With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?
The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).
The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.
The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.
One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)
The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.
Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)
Questions
- Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
- Go through each of the methods and consider the problems they are likely to create/have created.
- How important is it that monetary policy measures affect people’s expectations?
- What effects do the measures have on the distribution of income between borrowers and savers?
- What are annuities? How are these affected by policies of monetary easing?
- How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
- Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
Each year world political and business leaders meet at the World Economic Forum in the Swiss resort of Davos. The aim is to assess the progress of the global economy and to look at challenges ahead and what can be done about them.
Cynics claim that the round of presentations, discussions, Champagne receptions and fine dining rarely leads to anything concrete. Those who are less cynical argue that the Forum gives a unique opportunity for considering policy options and helping to shape a global consensus.
This year the mood was more optimistic. Many believe that the worst of the financial crisis is behind us. Stock markets are buoyant; the banking system seems more secure; the eurozone has not collapsed; growth prospects seem a little brighter.
But perhaps ‘optimistic’ is an overstatement. ‘Less pessimistic’ might be a better description. As Christine Lagarde, head of the IMF, pointed out in her speech:
The recovery is still weak, and uncertainty is still high. As the IMF announced just a few hours ago in our World Economic Outlook, we expect global growth of only 3½ percent this year, not much higher than last year. The short-term pressures might have alleviated, but the longer-term pressures are still with us. (Click here for transcript).
In both her speech and her press conference, she went on to outline the policies the IMF feels should be adopted to achieve sustained global growth.
The articles below summarise the outcomes of the Forum and some of the views expressed.
Articles
Too soon for sighs of relief Deutsche Welle, Andreas Becker (27/1/13)
Davos 2013: The icy economic chill begins to thaw The Telegraph, Louise Armitstead (26/1/13)
IMF Projects Modest Pick-up in Economic Growth in 2013 IMF videos, Olivier Blanchard, IMF Chief Economist (23/1/13)
Managing Director’s New Year Press Briefing IMF videos, Christine Lagarde, IMF Managing Director
Mark Carney in Davos: what’s up next for the global economy Maclean’s (Canada), Erica Alini (26/1/13)
World Economic Forum ends on warning note over ‘complacency’ The Guardian, Graeme Wearden (26/1/13)
Angela Merkel tells Davos austerity must continue The Guardian, Graeme Wearden and Larry Elliott (24/1/13)
Davos 2013: A ‘sigh of relief’ at the World Economic Forum BBC News, Stephanie Flanders (27/1/13)
Happy talk The Economist (27/1/13)
Davos Man and his defects The Economist, Schumpeter (26/1/13)
Davos: are the captains of capitalism finally paying attention? The Observer (27/1/13)
Official site
The Global Agenda 2013 The World Economic Forum
IMF projections
Modest Growth Pickup in 2013, Projects IMF IMF Survey Magazine: In the News (23/1/13)
World Economic Outlook Update IMF (23/1/13)
Questions
- Why was the mood at the WEF less pessimistic than in 2012?
- What threats remain to sustained global recovery?
- What policies are being recommended by Christine Lagarde of the IMF? Explain the reasoning behind the recommendations.
- What disagreements are there between global leaders on the scope for fiscal and monetary policies to stimulate economic growth?
- In her press conference, Christine Lagarde stated that “the teams here have concluded that the fiscal multipliers were higher in the context of that unbelievable international crisis”. Do you agree with this statement? Explain.
While the Western world has struggled with economic growth for the past 6 years, emerging economies such as China, Brazil and India have recorded some very high rates of growth. Throughout 2012, there were signs that these economies were not going to be the saviour of the global economy that we all thought. But, as we enter 2013, is it these economies that still hold the hope of the West for more positive figures and better economic times?
The article below from BBC News, in particular, considers the year ahead for the Asian economies and what it might mean for the Western world. Although these countries are by no means safeguarded against the impending approach of the US economy to their fiscal cliff or the ongoing eurozone crisis, they have seemed to be more insulated than the rest of the world. A crucial question to consider is whether this will continue. Furthermore, are the growth levels and policies of a country such as China sustainable? Can it continue to record such high growth rates in the face of the global economic situation?
