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.
The first link below is to an excellent article by Noriel Roubini, Professor of Economics at New York University’s Stern School of Business. Roubini was one of the few economists to predict the 2008 financial crisis and subsequent recession. In this article he looks at the current problem of substantial deficiency of demand: in other words, where actual output is well below potential output (a negative output gap). It is no wonder, he argues, that in these circumstances central banks around the world are using unconventional monetary policies, such as virtually zero interest rates and quantitative easing (QE).
He analyses the causes of deficiency of demand, citing banks having to repair their balance sheets, governments seeking to reduce their deficits, attempts by firms to cut costs, effects of previous investment in commodity production and rising inequality.
The second link is to an article about the prediction by the eminent fund manager, Crispin Odey, that central banks are running out of options and that the problem of over-supply will lead to a global slump and a stock market crash that will be ‘remembered in a hundred years’. Odey, like Roubini, successfully predicted the 2008 financial crisis. Today he argues that the looming ‘down cycle will cause a great deal of damage, precisely because it will happen despite the efforts of central banks to thwart it.’
I’m sorry to post this pessimistic blog and you can find other forecasters who argue that QE by the ECB will be just what is needed to stimulate economic growth in the eurozone and allow it to follow the USA and the UK into recovery. That’s the trouble with economic forecasting. Forecasts can vary enormously depending on assumptions about variables, such as future policy measures, consumer and business confidence, and political events that themselves are extremely hard to predict.
Will central banks continue to deploy QE if the global economy does falter? Will governments heed the advice of the IMF and others to ease up on deficit reduction and engage in a substantial programme of infrastructure investment? Who knows?
An Unconventional Truth Project Syndicate, Nouriel Roubini (1/2/15)
UK fund manager predicts stock market plunge during next recession The Guardian, Julia Kollewe (30/1/15)
Questions
- Explain each of the types of unconventional monetary policy identified by Roubini.
- How has a policy of deleveraging by banks affected the impact of quantitative easing on aggregate demand?
- Assume you predict that global economic growth will increase over the next two years. What reasons might you give for your prediction?
- Why have most commodity prices fallen in recent months? (In the second half of 2014, the IMF all-commodity price index fell by 28%.)
- What is likely to be the impact of falling commodity prices on global demand?
- Some neo-liberal economists had predicted that central bank policies ‘would lead to hyperinflation, the US dollar’s collapse, sky-high gold prices, and the eventual demise of fiat currencies at the hands of digital krypto-currency counterparts’. Why, according to Roubini, did the ‘root of their error lie in their confusion of cause and effect’?
The articles linked below look at the dangers of deflation and policies of central banks to counter it.
Deflation in economics has three meanings. The first is falling prices: i.e. negative inflation. The second, more traditional meaning, is a fall in real aggregate demand, resulting in lower output, higher unemployment and lower inflation – and quite possibly an actual fall in the price level. These first two definitions describe what is generally seen as an undesirable situation. The third is a slowing down in the growth of real aggregate demand, perhaps as a result of a deliberate act of fiscal and/or monetary policy. This third meaning could describe a desirable situation, where unsustainable growth is reduced and inflation is reduced from an above-target level.
Here we focus on the first definition. The first two articles look at the dangers of a fall in the price level. The chart below shows falling inflation, although not actually deflation, in China, France, Germany and the UK (click here for a PowerPoint). Several European countries, however, are experiencing actual deflation. These include: Greece, Spain, Hungary, Poland and Sweden. Inflation in the eurozone for 2014 is expected to be a mere 0.5%.
The most obvious danger of deflation (or expected deflation) is that people will delay spending on durable goods, such as cars, furniture and equipment, hoping to buy the items cheaper later. 
The result could be a fall in aggregate demand and a fall in output and employment.
For retailers, this is all spelling Christmas doom. Already the runup to the most crucial time of the year for shops is being characterised by a game of chicken. Shoppers are wondering how long they can leave their festive buying in the hope of late bargains.
Interest rates may be low, but for people with debts, this is being offset by the fact that inflation is no longer reducing the real value of that debt. For people with credit card debt, personal loans and most mortgages, the interest rate they pay is significantly above the rate of inflation. In other words, the real interest rate on their debt is still significantly positive. This may well discourage people from borrowing and spending, further dampening aggregate demand. And, with a Bank Rate of just 0.5%, there is virtually no scope for lowering the official interest rate further.
