The US economic recovery is slowing. As consumer and business confidence wanes, so there is growing talk of a double-dip recession. So what’s to be done about it? How can aggregate demand be boosted without spooking the markets?
One solution would be for a further fiscal stimulus. The one instituted in January 2009 in the depth of the recession has virtually worked itself out, with many short-term projects financed by the stimulus having come to an end. But any further stimulus would cause further worries about America’s balooning public-sector deficit, which already is predicted to be some 10.6% for 2010 (up from 1.1% in 2007).
The alternative is to use monetary policy. But, with the Federal Reserve rate already at between 0% and 0.25% (where it has been since the end of 2008), there is no scope for further cuts in interest rates. If monetary policy is to be used to give an additional boost to the economy, then further quantitiative easing is necessary. This is what the Federal Reserve decided to do on 10 August. As the Independent (see link below) states:
The US Federal Reserve decided last night to extend its $1.55 trillion programme of quantitative easing in an attempt to rejuvenate an economic recovery that the central bank admitted was turning out “more modest” than it expected.
The interest rate-setting Federal Open Market Committee bowed to calls from across the financial markets to extend its support, saying it would pump new money into the markets at a rate equivalent to about $200bn a year, and it left the duration of its efforts open-ended.
So how successful is this policy likely to be? The following articles look at the issues.
Articles
‘Light’ quantitative easing for slow US economic recovery New Statesman (11/8/10)
Fed sets the printing press rolling again to juice recovery Independent, Stephen Foley (11/8/10)
US Federal Reserve reveals plan to buy government debt Herald Scotland, Douglas Hamilton (11/8/10)
Some questions and answers on the Fed`s new policy Money Control (11/8/10)
Fed downgrades recovery outlook Financial Times, James Politi and Michael Mackenzie (10/8/10)
Fed acts as US recovery loses steam ABC News, Peter Ryan (11/8/10)
Top Fed Official, Warns Fed Risks Repeating Past Mistakes Huffington Post, Thomas Hoenig (11/8/10)
Austerity or stimulus? Some economists ha
The Fed must address Main Street’s credit crunch The Economist, Guillermo Calvo (15/8/10)
The Fed has options to lower real interest rates The Economist, Mark Thoma (15/8/10)
Fear of renewed recession in America is overblown; so is some of the optimism in the euro area The Economist (12/8/10)
Analysts’ view: Economists divided on effectiveness of Fed move Reuters (11/8/10)
If the Fed’s going to monetise debt, now’s the time to do it The Economist, Laurence Kotlikoff (13/8/10)
A former Fed official offers advice to Ben Bernanke The Economist, Joseph Gagnon (17/8/10)
America’s century is over, but it will fight on Guardian, Larry Elliott (23/8/10)
Federal Reserve documents
Press Release on monetary policy Federal Reserve (10/8/10)
Information on Federal Open Market Committee Federal Reserve
Questions
- What are are the arguments for using quantitative easing?
- Explain the process by which quantitative easing increases (a) narrow money and (b) broad money.
- How has the US and global economic situation changed since June 2010?
- Could the Fed’s policy be described as one of quantitative easing or merely one of maintaining the existing quantity of money? Explain.
- What are dangers in pursuing a policy of quantitative easing?
- What are the arguments for pursuing tight fiscal policy at the same time as loose monetary policy?
- Why does Thomas Hoenig claim that the Fed risks repeating past mistakes?
- How could the real rate of interest be reduced if the nominal rate is virtually zero and cannot be negative?
- Explain what is meant by ‘seigniorage’ (see the final The Economist article above).
Every three months, the Bank of England produces its Inflation Report. This includes forecasts for inflation and economic growth for the next three years. The forecasts are presented as fan charts. These depict the probability of various outcomes for inflation or growth in the future. “In any particular quarter of the forecast period, GDP is expected to lie somewhere within the fan on 90 out of 100 occasions.” Each coloured band represents a 10% probability of occurrence. “Although not every member will agree with every assumption on which our projections are based, the fan charts represent the MPC’s best collective judgement about the most likely paths for inflation and output, and the uncertainties surrounding those central projections.” The broader the fan the less confident are the forecasts. The fans have tended to get broader in recent Reports, reflecting the greater uncertainties in the UK and global economies since the credit crunch.