The Japanese economy has been in serious trouble for a couple of decades, but measures to boost growth for this economy are expected. If these do occur, then western economies may feel some of their positive effects. At present, there is a degree of optimism as we enter the New Year, but how long this will last is anybody’s guess. The following articles consider the year ahead.
Asian economies face regional and global challenges BBC News (1/1/13)
Asia faces hard road ahead China Daily, Haruhiko Kuroda and Changyong Rhee (31/12/12)
Asia to continue rise despite US fiscal cliff Economic Times, Sugata Ghosh (1/1/13)
‘3.6% growth’ for global economy next year China Daily, Alvin Foo (28/12/12)
Asian economies surge ahead despite global slowdown Coast Week, Ding Qilin and Hu Junxin (4/1/13)
Global grind The Economist, Robin Bew (21/11/12)
Questions
- Why have the Asian economies been more insulated to the global economic conditions over the past few years, in comparison with the Western world?
- What challenges will the global economy be facing over the coming year?
- What challenges are the Asian economies facing? How different are they from the challenges you identified in question 3?
- Why is the rate of exchange an important factor for an economy such as Japan?
- What does a low exchange rate for the yen mean for European countries? Is it likely to be seen as a good or bad thing? What about for South Korea? Use a diagram to help you answer this question.
- Why is the economic situation in countries such as China and India so important for the rest of the global economy? Use a diagram to illustrate this.
Japan’s general election on 16 December was won by the centre-right Liberal Democratic Party (LDP), led by Shinzo Abe. It gained a two-thirds majority in the lower house. It returns to power after losing to the Democratic Party in 2009. Previously it had been in office for most of the time since 1955.
The LDP has promised to revive the flagging Japanese economy, which has been suffering from years of little or no growth and returned to recession last quarter. Economic confidence has been damaged by a dispute with China about the sovereignty over some small islands in the East China Sea. The economy, whose exports make up some 13% of GDP, has suffered from the global slowdown and a high yen. The yen has appreciated against the dollar by around 40% since 2007.
The economy has also suffered from the shutdown of all its nuclear reactors following the earthquake and tsunami last year. Nuclear power accounted for over 30% of the country’s electricity generation.
Mr Abe promises to revive the economy through fiscal and monetary policies. He plans a fiscal stimulus package in early 2013, with increased government expenditure on infrastructure and other public-works. He also wants the Bank of Japan to increase its inflation target from 1% to 3% and to achieve this through various forms of monetary easing.
The initial reactions of markets to the election result were favourable. The stock market rose and the yen fell.
However, as the following articles discuss, there are dangers associated with Mr Abe’s policies. The expansionary fiscal policy will lead to a rise in the country’s general-government debt, which, at some 240% of GDP, is by far the largest in the developed world. This could lead to a loss of confidence in Japanese debt and a fall in the price of bonds on the secondary markets and a rise in government borrowing costs. Also, a depreciation of the yen, while welcomed by exporters, would increase the price of imports, including food and raw materials.
Changing of guard in Japan as PM concedes vote CNN, Yoko Wakatsuki, Brian Walker, and Hilary Whiteman (17/12/12)
LDP Win Clears Pipes for Japan Fiscal Spigot Bloomberg Businessweek, Toru Fujioka (17/12/12)
Economic implications of Japan’s election Huffington Post (16/12/12)
Japan economy contracts again Taipei Times (11/12/12)
Japan elections: Shares rise and yen weakens on Abe win BBC News (17/12/12)
Shinzo Abe’s challenges in reviving Japan’s economy BBC News, Puneet Pal Singh (17/12/12)
Can Shinzo Abe Save Japan? Slate, Matthew Yglesias (30/11/12)
Deflation only natural when politicians refuse to fix oversupplied Japan Japan Times, Teruhiko Mano (17/12/12)
New Year messages from Japan BBC News, Stephanie Flanders (18/12/12)
Japan – Muddling On Or Growing Stronger? Seeking Alpha, Anthony Harrington (12/12/12)
Japanese government unveils £138bn stimulus package The Guardian (11/1/13)
Questions
- Using macroeconomic data from sources such as sites 6, 7 and 9 in the Economics Network’s Economic Data freely available online, describe Japan’s macroeconomic situation over the past 10 years.
