Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.
Although the ECB at its meeting in Malta on 22 October decided to keep both interest rates and asset purchases (€60 billion per month) at current levels, Mario Draghi stated at the press conference that, at its next meeting on December 3rd, the ECB would be prepared to cut interest rates and re-examine the size, composition and duration of its quantitative easing programme. He stopped short, however, of saying that interest rates would definitely be cut or quantitative easing definitely increased. He said the following:
“The Governing Council has been closely monitoring incoming information since our meeting in early September. While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation. Most notably, the strength and persistence of the factors that are currently 
slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.
In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”
Mario Draghi also argued that monetary policy should be supported by fiscal policy and structural policies (mirroring Japan’s three arrows). Structural policies should include actions to improve the business environment, including the provision of an adequate public infrastructure. This is vital to “increase productive investment, boost job creation and raise productivity”.
As far as fiscal policies are concerned, these “should support the economic recovery, while remaining in compliance with the EU’s fiscal rules”. In other words, fiscal policy should be expansionary, while staying within the limits set by the Stability and Growth Pact.
His words had immediate effects in markets. Eurozone government bond yields dropped to record lows and the euro depreciated 3% against the US dollar over the following 24 hours.
Webcasts
ECB Press Conference on YouTube, Mario Draghi (22/10/15)
Draghi reloads bazooka FT Markets, Ferdinando Guigliano (22/10/15)
Articles
Mario Draghi: ECB prepared to cut interest rates and expand QE The Guardian, Heather Stewart (22/10/15)
Draghi signals ECB ready to extend QE Financial Times, Claire Jones and Elaine Moore (22/10/15)
Dovish Mario Draghi sends bond yields to new lows Financial Times, Katie Martin (23/10/15)
What Draghi Said on QE, Policy Outlook, Global Risks and Inflation Bloomberg, Deborah Hyde (22/10/15)
ECB set to ‘re-examine’ stimulus policy at next meeting BBC News (22/10/15)
The global economy warrants a big dose of caution The Guardian, Larry Elliott (25/10/15)
ECB Press Conference
Introductory statement to the press conference (with Q&A) ECB, Mario Draghi (President of the ECB), Vítor Constâncio (Vice-President of the ECB) (22/10/15)
Questions
- Why is the ECB considering further expansionary monetary policy?
- What monetary measures can a central bank use to stimulate aggregate demand?
- Explain the effects of Mario Draghi’s announcement on bond and foreign exchange markets.
- What are the objectives of ECB monetary policy according to the its mandate?
- Should the ECB consider using quantitative easing to provide direct funding for infrastructure projects?
- What constraints does the EU’s Stability and Growth Pact impose on eurozone countries?
- What are the arguments for and against (a) the Bank of England and (b) the US Federal Reserve engaging in further QE?
- If the ECB does engage in an expanded QE programme, what will determine its effectiveness?
The International Monetary Fund has just published its six-monthly World Economic Outlook (WEO). The publication assesses the state of the global economy and forecasts economic growth and other indicators over the next few years. So what is this latest edition predicting?
Well, once again the IMF had to adjust its global economic growth forecasts down from those made six months ago, which in turn were lower than those made a year ago. As Larry Elliott comments in the Guardian article linked below:
Every year, economists at the fund predict that recovery is about to move up a gear, and every year they are disappointed. The IMF has over-estimated global growth by one percentage point a year on average for the past four years.
In this latest edition, the IMF is predicting that growth in 2015 will be slightly higher in developed countries than in 2014 (2.0% compared with 1.8%), but will continue to slow for the fifth year in emerging market and developing countries (4.0% in 2015 compared with 4.6% in 2014 and 7.5% in 2010).
In an environment of declining commodity prices, reduced capital flows to emerging markets and pressure on their currencies, and increasing financial market volatility, downside risks to the outlook have risen, particularly for emerging market and developing economies.
So what is the cause of this sluggish growth in developed countries and lower growth in developing countries? Is lower long-term growth the new norm? Or is this a cyclical effect – albeit protracted – with the world economy set to resume its pre-financial-crisis growth rates eventually?
To achieve faster economic growth in the longer term, potential national output must grow more rapidly. This can be achieved by a combination of more rapid technological progress and higher investment in both physical and human capital. But in the short term, aggregate demand must expand sufficiently rapidly. Higher short-term growth will encourage higher investment, which in turn will encourage faster growth in potential national output.
But aggregate demand remains subdued. Many countries are battling to cut budget deficits, and lending to the private sector is being constrained by banks still seeking to repair their balance sheets. Slowing growth in China and other emerging economies is dampening demand for raw materials and this is impacting on primary exporting countries, which are faced with lower exports and lower commodity prices.