Since the last Report, the forecast for economic growth in 2011 has been adjusted downwards from 3.4% to 2.5%. Inflation, while still being forecast to be below the target of 2% in two years’ time, is forecast to rise in the short term, thanks to higher commodity prices and the rise in VAT from 17.5% to 20% in January 2011.
So what impact, according to the Report, will various factors such as the Coalition’s emergency Budget in June, rising commodity prices, falling consumer confidence and improving export performance have on the economy? And how much credence should be put on the forecasts? The following articles address these questions
Articles
Bank chief warns of ‘choppy recovery’ Independent, Russell Lynch (11/8/10)
King warns of ‘choppy recovery’ for economy Channel 4 News, Faisal Islam (11/8/10)
Bank of England warns UK recovery will be weaker than hoped Telegraph (11/8/10)
Bank of England lowers UK growth forecast Telegraph, Angela Monaghan (11/8/10)
Bank of England cuts UK economic growth forecasts Guardian, Katie Allen (11/8/10)
Bank of England forecasts ‘choppy’ economic recovery BBC News, Katie Allen (11/8/10)
Bank of England Cuts Outlook for Economic Growth Bloomberg, Jennifer Ryan (11/8/10)
Why is the UK heading into choppy waters? BBC News Analysis, Hugh Pym (11/8/10)
Bank of England overhauls forecast model after errors Telegraph, Philip Aldrick (11/8/10)
The Bank’s impossible balancing act Independent, David Prosser (11/8/10)
How uncertain exactly is the uncertain BoE? Reuters Blogs, MacroScope (11/8/10)
‘Slowflation’ – the combination the Bank of England fears most Independent, Sean O’Grady (11/8/10)
The Bank is right to paint a mixed picture Independent, Hamish McRae (11/8/10)
Sterling falls, gilts rally after Bank of England cuts growth forecasts Guardian Blogs, Elena Moya (11/8/10)
Report
Inflation Report
Inflation Report Press Conference
Questions
- Do the Bank of England’s forecasts suggest that the UK economy is on track for meeting the inflation target in 24 months’ time?
- How much reliance should be put on Bank of England inflation and growth forecasts? You might want to check out the forecasts made one and two years ago for current (2010) rates of inflation and growth (see Inflation Reports (by date)).
- What are the factors that have persuaded the Bank of England to reduce its forecast for the rate of economic growth in 2011? Are these factors all on the demand side?
- According to the fan chart for economic growth, what is the probability that the UK economy will move back into recession in 2011?
- Will the rise in VAT in January 2011 cause inflation to be higher in 2012 than in 2010 (other things being equal)? Explain.
- Why did the FTSE fall by 2.4% on the day the Report was released?
- If commodity price inflation increases (see Food prices: a question of supply and demand), what impact is this likely to have (a) on the rate of economic growth; (b) on the rate of interest chosen by the MPC?
- What policy should the Bank of England adopt to tackle ‘slowflation’?
In the aftermath of the credit crunch and the recession, many banks had to be bailed out by central banks and some, such as Northern Rock and RBS, were wholly or partially nationalised. Tougher regulations to ensure greater liquidity and higher proportions of capital to total liabilities have been put in place and further regulation is being planned in many countries.
So are banks now able to withstand future shocks?
In recent months, new threats to banks have emerged. The first is the prospect of a double-dip recession as many countries tighten fiscal policy in order to claw down debts and as consumer and business confidence falls. The second is the concern about banks’ exposure to sovereign debt: i.e. their holding of government bonds and other securities. If there is a risk that countries might default on their debts, then banks would suffer and confidence in the banking system could plummet, triggering a further banking crisis. With worries that countries such as Greece, Spain, Portugal, Italy and Ireland might have problems in servicing their debt, and with the downgrading of these countries by rating agencies, this second problem has become more acute for banks with large exposure to the debt of these and similar countries.
To help get a measure of the extent of the problem and, hopefully, to reassure markets, the Committee of European Banking Supervisors (CEBS) has been conducting ‘stress tests’ on European banks. On 24 July, it published its findings. The following articles look at these tests and the findings and assess whether the tests were rigorous enough.
