Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.
Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.
But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.
Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. 
The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.
Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.
Some indication that the ’emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.
Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.
The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.
It would seem that the emergency continues!
Articles
QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)
ECB materials
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi
Questions
- What are meant by narrow and broad money?
- What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
- Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
- Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
- Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
- Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
- Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
- What are the disadvantages of quantitative easing?
- What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.
The RRR is the percentage of liabilities that banks are required to hold in the form of cash reserves – money that could otherwise have been used for lending. This latest move will bring the compulsory ratio for the larger banks down from 17.5% to 17%. This may sound like only a small reduction, but it will release some ¥650bn to ¥690bn (around $100bn) of reserves that can be used for lending.
The cut from 17.5% to 17% is the fourth this year. Throughout 2014 and 2015 it was stable at 20%.
The hope is that this lending will not only help to boost economic growth but also stimulate demand for the consumption of services. The measure can thus be seen as part of a broader strategy as the authorities seek to re-balance the economy away from its reliance on basic manufacturing towards a more diversified economy. It is also hoped that the extra demand will help to boost jobs and thus provide more opportunities for people laid off from traditional manufacturing industries.
It is expected that further reductions in the RRR will be announced later in the year – perhaps a further 1.5 to 2 percentage points.
But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.
One issue that concerns both the Chinese and overseas competitors is the effect of the measure on the exchange rate. By increasing the money supply, the measure will put downward pressure on the exchange rate as it will boost the demand for imports.
The Chinese authorities have been intervening in the foreign exchange market to arrest a fall in the yuan (¥) because of worries about capital outflows from China. The yuan was devalued by 2.9% in August 2015 from approximately ¥1 = ¢16.11 to approximately ¥1 = ¢15.64 (see chart) and after a modest rally in November 2015 it began falling again, with the Chinese authorities being unwilling to support it at the November rate. By January 2016, it had fallen a further 2.8% to approximately ¢15.20 (click here for a PowerPoint file of the chart).
But despite the possible downward pressure on the yuan from the cut in the reserve requirement, it will probably put less downward pressure than a cut in interest rates. This is because an interest rate cut has a bigger effect on capital outflows as it directly reduces the return on deposits in China. The central bank had already cut its benchmark 1-year lending rate from 6% to 4.35% between November 2014 and October 2015 and seems reluctant at the current time to cut it further.
China central bank resumes easing cycle to cushion reform pain Reuters, Pete Sweeney (29/2/16)
China cuts reserve requirements for banks to boost economy PressTV (29/2/16)
China Moves to Bolster Lending by Easing Banks’ Reserve Ratio New York Times, Neil Gough (29/2/16)
Economists React: China’s ‘Surprise’ Bank Reserve Cut Wall Street Journal (29/2/16)
China Cuts Banks’ Reserve Requirement Ratio Bloomberg, Enda Curran (29/2/16)
China Reserve-Ratio Cut Signals Growth Is Priority Over Yuan Bloomberg, Andrew Lynch (29/2/16)
China reserve ratio cut not a signal of impending large-scale stimulus: Xinhua Reuters, Samuel Shen and John Ruwitch (2/3/16)
China injects cash to boost growth and counter capital outflows Financial Times, Gabriel Wildau (29/2/16)
China’s Economic Policy Akin To Pushing On A String Seeking Alpha, Bruce Wilds (2/3/16)
China cuts banks’ reserve ratio for fifth time in a year: Why and what’s next Channel NewsAsia, Tang See Kit, (1/3/16)
Questions
- Explain what is mean by the required reserve ratio (RRR).
- Explain how credit creation takes place.
- What will determine the amount of credit creation that will take place as a result of the $100bn of reserves in Chinese banks released for lending by the cut in the RRR from 17.5% to 17%.
- What prompted the recent cuts in the RRR?
- Why may China’s recent monetary policy measures be like pushing on a string?
- Is the reduction in the RRR a purely demand-side measure, or will it have supply-side consequences?
- Explain how different types of monetary policy affect the exchange rate.
- Should other countries welcome the cut in China’s RRR? Explain.
There is a lot of pessimism around about the state of the global economy and the prospects for more sustained growth. Stock markets have been turbulent; oil and other commodity prices have fallen; inflation has been below central bank targets in most countries; and growth has declined in many countries, most worryingly in China.
The latest worry, expressed by finance ministers at the G20 conference in Shanghai, is that UK exit from the EU could have a negative impact on economic growth, not just for the UK, but for the global economy generally.
But is this pessimism justified? In an interesting article in the Independent, Hamish McRae argues that there are five signs that the world economy is not doomed yet! These are:
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There are more monetary and fiscal measures that can still be taken to boost aggregate demand. |
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Despite some slowing of economic growth, there is no sign of a global recession in the offing. |
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US and UK growth are relatively buoyant, with consumer demand ‘driving the economy forward’. |
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Deflation worries are too great, especially when lower prices are caused by lower commodity prices. These lower costs should act to stimulate demand as consumers have more real purchasing power. |
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Inflation may start to edge upwards over the coming months and this will help to increase confidence as it will be taken as a sign that demand is recovering. |
So, according to McRae, there are five things we should look for to check on whether the global economy is recovering. He itemises these at the end of the article. But are these the only things we should look for?
Five signs that the world economy is not doomed yet Independent, Hamish McRae (27/2/15)
Questions
- What reasons are there to think that the world will grow more strongly in 2016 than in 2015?