Quantitative easing and rock bottom interest rates have helped somewhat to offset these adverse effects on aggregate demand, but as the USA and UK come closer to raising interest rates, so this could dampen global demand further and cause capital to flow from developing countries to the USA in search of higher interest rates. This will put downward pressure on developing countries’ exchange rates, which, while making their exports more competitive, will make it harder for them to finance dollar-denominated debt.
As we have seen, long-term growth depends on growth in potential output, but productivity growth has been slower since the financial crisis. As the Foreword to the report states:
The ongoing experience of slow productivity growth suggests that long-run potential output growth may have fallen broadly across economies. 
Persistently low investment helps explain limited labour productivity and wage gains, although the joint productivity of all factors of production, not just labour, has also been slow. Low aggregate demand is one factor that discourages investment, as the last World Economic Outlook report showed. Slow expected potential growth itself dampens aggregate demand, further limiting investment, in a vicious circle.
But is this lower growth in potential output entirely the result of lower demand? And will the effect be permanent? Is it a form of hysteresis, with the effect persisting even when the initial causes have disappeared? Or will advances in technology, especially in the fields of robotics, nanotechnology and bioengineering, allow potential growth to resume once confidence returns?
Which brings us back to the short and medium terms. What can be done by governments to stimulate sustained recovery? The IMF proposes a focus on productive infrastructure investment, which will increase both aggregate demand and aggregate supply, and also structural reforms. At the same time, loose monetary policy should continue for some time – certainly as long as the current era of falling commodity prices, low inflation and sluggish growth in demand persists.
Articles
Uncertainty, Complex Forces Weigh on Global Growth IMF Survey Magazine (6/10/15)
A worried IMF is starting to scratch its head The Guardian, Larry Elliott (6/10/15)
Storm clouds gather over global economy as world struggles to shake off crisis The Telegraph, Szu Ping Chan (6/10/15)
Five charts that explain what’s going on in a miserable global economy right now The Telegraph, Mehreen Khan (6/10/15)
IMF warns on worst global growth since financial crisis Financial Times, Chris Giles (6/10/15)
Global economic slowdown in six steps Financial Times, Chris Giles (6/10/15)
IMF Downgrades Global Economic Outlook Again Wall Street Journal, Ian Talley (6/10/15)
WEO publications
World Economic Outlook, October 2015: Adjusting to Lower Commodity Prices IMF (6/10/15)
Global Growth Slows Further, IMF’s latest World Economic Outlook IMF Podcast, Maurice Obstfeld (6/10/15)
Transcript of the World Economic Outlook Press Conference IMF (6/10/15)
World Economic Outlook Database IMF (October 2015 edition)
Questions
- Look at the forecasts made in the WEO October editions of 2007, 2010 and 2012 for economic growth two years ahead and compare them with the actual growth experienced. How do you explain the differences?
- Why is forecasting even two years ahead fraught with difficulties?
- What factors would cause a rise in (a) potential output; (b) potential growth?
- What is the relationship between actual and potential economic growth?
- Explain what is meant by hysteresis. Why may recessions have a permanent negative effect, not only on trend productivity levels, but on trend productivity growth?
- What are the current downside risks to the global economy?
- Why have commodity prices fallen? Who gains and who loses from lower commodity prices? Does it matter if falling commodity prices in commodity importing countries result in negative inflation?
- To what extent can exchange rate depreciation help commodity exporting countries?
- What is meant by the output gap? How have IMF estimates of the size of the output gap changed and what is the implication of this for actual and potential economic growth?
If you asked virtually any banker or economist a few years ago whether negative (nominal) interest rates were possible, the answer would almost certainly be no.
Negative real interest rates have been common at many points in time – whenever the rate of inflation exceeds the nominal rate of interest. People’s debts and savings are eroded by inflation as the interest due or earned does not keep pace with rising prices.
But negative nominal rates? Surely this could never happen? It was generally believed that zero (or slightly above zero) nominal rates represented a floor – ‘a zero lower bound’.
The reasoning was that if there were negative nominal rates on borrowing, you would effectively be paid by the bank to borrow.
In such a case, you might as well borrow as much as you can, as you would owe less later and could pocket the difference.
A similar argument was used with savings. If nominal rates were negative, savers might as well withdraw all their savings from bank accounts and hold them as cash (perhaps needing first to buy a safe!) Given, however, that this might be inconvenient and potentially costly, some people may be prepared to pay banks for looking after their savings.
Central bank interest rates have been hovering just above zero since the financial crisis of 2008. And now, some of the rates have turned negative (see chart above). The ECB has three official rates:
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The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system. |
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The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem. |
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The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. |
The first of these is the most important rate and remains above zero – just. Since September 2014, it has been 0.05%. This rate is equivalent to the Bank of England’s Bank Rate (currently still 0.5%) and the Fed’s Federal Funds Rate (currently still between 0% and 0.25%).