Articles
Bank balance: EU stress tests explained Financial Times, Patrick Jenkins, Emily Cadman and Steve Bernard (13/7/10)
Seven EU banks fail stress test healthchecks BBC News, Robert Peston (23/7/10)
Interactive: EU stress test results by bank Financial Times, Emily Cadman, Steve Bernard, Johanna Kassel and Patrick Jenkin (23/7/10)
Q&A: What are the European bank stress tests for? BBC News (23/7/10)
Europe’s Stress-Free Stress Test Fails to Make the Grade Der Spiegel (26/7/10)
A test cynically calibrated to fix the result Financial Times, Wolfgang Münchau (25/7/10)
Europe confronts banking gremlins Financial Times (23/7/10)
Leading article: Stressful times continue Independent (26/7/10)
Europe’s banking check-up Aljazeera, Samah El-Shahat (26/7/10)
Finance: Stressed but blessed Financial Times, Patrick Jenkins (25/7/10)
Were stress test rigorous enough? BBC Today Programme, Ben Shore (24/7/10)
Banks’ stress test ‘very wooly’ BBC Today Programme, Peter Hahn and Graham Turner(24/7/10)
Stress test whitewash of European banks World Socialist Web Site, Stefan Steinberg (26/7/10)
Stress tests: Not many dead BBC News blogs: Peston’s Picks, Robert Peston (23/7/10)
Not much stress, not much test Reuters, Laurence Copeland (23/7/10)
Stress-testing Europe’s banks won’t stave off a deflationary vortex Telegraph, Ambrose Evans-Pritchard (18/7/10)
European banking shares rise after stress tests BBC News (26/7/10)
Euro banks pass test, gold falls CommodityOnline, Geena Paul (26/7/10)
Report
2010 EU-wide Stress Testing: portal page to documents CEBS
Questions
- Explain what is meant by a bank stress test?
- What particular scenarios were tested for in the European bank stress tests?
- Assess whether the tests were appropriate? Were they too easy to pass?
- What effect did the results of the stress tests have on gold prices? Explain why (see final article above).
- What stresses are banks likely to face in the coming months? If they run into difficulties as a result, what would be the likely reaction of central banks? Would there be a moral hazard here? Explain.
We have learnt a lot this week about the appetite of households for spending. And, it appears that they are not particularly hungry. On Monday, the Quarterly National Accounts for Q1 revealed that, in real terms, household sector spending fell by 0.1% in the quarter despite disposable income growing by 2.1%. Today, we have learnt that households have continued to increase the amount of equity in their homes. The Housing Equity Withdrawal (HEW) figures for Q1 show that households increased their stake in housing by some £3.2 billion.
Housing Equity Withdrawal occurs when lending secured on dwellings increases by more than the investment in the housing stock. Housing investment relates largely to the purchase of brand new homes and to major home improvements, but also includes housing moving costs such as legal fees. What the Bank of England does is to compare these levels of housing investment with the amount of additional secured lending. If the Bank of England finds that additional secured lending is equal to the amount of housing investment then HEW is zero. If it is positive, then additional secured lending is greater than the levels of housing investment. This would show that the household sector was extracting equity from the housing stock and using mortgage lending to fund consumption, to purchase financial assets or to pay off unsecured debts, like credit cards.
But, the point here is that HEW is actually negative and has been so since the second quarter of 2008. Negative HEW means that housing investment levels are greater than the levels of new secured borrowing. In other words, household are increasing their housing equity. But, there is a cost to this choice because by doing so households are using money that could otherwise be assigned for spending or purchasing financial assets. One way of measuring the potential extent of foregone consumption is to note that the Bank estimates that the level of equity injected into housing in Q1 was equivalent to 1.3% of disposable income. Since Q2 2008 households have injected equity into housing to the tune of £38.34 billion, which is equivalent to 1.97% of disposable income, some of which might have otherwise been used to fund spending.
The negativity of HEW is not that surprising. In difficult economic times many of us might be tempted, if we can, to reduce our exposure to debt. Low interest rates may also be inducing households to pay off debt either because the interest rates on saving products are low and unattractive or because the size of mortgage payments for those on now lower variable rate mortgages gives them income with which to pay debt off. The bottom line is that after many years happily spending, households appear to be dining off a different menu.
