’t see an end to the recession and keep holding off on investment plans and the public don’t want to go out and start spending, because there’s no guarantee that the economy is on its way back up. The more you worry about your finances, the less likely you are to go out and start spending, even though that could be the stimulus that a shrinking economy needs.
According to the British Retail Consortium, consumer confidence in the UK is on its way back up and currently stands at an 18-month high – which doesn’t actually say much given the past 18-months!! Despite this, job worries still remain and this has been highlighted significantly in the past week, when Britain’s youngest person ever was made redundant: a 13-year old paper boy. Whilst consumer confidence is argued to be returning to the UK, consumer confidence has been going in the opposite direction in the USA, with further fears of job losses. US confidence had been improving but unexpectedly fell in October. Is that what the UK has to look forward to?
So, why is consumer confidence so important? How does it affect the length of recovery and what is expected to happen over the next few months? Read the articles below to find out more.
US consumer confidence takes hit BBC News (27/10/09)
Consumer confidence hits 18-month high The Independent, David Prosser (1/11/09)
Consumer confidence on the rise BBC News (2/11/09)
Confidence boost hints that worst of recession now over The Scotsman, Peter Ranscombe (2/11/09)
US Michigan Sentiment fell to 70.6 this month Bloomberg, Courtney Schlisserman (30/10/09)
Euro-zone Consumer confidence improves The Wall Street Journal, Ilona Billington and Roman Kessler (30/10/09)
Retailers set for a merry Christmas DIYWeek (2/11/09)
Job fears still remain despite biggest increase in consumer confidence in 18 months, says British Retail Consortium Liverpool Echo, Neil Hodgson (2/11/09)
Business and consumer surveys in each of the EU countries and in the EU as a whole can be found at:
Business and Consumer Surveys European Commission
Questions
- In what ways does consumer confidence affect economic growth?
- Are there likely to be any adverse consequences of consumer confidence returning to the market?
- What are some of the reasons for the unexpected fall in consumer confidence in the USA? Do you think a similar thing is likely to happen in the UK?
- Expectations are crucial in economics. What is the difference between adaptive and rational expectations? How do they affect adjustment to the short- and long-run equilibrium?
- Can anything be done to improve confidence or is it simply a case of leaving things as they are … and waiting?
CPI inflation in the 12 months to September 2009 fell to 1.1% (from 1.6% in the 12 months to August). RPI inflation for the same period was -1.3%. In other words, retail prices actually fell by 1.3% in the 12 months to September. According to the ONS, “By far the largest downward pressure affecting the change in the CPI annual rate came from housing and household services. This was principally due to average gas and electricity bills, which were unchanged between August and September this year but rose a year ago when some of the major suppliers increased their tariffs.” (See below for link.)
If the CPI inflation rate falls below 1% (or rises above 3%), the Governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining why and also what the Bank of England intends to do about this. The Bank of England targets the forecast CPI inflation 24 months’ hence and attempts to achieve a rate of 2%. Normally, if the forecast rate is below 2%, the Monetary Policy Committee will decide to cut the rate of interest. The last Bank of England Inflation Report (August 2009) forecast CPI inflation of around 1.5% in 24 months’ time. If the November Inflation Report forecasts a similar figure, or even below, what can be done? Bank Rate is already at a historic low of just 0.5% and a further cut is unlikely to have much effect. Should the Bank of England, then, engage in another dose of quantitative easing? Perhaps the letter, if it has soon to be written, will make it clear.
UK consumer price inflation at 5-year low BusinessWeek (13/10/09)
Recession helps push inflation to five-year low Independent (14/10/09)
Inflation falls to lowest in five years Guardian (13/10/09)
Inflation dip likely to be short-lived Guardian (13/10/09)
Deflation, not inflation would be the bigger threat if the Conservatives do what they say Jeremy Warner blog, Telegraph (13/10/09)
Pound hit by falling UK inflation BBC News (13/10/09)
Pound hit by falling UK inflation (video) BBC News (13/10/09)
Pound pays price as inflation slides to five-year low Times Online (14/10/09)
Investors weigh risks of inflation and deflation Financial Times (12/10/09)
Wage ‘catch up’ for public sector BBC Today Programme (14/10/09)
Current data on UK Inflation (National Statistics)
Time series data (annual, quarterly and monthly) on UK prices and inflation Economic and labour Market Review (National Statistics)
Questions
- Why did the annual rate of CPI inflation fall so much in September 2009?
- Is the Bank of England Governor likely to have to write a letter (or letters) to the Chancellor in the coming months? Explain why or why not. What is likely to be the role of expectations in determining whether a letter has to be written?
- Why did the sterling exchange rate fall on the announcement of the inflation figure? What are likely to be the effects of this? What will determine the size of these effects?
- Why may additional amounts of quantitative easing be necessary in the coming months? How would a contractionary fiscal policy affect the desirability of additional quantitative easing?