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.
- 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?).
- 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.
With university fees for home students in England of £9250 per year and with many students receiving maintenance loans of around £9000 per year, many students are graduating with debts in excess of £50 000. Loans are repaid at a marginal rate of 9% on incomes over £25 716.
Many students also study for a masters degree. The average fee for a taught, classroom-based masters (MA) is £7392 and for a laboratory-based masters (MSc) is £8167 but can be considerably higher at some prestigious universities where demand is high. Government loans of up to £10 906 are available to contribute towards fees and maintenance. These are paid back at a marginal rate of 6% for people earning over £21 000, giving a combined marginal rate of 15% for first and masters degrees.
For high earners on the 40% income tax rate, the combined marginal rate of payment out of income is 40% tax, plus 2% national insurance, plus 15% for those with undergraduate and masters loans. This gives a combined marginal rate of 57%.
Average student debt in England is higher even than in the USA, where the average is $37 000. US university courses are more expensive than in the UK, costing an average of $34 000 per year in tuition alone. But undergraduates can borrow less. They can borrow between $5500 and $12 500 per year in federal loans towards both fees and maintenance, and some private loans are also available. Most students do some paid work during their studies to make up the difference or rely on parents contributing. Parental contributions mean that students from poor families end up owing more. According to a Guardian article:
Race is a huge factor. Black students owe an average of $7400 more than white students when they graduate, the Brookings Institution found. After graduation, the debt gap continues to widen. Four years after graduation, black graduates owe an average of nearly $53 000 – nearly double that of white graduates.
Student debt looks to become one of the key issues in the 2020 US presidential election.
Pressure to cancel student fees and debt in the USA
Most of the Democratic candidates are promising to address student fees and debt. Student debt, they claim, places an unfair burden on the younger generation and makes it hard for people to buy a house, or car or other major consumer durables. This also has a dampening effect on aggregate demand.
The most radical proposal comes from Bernie Sanders. He has vowed, if elected, to abolish student fees and to cancel all undergraduate and graduate debt of all Americans. Other candidates are promising to cut fees and/or debt.
Although most politicians and commentators agree that the USA has a serious problem of student debt, there is little agreement on what, if anything, to do about it. There are already a number of ways in which student debt can be written off or reduced. For example, if you work in the public sector for more than 10 years, remaining debt will be cancelled. However, none of the existing schemes is as radical as that being proposed by many Democrats.
Criticisms of the Democrats’ plans are mainly of two types.
The first is the sheer cost. Overall debt is around $1.6tn. What is more, making student tuition free would place a huge ongoing burden on government finances. Bernie Sanders proposes introducing a financial transactions tax on stock trading. This would be similar to a Tobin tax (sometimes dubbed a ‘Robin Hood tax’) and would include a 0.5% tax on stock transactions, a 0.1% tax on bond trades and a 0.005% tax on transactions in derivatives. He argues that the public bailed out the financial sector in 2008 and that it is now the turn of the financial sector to come to the aid of students and graduates.
The other type of criticism concerns the incentive effects of the proposal. The core of the criticism is that loan forgiveness involves moral hazard.
The moral hazard of loan forgiveness
The argument is that cancelling debt, or the promise to do so, encourages people to take on more debt. Generally, moral hazard occurs when people are protected from the consequences of their actions and are thus encouraged to make riskier decisions. For example, if you are ensured against theft, you may be less careful with your belongings. As the Orange County Register article linked below states:
If the taxpayers pay the debts of everyone with outstanding student loans, how will that affect the decisions made by current students thinking about their choices for financing higher education? What’s the message? Borrow as much as you can and wait for the debt to be canceled during the next presidential primary campaign?
Not only would more students be encouraged to go to college, but they would be encouraged to apply for more costly courses if they were free.
Universities would be encouraged to exaggerate their costs to warrant higher fees charged to the government. The government (federal, state or local) would have to be very careful in auditing courses to ensure costs were genuine. Universities could end up being squeezed for finance as government may try to cut payments by claiming that courses were overpriced.
Even if fees were not abolished, cancelling debts would encourage students to take on larger debt, if that was to be cleared at some point in the future. What is more, students (or their parents) who could afford to pay, would choose to borrow the money instead.
But many countries do have free or highly subsidised higher education. Universities are given grants which are designed to reflect fair costs.
- Assess the arguments for abolishing or substantially reducing student fees.
- Assess the arguments against abolishing or substantially reducing student fees.
- Assess the arguments for writing off or substantially reducing student debt.
- Assess the arguments against writing off or substantially reducing student debt.
- If it were decided to cancel student debt, would it be fair to pay students back for any debt they had already paid off?
- Does tackling the problem of student debt necessarily lead to a redistribution of wealth/income?
- Give some other examples of moral hazard.
- If student fees were abolished, would there be any problem of adverse selection? If so, how could this be overcome?
- Find out what the main UK parties are advocating about student fees and debt in the nations of the UK for home and non-home students. Provide a critique of each of their policies.
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.
- 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.
- 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)
- 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.