As we saw in the news item The difficult exit from cheap money, central banks around the world have been operating an extremely loose monetary policy since the beginning of 2009. Their interest rates have been close to zero and trillions of dollars of extra money has been injected into the world economy through various programmes of quantitative easing.
For the past few months the Federal Reserve has been purchasing bonds under its most recent programme dubbed QE3, and thereby increasing narrow money, by $85 billion per month. Since the start of its QE programme in 2009, it has pumped around $2.8 trillion of extra money into the US and world economies. This huge increase in money supply has boosted the demand for assets worldwide and world stock markets have risen. Much of the money has flowed into developing countries, such as India, and has acted as a boost to their economies.
Once the US economy is growing strongly again, the aim is to taper off, and ultimately end or even reverse, the QE programme. It was expected that the Fed would decide to start this tapering off process at its meeting on 18 September – perhaps reducing bond purchases initially by some $10 billion. (Note that this would still be an increase in money supply, just a slightly smaller one.) Over the past few days, US bond prices have been falling (and yields increasing) in anticipation of such a move.
As it turned out, the Fed decided to delay tapering off. It will continue with its assets purchase programme of $85 billion per month for the time being. The reason given was that the US economy was still too fragile and needed the monthly injections of money to stay at the current level.
Normally it might be expected that the announcement of a more fragile recovery would cause the US stock market, and others worldwide, to fall. In fact the opposite occurred, with investors relieved that the extra money, which allows extra asset purchases, would continue at the same rate.
But this then raises the question of just what will be the effect when tapering off does actually occur. Will stock markets then go into a tailspin? Or will they merely stop rising so fast. That depends very much on the role of speculation.
Webcasts
Bernanke’s Own Words on Asset Purchases, Economy Bloomberg (18/9/13)
Bernanke: Fed to delay bond tapering PBS Newshour on YouTube (full speech plus questions) (18/9/13)
No tapering announced by Fed CNBC on Yahoo Finance (18/9/113)
The impact of US stimulus moves at home and abroad BBC News, Stephanie Flanders (18/9/13)
Is the upturn reaching Americans? BBC World, Stephanie Flanders (17/9/13)
Shares hit high as Federal Reserve maintains stimulus BBC News, Stephanie Flanders (18/9/13)
US Fed decision to delay tapering was a relief ET Now (India), Bimal Jalan (19/9/13)
Articles
Federal Reserve surprises markets by delaying QE tapering The Telegraph, Katherine Rushton (18/9/13)
Federal Reserve delays QE tapering: the full statement The Telegraph (18/9/13)
Q&A: What is tapering? BBC News (18/9/13)
Fed delay is no reason to celebrate The Guardian, Larry Elliott (19/9/13)
Federal Reserve tapering decision has baffled the markets The Guardian, Larry Elliott (19/9/13)
Taper tiger The Economist (21/9/13)
Everything You Need to Know About the Fed’s Decision Not to Taper QE3 The Atlantic, Matthew O’Brien (18/9/13)
Fed’s dovish turn leaves Wall Street economists mulling taper timing: poll Reuters, Chris Reese (18/9/13)
Good news and bad news from the Fed BBC News, Stephanie Flanders (19/9/13)
Is the Fed frightened of its shadow? BBC News, Robert Peston (19/9/13)
The Federal Reserve and Janet Yellen face a tough task with insufficient tools The Guardian, Mohamed A. El-Erian (14/10/13)
Questions
- Why might a slowing down in the increase in US money supply cause asset prices to fall, rather than merely to rise less quickly?
- Why has the US QE programme led to a rise in asset prices overseas?
- Distinguish between stabilising and destabilising speculation. Which type of speculation has been occurring as a result of the US QE programme?
- How has QE affected unemployment in the UK and USA? How is the participation rate and the flexibility of labour markets relevant to the answer?
- Explain the following two statements by Stephanie Flanders and Robert Peston respectively. “The market conditions argument has a circularity to it: talk of tapering leads to higher market rates, which in turn puts the taper itself on hold.” “The Fed simply hinting that less money would be created, means that there will be no reduction in the amount of money created (for now at least).”