The third of the ECB’s rates is currently 0.3%, but the second – the rate on overnight deposits in the ECB by banks in the eurozone – is currently –0.2%. 
In other words, banks have to pay the ECB for making these overnight deposits (deposits that can be continuously rolled over). The idea has been to encourage banks to lend rather than simply keeping unused liquidity.
In Nordic countries, the experiment with negative rates has gone further. With plenty of slack in the Swedish economy, negative inflation and an appreciating krona, the Swedish central bank – the Riksbank – cut its rates below zero.
Many City analysts believe that the Riksbank will continue cutting, reducing its key interest rate to minus 0.5% by the end of the year [it is currently 0.35%]. Switzerland’s is already deeper still, at minus 0.75%, while Denmark and the eurozone have joined them as members of the negative zone.
But the nominal interest rate on holding cash is, by definition, zero. If deposit rates are pushed below zero, then will more and more people hold cash instead? 
The hope is that negative nominal interest rates on bank accounts will encourage people to spend. It might, however, merely encourage them to hoard cash.
The article below from The Telegraph looks at some of the implications of an era of negative rates. The demand for holding cash has been increasing in many countries and, along with it, the supply of banknotes, as the chart in the article shows. Here negative interest are less effective. In Nordic countries, however, the use of cash is virtually disappearing. Here negative interest rates are likely to be more effective in boosting aggregate demand.
Article
How Sweden’s negative interest rates experiment has turned economics on its head The Telegraph, Peter Spence (27/9/15)
Data
Central bank and monetary authority websites Bank for International Settlements
Central banks – summary of current interest rates global-rates.com
Questions
- Distinguish between negative real and negative nominal interest rates.
- What is the opportunity cost of holding cash – the real or the nominal interest rate forgone by not holding it in a bank?
- Are there any dangers of central banks setting negative interest rates?
- Why may negative interest rates be more effective in Sweden than in the UK?
- ‘Andy Haldane, a member of the Monetary Policy Committee (MPC) … suggested that to achieve properly negative rates, the abolition of cash itself might be necessary.’ Why?
- Why does Switzerland have notes of SF1000 and the eurozone of €500? Should the UK have notes of £100 or even £500?
- Why do some banks charge zero interest rates on credit cards for a period of time to people who transfer their balances from another card? Is there any incentive for banks to cut interest rates on credit cards below zero?
Productivity has been a bit of a problem for the UK economy for a number of years. Earlier posts from 2015 have discussed the trend in Tackling the UK’s poor productivity and The UK’s poor productivity record. Although the so-called ‘productivity gap’ has been targeted by the government, with George Osborne promising to take steps to encourage more long-term investment in infrastructure and create better incentives for businesses to improve productivity, the latest data suggest that the problem remains.
The ONS has found that the UK continues to lag behind the other members of the G7, but perhaps more concerning is that the gap has grown to its biggest since 1991. The data showed that output per hour worked was 20 percentage points lower in the UK than the average for the other G7 countries. The economic downturn did cause falls in productivity, but the UK has not recovered as much as other advanced nations. One of the reasons, according to the Howard Archer, chief UK economist at IHS Global Insight is that it ‘had been held back since the financial crisis by the creation of lots of low-skilled, low-paid jobs’. These are the jobs where productivity is lowest and this may be causing the productivity gap to expand. Other cited reasons include the lack of investment which Osborne is attempting to address, fewer innovations and problems of finance.
Despite these rather dis-heartening data, there are some signs that things have begun to turn around. In the first quarter of 2015, output per hour worked did increase at the fastest annual growth rate in 3 years and Howard Archer confirmed that this did show ‘clear sign that UK productivity is now seeing much-needed improvement.’ There are other signs that we should be optimistic, delivered by the Bank of England. Sir John Cunliffe, Deputy Governor for financial stability said:
“firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.”
The reason given for this optimism is the increase in the real cost of labour relative to the cost of investment. So, a bit of a mixed picture here. UK productivity remains a cause for concern and given its importance in improving living standards, the Conservative government will be keen to demonstrate that its policies are closing the productivity gap. The latest data is more promising, but that still leaves a long way to go. The following articles consider this data and news.
Articles
UK productivity shortfall at record high Financial Times, Emily Cadman (18/9/15)
UK productivity lags behind rest of 7 BBC News (17/9/15)
UK’s poor productivity figures show challenge for the government The Guardian, Katie Allen (18/9/15)
UK productivity lags G7 peers in 2014-ONS Reuters (18/9/15)
UK productivity second lowest in G7 Fresh Business Thinking, Jonathan Davies (18/9/15)
UK is 33% less productive than Germany Economia (18/9/15)
UK productivity is in the G7 ‘slow lane’ Sky News (18/9/15)
Data
AMECO Database European Commission, Economic and Financial Affairs
Labour Productivity, Q1 2015 ONS (1/7/15)
International Comparisons of Productivity, 2014 – First Estimates ONS (18/9/15)
Questions
- How could we measure productivity?