- What reasons are there to think that the world will grow less strongly in 2016 than in 2015?
- Distinguish between leading and lagging indicators of economic growth.
- Do you agree with McRae’s choice of five indicators of whether the world economy is likely to grow more strongly?
- What indicators would you add to his list?
- Give some examples of ‘economic shocks’ that could upset predictions of economic growth rates. Explain their effect.
Deflation is currently a concern in the UK and across Europe. However, relative to Japan, the deflation concern is small. In Japan, deflation has been problematic for more than two decades and this has had significant implications for the Japanese economy.
‘Abenomics’ has been in practice in Japan, as the Prime Minister, Shinzo Abe, has been trying to reflate the economy. Growth has been improving and the deflation concern appeared to be under control. However, GDP data now shows that the economy is once again declining and so with aggregate demand falling, this pushes down average prices across the economy and so the deflation risk re-emerges. This article from BBC News and another from The Guardian look at the economic policy known as ‘Abenomics’ and how the Japanese economy is faring.
Articles
Off target: Is it the end of ‘Abenomics’ in Japan? BBC News, Rupert Wingfield-Hayes (15/2/16)
Japan’s economy shrinks again as Abenomics is blown off course The Guardian, Justin McCurry (15/2/16)
Previous blogs
Japan’s deflation fears grow (update) (27/2/16)
Riding the Japanese roller coaster (15/2/16)
Japan’s interesting monetary stance as deflation fears grow (14/2/16)
Japan’s arrows missing their target (17/11/14)
Japan’s recovery (3/2/14)
Abenomics – one year on (16/12/13)
Japan’s three arrows (6/6/13)
Questions
- What are the key features of Japan’s ‘Abenomics’?
- Why is deflation such a concern? Surely falling prices are good for consumers and hence the economy.
- How has Japan been trying to reflate its economy and why has this failed?
- The yen is getting stronger, but how will this affect the Japanese economy? Use a demand and supply diagram to illustrate what has caused the value of the yen to fall and an aggregate demand and supply diagram to show the impact.
- Negative interest rates have been implemented in Japan. What does this mean for savers and borrowers and the economy?
- How do you think Japan’s stance on immigration and structural change is affecting its macroeconomy?
The government plans to improve broadband access across the country and BT is a key company within this agenda. However, one of the problems with BT concerns its natural monopoly over the cable network and the fact that this restricts competition and hence might prevent the planned improvements.
Ofcom, the communications watchdog has now said that BT must open up its cable network, making it easier for other companies to access. This will allow companies such as Sky, Vodafone and TalkTalk to invest in the internet network in the UK, addressing their criticisms that BT has under-invested in Openreach and this is preventing universal access to decent and affordable broadband. There have been calls for Ofcom to require BT and Openreach to separate, but Ofcom’s report hasn’t required this, though has noted that it ‘remains an option’.
BT has been criticised as relying on old cables that are not sufficient to provide the superfast broadband that the government wants. The report may come as a relief to BT who had perhaps expected that Ofcom might require it to sell its Openreach operation, but it will also remain concerned about Ofcom’s constant monitoring in the years to come. BT commented:
“Openreach is already one of the most heavily regulated businesses in the world but we have volunteered to accept tighter regulation … We are happy to let other companies use our ducts and poles if they are genuinely keen to invest very large sums as we have done.”
Its rivals will also be in two minds about the report, happy that some action will be taken, but wanting more, as Ofcom’s report suggests that “Openreach still has an incentive to make decisions in the interests of BT, rather than BT’s competitors”. A spokesperson for Vodafone said:
“BT still remains a monopoly provider with a regulated business running at a 28% profit margin …We urge Ofcom to ensure BT reinvests the £4bn in excess profits Openreach has generated over the last decade in bringing fibre to millions of premises across the country, and not just make half-promises to spend an unsubstantiated amount on more old copper cable.”
The impact of Ofcom’s report on the competitiveness of this market will be seen over the coming years and with a freer market, we might expect prices to come down and see improved broadband coverage across the UK. In order to achieve the government’s objective with regards to broadband coverage, a significant investment is needed in the network. With BT having to relinquish its monopoly power and the market becoming more competitive, this may be the first step towards universal access to superfast broadband. The following articles consider this report and its implications.
Ofcom opens a road to faster broadband The Guardian, Harriet Meyer and Rob Davies (28/2/16)
Ofcom: BT must open up its Openreach network Sky News (25/2/16)
How Ofcom’s review of BT Openreach could improve your internet service Independent, Doug Bolton (25/2/16)
Ofcom’s digital review boosts faltering broadband network Financial Times, Daniel Thomas (25/2/16)
The Observer view on broadband speeds in Britain The Observer, Editorial (28/2/16)
Ofcom tells BT to open up cable network to rivals’ BBC News (25/2/16)
Ofcom should go further and break up BT Financial Times, John Gapper (25/2/16)
BT escapes forced Openreach spin-off but Ofcom tightens regulations International Business Times, Bauke Schram (25/2/16)
Questions
- Why does BT have a monopoly and how might this affect the price, output and profits in this market?
- Ofcom’s report suggests that the market must be opened up and this would increase competitiveness. How is this expected to work?
- What are the benefits and costs of using regulation in a case such as this, as opposed to some other form of intervention?
- How might a more competitive market increase investment in this market?
- If the market does become more competitive, what be the likely consequences for consumers and firms?
Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.