- Why has the Japanese yen appreciated so much in recent years?
- What forms could monetary easing take in Japan?
- Why might it prove difficult to stimulate the Japanese economy through fiscal and monetary policies?
- What undesirable side-effects might result from expansionary fiscal and monetary policies?
- What structural weaknesses are there in the Japanese economy that have hindered economic growth? What policies might the new Japanese government pursue in tackling these structural weaknesses?
The UK is an island-economy. Therefore, trade is a crucial determinant of our economic performance. The competitiveness of our exports, in part, is affected by the exchange rate. Floating exchange rates are notoriously volatile. However, since the autumn of 2007 we have observed a significant depreciation of the UK exchange rate. In other words the number of units of many foreign currencies to the British pound has fallen. A depreciation helps to make our exports more competitive abroad. We detail the extent of this depreciation and any signs of a reversal in this pattern.
Rather than look at the British pound (or any currency) against the many foreign currencies separately we can look at the average exchange rate against a whole bundle of currencies. The average rate is calculated by weighting the individual exchange rates by the amount of trade between Britain and the other countries. This trade-weighted exchange rate is known as the effective exchange rate.
In analysing the competitiveness of the exchange rate, we can go one step further and adjust for the terms of trade. This means that we adjust for the average price of our exports relative to the average price of those goods we import. Therefore, as well as the nominal (actual) effective exchange rate we can calculate a real effective exchange rate. If the average price of our exports rises relative to the average price of imports, the real effective exchange rate rises relative to the nominal rate. It means that we are able to obtain a larger volume of imports from selling a given volume of exports.
The chart shows the nominal (actual) and real effective exchange rate for the British pound since 2002. The chart shows clearly how from the autumn of 2007 the effective exchange rate both in nominal and real terms began to fall sharply. Over the period from September 2007 to January 2009 the nominal effective exchange rate fell by 26 per cent. After adjusting for the relative price of exports to imports, we find the real effective exchange rate fell by 24 per cent. In other words, the British pound depreciated by close to one-quarter in just 16 months.
If we move the clock forward, we observe a mild appreciation of the British pound since July 2011. In nominal terms, the effective exchange rate has appreciated by 6.8 per cent while in real terms it has appreciated by 7.8 per cent. Nonetheless, if we compare September 2007 with October 2012, we find that the nominal effective exchange rate for the British pound is 19 per cent lower while the real effective exchange rate is approximately 13 per cent lower. This still constitutes a major competitive boost for our exporters.
Data
BIS effective exchange rate indices Bank for International Settlements
Articles
Sterling gains as eurozone weakness prevails Reuters UK, Phillip Baillie (7/12/12)
Pound steady after Autumn Statement Financial Times, Alice Ross (5/12/12)
Sterling at risk after triple-A warning, outlook negative Reuters UK, Phillip Baillie (6/12/12)
Questions
- Explain how the foreign demand for goods and assets generates a demand for British pounds. How will this demand be affected by the foreign currency price of the British pound, i.e. the number of foreign currency units per £1?
- Explain how the demand by British residents for foreign goods and assets generates a supply of British pounds. How will this supply be affected by the foreign currency price of the British pound, i.e. the number of foreign currency units per £1?
- What factors are likely to shift the demand and supply curves for British pounds on the foreign exchange markets?
- Illustrate the effect of a decrease in the demand for British goods and assets on the exchange rate (i.e. the foreign currency price of the British pound) using a demand-supply diagram.
- What is the difference between a nominal and a real effective exchange rate? Which of these is a better indicator of the competitiveness of our country’s exports?