- Why should we be optimistic about productivity if the real cost of labour is rising?
- If jobs are being created at slower rate and the economy is still expanding, why does this suggest that productivity is rising? What does it suggest about pay?
- Why is a rise in productivity needed to improve living standards?
Interest rates are the main tool of monetary policy and have a history of being an effective tool in creating macroeconomic stability. There has been much discussion since the end of the financial crisis concerning when interest rates would rise in the US (and the UK) and for the US, the case is stronger, given its rate of growth, which has averaged at 2.2% per annum since June 2009.
As in the UK, the question of ‘will rates rise?’ has a clear and certain answer: Yes. The more challenging question is ‘when?’. Much of the macroeconomic data for the US is promising, with positive economic growth (and relatively strong in comparison to the UK and Eurozone), a low unemployment rate and inflation of 0.3%. This last figure is ‘too low’, but it comes in at a much more attractive 1.2% if you exclude food and energy costs and there is an argument for doing this, given the price of oil. The data on unemployment and growth might suggest that the economy is at a stage where a rate rise could be managed, but the inflation data indicates that low interest rates might be needed to keep inflation above 0%. Furthermore, there are concerns that the low unemployment figure is somewhat misleading, given that under-employment is quite high at 10.3% and there are still many who are long-term unemployed, having been out of work for more than 6 months.
Interest rates can be a powerful tool in affecting the components of aggregate demand (AD) and hence the macroeconomic variables. If interest rates fall, it can help to stimulate AD by reducing borrowing costs for consumers and businesses, reducing the incentive to save, cutting variable rate mortgage payments and depreciating the exchange rate. Collectively these effects can stimulate an economy and hence create economic growth, reduce unemployment and push up prices. However, interest rates have been at almost 0% since the financial crisis, so the only way is up. Reversing the aforementioned effects could then spell trouble, if the economy is not in a sufficiently strong position.
For many, the strength of the US economy, while relatively good, is not yet good enough to justify a rate rise. It may harm investment, growth and unemployment and none of these variables are sufficiently high to warrant a rate rise, especially given the slowdown in the emerging markets. Karishma Vaswani, from BBC News said:
“The current global hand-wringing and head-holding over whether the US Fed will or won’t raise interest rates later has got investors here in Asia worried about what this means for their economies.
The Fed has become the favourite whipping boy of Asia’s central bankers, with cries from India to Indonesia to “just get on with it”.”
There are many, including Professor John Taylor from Stanford University and a former senior Treasury official, a rate rise is well over-due. The market is expecting one and has been for some time and these expectations aren’t going away, so ‘just get on with it.’ Janet Yellen, the Chair of the Federal Reserve is in a tricky situation. She knows that whatever is decided, markets around the world will react – no pressure then! The following articles consider the interest rate debate.
Articles
FTSE slides ahead of Fed interest rates decision The Telegraph, Tara Cunningham (17/9/15)
US’s interest rate rise dilemma BBC News, Andrew Walker (17/9/15)
US interest rate rise: how it could affect your savings and your mortgage Independent (17/9/15)
All eyes on Federal Reserve as it prepares for interest rate announcement The Guardian, Rupert Neate (16/9/15)
Federal Reserve meeting: Will US interest rates rise and should they? The Telegraph, Peter Spence (16/9/15)
Markets push US rate rise bets into 2016 as China woes keep Fed on hold: as it happened The Telegraph, Szu Ping Chan (17/9/15)
Federal Reserve puts rate rise on hold The Guardian (17/9/15)
US central bank leave interest rates unchanged BBC News (17/5/15)
Fed leaves interest rates unchanged Wall Street Journal, Jon Hilsenrath (17/9/15)
Asian markets mostly rally, US Futures waver ahead of Fed interest rate decision International Business Times, Aditya Tejas (17/9/15)
Data
Selected US interest rates Board of Governors of the Federal Reserve System (see, for example, Federal Funds Effective rate (monthly))
Questions
- What happened to US interest rates in September?
- Present the main arguments for keeping interest rates on hold.
- What were the arguments in favour of raising interest rates and do they differ depending on whether interest rates rise slowly or very rapidly?
- How did stock markets around the world react to Janet Yellen’s announcement? Is it good news for the UK?
- Using a diagram to support your explanation, outline why interest rates are such a powerful tool of monetary policy and how they affect the main macroeconomic objectives.
- Do you think other central banks will take note of the Fed’s decision, when they make their interest rate decisions in the coming months? Explain your answer.
Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.