At least in the UK, economic growth is now positive – for the time being at any rate. The danger is becoming more serious, however, in many eurozone countries, which are already back in recession or close to being so. The ECB, despite its tentative steps to ease credit conditions, it moving closer to the day when it announces full-blown quantitative easing and buys sovereign bonds of eurozone countries. The Bank of Japan has already announced that it is stepping up it QE programme – a vital ingredient in getting Abenomics back on track and pulling Japan out of its latest recession.
In the USA, by contrast, there is little danger of deflation, as the US economy continues to grow strongly. The downside of this, has been a large rise in consumer debt (but not mortgages) – the ingredients of a possible future bubble and even a new financial crisis.
Forget what central bankers say: deflation is the real monster The Observer, Katie Allen (23/11/14)
Why Deflation Is Such A Big Worry For Europe NPR, Jim Zarroli (31/10/14)
Exclusive: China ready to cut rates again on fears of deflation – sources Reuters, Kevin Yao (23/11/14)
Central Banks in New Push to Prime Pump Wall Street Journal Jon Hilsenrath, Brian Blackstone and Lingling Wei (21/11/14)
Are Central Banks Panicking? Seeking Alpha, Leo Kolivakis (21/11/14)
Questions
- What are (a) the desirable and (b) the undesirable consequences of deflation? Does the answer depend on how deflation is defined?
- What is meant by a ‘deflationary gap’? In what sense is ‘deflationary’ being used in this term?
- Why have oil prices been falling? How desirable are these falls for the global economy?
- Is there an optimal rate of inflation? If so, how would this rate be determined?
- The chart shows that inflation in Japan is likely to have risen in 2014. This in large part is the result to a rise in the sales tax earlier this year. If there is no further rise in the sales tax, which there will probably not be if Mr Abe’s party wins the recently called election, what is likely to be the effect of the 2014 tax rise on inflation in 2015?
- If the Bank Rate is below the rate of inflation, why are people facing a positive real rate of interest? Does this apply equally to borrowers and savers?
- In what sense is there a cultural revolution at the Bank of England?
One of the key prices in any economy is that of oil. Whenever oil prices change, it can have a knock-on effect on a range of other markets, as oil, or some variation, is used as an input into the production of countless products. The main products that consumers will see affected are energy prices and petrol prices..
Although on the supply-side, we see a large cartel in the form of OPEC, it is still the case that the forces of demand and supply directly affect the market price. Key things such as the demand for heating, economic growth, fears of war and disruption will change the demand and supply of oil. The possibility of militant strikes in oil producers, such as Syria, would normally reduce supply and push up the market price. However, we have actually seen oil prices drop much faster than we have in two years, dropping below $100 per barrel since September 5th. The slowdown of economic growth in Asia, together with the return of Libyan production at a level greater than expected have helped to push prices down and have offset the fears of global production.
The market forces pushing prices down, while good for consumers and firms that use crude oil or one of its by-products, are clearly bad for oil producers. (Click here for a PowerPoint of the chart.) Countries are urging OPEC to halt its production and thereby shift supply upwards to the left putting a stop to the downward oil price trend. Several countries are concerned about the impact of lower prices, and one country that may be significantly affected is Russia. Some are suggesting that the impact could be as big as 4% of Russia’s GDP, taking into account the ongoing political crisis with Ukraine.
The market for oil is highly susceptible to changes in both demand and supply-side factors. Microeconomic changes will have an impact, but at the same time any global macroeconomic factors can have significant effects on the global price. Expectations are crucial and as countries release information about the size of the oil stocks and inventories, it is adding to the downward pressure on prices. Some oil experts have predicted that prices could get as low as $80 per barrel before OPEC takes significant action, influenced heavily by countries like Saudi Arabia. The following articles consider this global market.
Articles
Iran urges OPEC to halt oil price slide Financial Times, Anjli Raval (26/9/14)
Oil overflow: as prices slump, producers grapple with a new reality The Globe and Mail, Shawn McCarthy and Jeff Lewis (27/9/14)
Weak demand, plentiful supply drive decline in oil prices International Distribution (26/9/14)
Oil prices plunging despite ISIS CNN Money, Paul R La Monica (25/9/14)
Oil prices fall on EIA report of big U.S. crude stocks build Reuters, Robert Gibbons (17/9/14)
Sanctions and weaker oil prices could cost Russia 4% of GDP – official RT (25/9/14)
Data
Spot oil prices Energy Information Administration
Weekly European Brent Spot Price Energy Information Administration (Note: you can also select daily, monthly or annual.)