- Why have US long-term interest rates, including mortgage rates, risen since May of this year?
- What impact have higher US long-term interest rates had on economies in the developing world? Explain.
At present, the Bank of England has an inflation target of 2% CPI at a 24-month time horizon. Most, other central banks also have simple Inflation targets. But central bankers’ opinions seem to be changing.
Consider four facts.
1. Many central banks around the world have had record low interest rates for nearly four years, backed up in some cases by programmes of quantitative easing, officially in pursuit of an inflation target.
2. The world is mired in recession or sluggish growth, on which monetary policy seems to have had only a modest effect.
3. Inflation seems to be poorly related to aggregate demand, at least within an economy. Instead, inflation in recent years seems to be particularly affected by commodity prices.
4. Success in meeting an inflation target could mean failure in terms of an economy achieving an actual growth rate equal to its potential rate.
It’s not surprising that there have been calls for rethinking monetary policy targets.
There have recently been two interesting developments: one is a speech by Mark Carney, Governor designate of the Bank of England; the other is a decision on targets by the Fed, reported at a press conference by Ben Bernanke, Chairman of the Federal Reserve.
Mark Carney proposes the possible replacement of an inflation target with a target for nominal GDP (NGDP). This could be, say, 5%. What is more, it should be an annual average over a number of years. Thus if the target is missed in one year, it can be made up in subsequent years. For example, if this year the actual rate of nominal GDP growth is 4%, then by achieving 6% next year, the economy would keep to the average 5% target. As Stephanie Flanders points out:
Moving to nominal GDP targets would send a signal that the Bank was determined to get back the nominal growth in the economy that has been lost, even if it is at the cost of pushing inflation above 2% for a sustained period of time.
In the USA, Ben Bernanke announced that the Fed would target unemployment by keeping interest rates at their current record lows until unemployment falls below a threshold of 6.5%.
Until recently, the Fed has been more flexible than most other central banks by considering not only inflation but also real GDP when setting interest rates. This has been close to following a Taylor rule, which involves targeting a weighted averaged of inflation and real GDP. However, in January 2012, the Fed announced that it would adopt a 2% long-run inflation target. So the move to targeting unemployment represents a rapid change in policy
So have simple inflation targets run their course? Should they be replaced by other targets or should targeting itself be abandoned? The following articles examine the issues.
Articles
UK
Mark Carney hints at need for radical action to boost ailing economies The Telegraph, Philip Aldrick (11/12/12)
George Osborne welcomes inflation target review The Telegraph, Philip Aldrick and James Kirkup (13/12/12)
Monetary policy: Straight talk The Economist, R.A. (12/12/12)
New Bank of England governor Mark Carney mulls end of inflation targets The Guardian, Larry Elliott (12/12/12/)
Carney’s trail of carnage Independent, Ben Chu (12/12/12)
Mark Carney suggests targeting economic output BBC News (12/12/12)
A new target for the Bank of England? BBC News, Stephanie Flanders (14/12/12)
Should the UK really ditch inflation target? Investment Week, Katie Holliday (14/12/12)
BoE economist Spencer Dale warns on Mark Carney’s ideas The Telegraph, Philip Aldrick (12/12/12)
USA
Ben Bernanke Outlines Fed Policy for 2013 IVN, Alex Gauthier (14/12/12)
Fed gives itself a new target BBC News, Stephanie Flanders (13/12/12)
Fed to Keep Easing, Sets Target for Rates CNBC, Jeff Cox (12/12/12)
Bernanke calls high unemployment rate ‘an enormous waste’ Los Angeles Times, Jim Puzzanghera (12/12/12)
Think the Fed has been too timid? Check out Britain and Japan. Washington Post, Brad Plumer (13/12/12)
Inflation Targeting is Dead, Long Live Inflation! The Market Oracle, Adrian Ash (14/12/12)
Speech and press conference
Guidance Bank of Canada, Mark Carney (11/12/12)
Transcript of Chairman Bernanke’s Press Conference Federal Reserve Bank, Ben Bernanke (12/12/12)
Questions
- Which of the following would meet an NGDP target of 5%: (a) 5% real growth and 0% inflation; (b) 5% real growth and 5% inflation; (c) 5% inflation and 0% growth?