Articles
Homeowners raise stakes in homes, says Bank of England BBC News (15/7/10)
Mortgage debt drops £3.2 billion Independent, Nicky Burridge (15/7/10)
Drop in outstanding mortgage debt UK Press Association (15/7/10)
Equity withdrawal still negative Financial Times, Cara Waters (15/7/10)
Saving may cause a double-dip recession Telegraph, Harry Wallop (13/7/10)
Data
Housing equity withdrawal (HEW) statistical releases Bank of England
Quarterly National Accounts, 1st Quarter 2010 ONS
Questions
- What do you understand by the term ‘housing equity withdrawal’?
- Compare the possible implications for consumer spending of positive HEW and negative HEW.
- What factors do you think lie behind the eight consecutive quarters of negative HEW?
- Why might a low interest rate environment affect the incentive to withdrawal housing equity? What other variables might also affect levels of HEW?
- How does HEW affect the net worth of households?
What’s going to happen to stock market prices? If we knew that, we could be very rich! Nevertheless, financial analysts constantly try to predict the movements of shares in order to decide when to buy and when to sell. One thing they do is to look at charts of price movements and look for patterns. These ‘chartists’, as they are sometimes called, refer to something known as the ‘death cross’ or ‘dark cross’.
So what is the death cross? Imagine a chart of the movements of share prices, such as the FTSE 100 in the UK or the Dow Jones Industrial Average and S&P 500 in the USA. These movements can be shown as a moving average. In other words, for each day you plot the average of the past so many days. Typically, 200-day (sometimes 100-day) and 50-day moving averages are plotted. The 200-day (or 100-day) is taken as the long-term moving average and the 50-day as the short-term moving average. In a falling market, if the short-term moving average crosses below the long-term moving average, this is called the ‘death cross‘ as it signifies growing downward pressure in the market. The fall in the long-term average in these circumstances will indeed lag behind the fall in the short-term moving average.
Markets around the world are experiencing the death cross. So should be be worried? Or is this like looking for patterns in tea leaves, or the stars, and using them to make bogus predictions? So: science or mumbo jumbo?
First the science: the death cross indicates a fall in confidence. And at present, there is much for investors to worry about. Burgeoning debts, austerity measures and fears of a double-dip recession are spooking markets.
Now the mumbo jumbo. Just because markets are falling at the moment, this does not prove that they will go on falling. Markets are often spooked, only to recover when ‘sanity’ returns. People may soon start to believe that a second credit crunch will not return, given all the regulatory and support measures put in place, the huge amount of liquidity waiting to be invested and the support packages from the ECB and IMF for Greece and, potentially, for other eurozone countries having difficulties servicing their debts. In other words, patterns may repeat themselves, but not necessarily. It depends on circumstances.
Articles
Market’s Swoon Prompts Fears Of the Dreaded ‘Death Cross’ CNBC, Jeff Cox (1/7/10)
Death Cross in S&P 500 May Not Lead to Rout: Technical Analysis Bloomberg Businessweek, Alexis Xydias (30/6/10)
Are the markets about to encounter the”Death Cross”? BBC News, Jamie Robertson (1/7/10)
MarketBeat Q&A: Debunking the ‘Death Cross’ Wall Street Journal blogs, Matt Phillips (30/6/10)
Technical analysis and market data
Moving Average Crossovers TradingDay.com, Alan Farley
Death Cross Investopedia
FTSE 100 historical prices Yahoo Finance
S&P 500 historical prices Yahoo Finance
Dow Jones historical prices Yahoo Finance
Questions
- Explain what is meant by the death cross and use a diagram to illustrate it. What is menat by the golden cross. Again, use a diagram to illustrate it.
- Under what circumstances would speculation against stock market price movements be (a) stabilising and (b) destabilising?
- What is the implication for stock market prices of a ‘wall of money’?
- How much faith should be put in chartist explanations of stock market prices? Do criticisms of chartism apply to all time-series analysis that is used for forecasting?
- Look back at newspaper articles from a year ago and see what they were predicting about stock market prices. Have their preductions been borne out? If so, why? If not, why not?