Annual Statistical Bulletin OPEC
Questions
- What are the key factors on the microeconomic side that affect (a) demand and (b) supply of oil?
- Explain the key macroeconomic factors that are likely to have an impact on global demand and supply of oil.
- Militant action in some key oil producing countries has caused fears of oil disruption. Why is that oil prices don’t reflect these very big concerns?
- Use a demand and supply diagram to explain the answer you gave to question 3.
- What type of intervention could OPEC take to stabilise oil prices?
- Why is the Russian economy likely to be adversely affected by the trend in oil prices?
- Changes in the global macroeconomy will directly affect oil prices. Is there a way that changes in oil prices can also affect the state of the global economy?
The Office for National Statistics (ONS) reported that the quantity of retail sales in the UK was 3.9% higher in August than it had been in July. However strong price competition meant that the value of these sales increased by only 0.4%. What were the key factors driving the big increase in the quantity of sales? Was it simply the response of consumers to falling prices?
The data indicated that there was strong demand for goods associated with the housing market such as carpets, fridges and cookers. Spending on furniture increased very rapidly with sales rising by 24% over a 12 month period. Flat packed furniture proved to be particularly popular with consumers.
There was also strong demand for electrical goods and more specifically vacuum cleaners. The ONS estimated that a boom in the sale of vacuum cleaners in August was responsible for 25% of the increase in retail sales.
Why did the sales of vacuum cleaners increase so rapidly in August? Did UK households suddenly decide to keep their houses cleaner? The sales data shows that certain types of vacuum cleaners sold in much larger numbers than others.
For example, Tesco reported a 44% increase in the sales of 2,000 watt vacuum cleaners in the last two weeks in August while the Co-op reported an increase of 38%. Referring to the last weekend in August, the head of small domestic appliances at the on-line retailer ao.com stated that
We saw a huge surge in sales of corded vacuums over 1,600 watts over the weekend, with sales quadrupling.
There were also reports that a significant number of customers were buying more than one vacuum cleaner with these larger motors.
The key reason for the sudden surge in demand was the implementation of new regulations by the European Union as part of its energy efficiency directive. The ultimate objective of this directive is to reduce climate change. The specific policy that appears to have had such a big impact on consumers in the UK was the ban imposed on firms in the EU from making or importing vacuum cleaners that have motors above 1600 watts. This ban came into effect on the 1st September 2014.
A spokesperson for the consumer group Which? stated in August that
If you’re in the market for a powerful vacuum, you should act quickly, before all the models currently sell out. A Best Buy 2,200-watt vacuum costs around £27 a year to run in electricity – only around £8 more than the best scoring 1,600-watt we’ve tested.
The EU plans to reduce the maximum permitted wattage in vacuum cleaners to 900 watts in 2017. Restrictions have already been imposed on bigger electrical appliances such as televisions, washing machines and refrigerators. The EUs Ecodesign directive may also be extended to a range of smaller electrical appliances such as toasters and hair dressers in the future. It’ll be interesting to see if consumers respond in the same way to regulations imposed by the EU in the future.
Ten days left to vacuum up a powerful cleaner BBC (21/08/14)
Housing boom, food discounting and vacuum ban boost UK spending The Guardian, Larry Elliott, Phillip Inman, Lisa Bachelor (18/9/14)
UK retail sales boosted by vacuum cleaner sales BBC (18/9/14)
Retailers sell out of vacuum cleaners ahead of EU ban The Telegraph, Elliot Pinkham (30/8/14)
Power surge! Fourfold rise in sales of super vacuums: Some customers buying two or more models to beat new EU regulations Daily Mail, Andrew Levy (1/9/14)
Energy Efficiency Directive European Commission (accessed on 24/9/14)
Vacuum cleaner splurge pushes up UK retail sales The Guardian, Phillip Inman (18/9/14)
Questions
- Using a demand and supply diagram, illustrate what has happened in the market for high wattage vacuum cleaners in August. Pay particular attention in your answer to the role of expectations.
- What did your previous diagram predict would happen to the price of high wattage vacuum cleaners in August? Did this in fact happen?
- A fully informed rational consumer may purchase a higher wattage vacuum cleaner if they consider that the improvement in cleaning performance is greater than the extra cost of purchasing and using the cleaner. Can you provide an economic rationale for banning the sale of these machines in these circumstances?
- Using a demand and supply diagram illustrate the impact of banning the sale of a product in a competitive market.
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.