- What are the main arguments in favour of an NGDP target?
- What factors would need to be taken into account in deciding the target rate of NGDP?
- What are the main arguments against an NGDP target?
- Is it possible to target two indicators with one policy instrument (interest rates)? Explain.
- Explain what is meant by Taylor rule?
- Is having an unemployment target a type of Taylor rule?
- Why may the rate of inflation (whether current or forecast) be a poor indicator of the state of the real economy?
The US Federal Reserve bank has launched a third round of quantitative easing, dubbed QE3. The hope is that the resulting growth in money supply will stimulate spending and thereby increase growth and employment.
Ben Bernanke, the Fed Chairman, had already said that the stagnation of the labour market is of grave concern because of “the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years”. Not, surprisingly, the markets were expecting strong action – and that is what they got.
Under QE3, the Fed will buy mortgage-backed securities of $40bn per month. And this will go on for as long as it takes for the employment market to show significant improvement. It is this open-ended commitment which makes QE3 different from QE1 and QE2. Under these earlier rounds of quantitative easing, the Fed purchased a fixed amount of assets – $2.3tn of bonds.
QE3 also comes on top of a policy in operation since September 2011 of buying long-term government bonds in the market and selling shorter-dated ones. This ‘funding’ operation is known as ‘Operation Twist’.
The markets responded favourably to the announcement of QE3, especially to the fact that its size and duration would depend on the state of the real economy. Nevertheless, there are real questions about its likely effectiveness. The most important is whether the increase in narrow money will translate into an increase in borrowing and spending and hence an increase in broad money; or whether the rise in narrow money will be offset by a fall in the velocity of circulation as banks seek to increase their liquidity ratios and to recapitalise.
The following articles look at the details of QE3 and whether it is likely to achieve its desired result. Will the Fed be forced to raise asset purchases above $40bn per month or to introduce other measures?
Articles
Federal Reserve to buy more debt to boost US economy BBC News (14/9/12)
Bernanke takes plunge with QE3 Financial Times, Robin Harding (14/9/12)
US monetary policy at an important turning point Financial Times, Gavyn Davies (2/9/12)
Cliffhanger The Economist (22/9/12)
Your flexible Fed BBC News, Stephanie Flanders (13/9/12)
Back Ben Bernanke’s QE3 with a clothes peg on your nose The Telegraph, Ambrose Evans-Pritchard (23/9/12)
QE3 Stimulus from Federal Reserve Drives Mortgage Rates Down to Record Lows TellMeNews, Sharon Wagner (24/9/12)
Helicopter Ben Bernanke: The Problem With QE1, QE2, QE3 and QE Infinity TellMeNews, Martin Hutchinson (18/9/12)
QE: More bang than buck Business Spectator, Stephen Grenville (18/9/12)
QE3: What it Really Means PBS NewsHour, Paul Solman (20/9/12)
US Data
US Money Stock Measures Federal Reserve Statistical Release
Data Releases Board of Governors of the Federal Reserve System
Civilian Unemployment Rate (UNRATE) FRED Economic Data
Questions
- What distinguishes the Fed’s QE3 from its QE1 and 2?
- What will determine the likely success of QE3 in stimulating the real economy?
- Why has there been a huge surge in liquidity preference in the USA? What would have been the impact of this without QE1 and QE2?
- Explain what is meant by ‘portfolio balance effects’ and how significant are these in determining the success of quantitative easing?
- Does QE3 suggest that the Fed is pursuing a type of Taylor Rule?
- Why might QE3 be a “pro-cyclical” blunder?
- To what extent would monetarists approve of the Fed’s policies on QE?
- How is QE3 likely to affect the dollar exchange rate and what implications will this have for countries trading with the USA?
Recent data on the US economy suggest that it may be heading back towards recession. Confidence is waning as growth slows. US GDP growth figures for the second quarter of 2010 have just been revised downwards: from 2.4% to 1.6%. And although growth is still quite strongly positive, unemployment is not coming down.
Most economists still think that the US economy will avoid a double dip, but many think that it is nevertheless a distinct possibility. For example, economists at Goldman Sachs put the likelihood of a double-dip recession at 25% to 30%, which although less than 50% is still a substantial risk.
Ben Bernanke, Chairman of the Federal Reserve, told a gathering of bankers and economists in Wyoming on August 27 that the Fed “will do all that it can” to avoid a double dip. According to Bernanke:
In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high… Central bankers alone cannot solve the world’s economic problems. That said, monetary policy continues to play a prominent role in promoting the economic recovery and will be the focus of my remarks today.
Bernanke outlined four monetary policy options that could be pursued, the first three of which were real possibilities for the Fed if economic growth did stall.
• The first would be to sell long-term government securities on the open market – a form of open-market operation. This quantitative easing would expand the money supply and should push long-term interest rates down (short-term interest rates are already virtually zero).
• The second would be to reduce interest rates paid to banks on reserves held in the Fed. These are currently around 0.25% and hence the scope for reductions here are very limited
• The third would be to promise to keep short-term interest rates low for a longer period than markets currently expect, thereby assuring markets that borrowing would remain cheap for some considerable time.
• The fourth option, and one not currently contemplated by the Fed, would be to raise the inflation rate target above its current level of 1.5% to 2%.
The first of the following two podcasts, which includes an interview with US Managing Editor of the Financial Times, Gillian Tett, looks at what the Fed might do. Is the solution to expand aggregate demand through monetary policy or are the problems more structural in nature? The other podcasts and the articles look at Bernanke’s proposals and their scope for avoiding a double dip.
Podcasts
‘No magic wand’ for US economy BBC Today Programme, Mark Mardell and Gillian Tett (27/8/10)
Fed Offers Higher Ground In Economic Mudslide NPR, Scott Horsley (28/8/10)
Roubini Interview Excerpt Bloomberg, Nouriel Roubini (27/8/10)
Articles
Bernanke Says Fed Will Do `All It Can’ to Ensure U.S. Recovery Bloomberg, Craig Torres and Scott Lanman (27/8/10)
What ammunition does the Fed have left? Reuters (27/8/10)
Fed is prepared to keep U.S. out of recession, Bernanke vows Los Angeles Times, Jim Puzzanghera (28/8/10)
Bernanke soothes rattled markets Telegraph (28/8/10)
Ben Bernanke promises to step in as US economy veers back towards recession Guardian, Katie Allen (27/8/10)
Shoot out at Jackson Hole – the world’s central bankers take aim at deflation Independent, Sean O’Grady (27/8/10)
Treasury Two-Year Yields Increase Most Since April After Bernanke Speech Bloomberg, Cordell Eddings (28/8/10)
Bernanke speech shows effort to find Fed consensus One News Now, Jeannine Aversa (28/8/10)
Analysis: The uncomfortable mathematics of monetary policy Reuters, Pedro Nicolaci da Costa (28/8/10)
Ben Bernanke calls for help to revive the stuttering US economy Guardian, Richard Adams (28/8/10)
Fed stands by to boost US growth Financial Times, Robin Harding, Michael Mackenzie and Alan Rappeport (27/8/10)
Bernanke outlines options for Fed Financial Times, Robin Harding (27/8/10)
Speech
The Economic Outlook and Monetary Policy Ben Bernanke (27/8/10)
Data
US Bond Rates Yahoo Finance
US interest rates Federal Reserve Statistical Release
Questions
- Why is growth in the US economy slowing?
- Why has the recovery from recession in the USA so far not resulted in a reduction in unemployment?
- What structural problems are there in the US economy?
- What further scope is there for monetary policy in stimulating the US economy?
- What are the arguments for the Fed introducing a new programme of quantitative easing?
- How important are expectations in determining whether the US recovery will be maintained or whether there will be a double-dip recession?
- What impact did Bernanke’s speech have on bond markets and why?
As we saw in the news item The difficult exit from cheap money, central banks around the world have been operating an extremely loose monetary policy since the beginning of 2009. Their interest rates have been close to zero and trillions of dollars of extra money has been injected into the world economy through various programmes of quantitative easing.
