As the prospects for the global recovery become more and more gloomy, so the need for a boost to aggregate demand becomes more pressing. But the scope for expansionary fiscal policy is very limited, given governments’ commitments around the world to deficit reduction.
This leaves monetary policy. In the USA, the Federal Reserve has announced a policy known as ‘Operation Twist’. This is a way of altering the funding of national debt, rather than directly altering the monetary base. It involves buying long-term government bonds in the market and selling shorter-dated ones (of less than three years) of exactly the same amount ($400bn). The idea is to drive up the price of long-term bonds and hence drive down their yield and thereby drive down long-term interest rates. The hope is to stimulate investment and longer-term borrowing generally.
Meanwhile in Britain it looks as if the Bank of England is about to turn to another round of quantitative easing (QE2). The first round saw £200bn of asset purchases by the Bank between March 2009 and February 2010. Up to now, it has resisted calls to extend the programme. However, it is now facing increased pressure to change its mind, not only from commentators, but from members of the government too.
But will expansionary monetary policy work, given the gloom engulfing the world economy? Is there a problem of a liquidity trap, whereby extra money will not actually create extra borrowing and spending? Many firms, after all, are not short of cash; they are simply unwilling to invest in a climate of falling sales and falling confidence.
Articles on Operation Twist
Fed takes new tack to avoid U.S. economic slump Reuters, Mark Felsenthal and Pedro da Costa (21/9/11)
How the Fed Can Act When Washington Cannot Associated Press on YouTube (20/9/11)
Analysis: Fed’s twist moves hurts company pension plans Reuters, Aaron Pressman (21/9/11)
What is Operation Twist? Guardian, Phillip Inman (21/9/11)
Operation Twist in the Wind Asia Times, Peter Morici (23/9/11)
Operation Twist won’t kickstart the US economy Guardian, Larry Elliott (21/9/11)
Stock markets tumble after Operation Twist … and doubt Guardian, Julia Kollewe (22/9/11)
‘Twist’ is a sign of the Fed’s resolve Financial Times, Robin Harding (22/9/11)
All twist, no shout, from the Fed Financial Times blogs, Gavyn Davies (21/9/11)
Twisting in the wind? BBC News, Stephanie Flanders (21/9/11)
Restraint or stimulus? Markets and governments swap roles BBC News, Stephanie Flanders (7/9/11)
FOMC Statement: Much Ado, Little Impact Seeking Alpha, Cullen Roche (21/9/11)
Why the Fed’s Operation Twist Will Hurt Banks International Business Times, Hao Li (21/9/11)
The Federal Reserve: Take that, Congress The Economist (21/9/11)
Articles on QE2
Bank of England’s MPC indicates QE2 is a case of if not when The Telegraph, Angela Monaghan (21/9/11)
Bank of England quantitative easing ‘boosted GDP’ BBC News (19/9/11)
Bank of England minutes indicate more quantitative easing on the cards Guardian, Julia Kollewe (21/9/11)
Fed and Bank of England publications
Press Release [on Operation Twist] Board of Governors of the Federal Reserve System (21/9/11) (Also follow links at the bottom of the Press Release for more details.)
Minutes of the Monetary Policy Committee Meeting, 7 and 8 September 2011 Bank of England (21/9/11) (See particularly paragraphs 29 to 32.)
Questions
- Explain what is meant by Operation Twist.
- What determines the extent to which it will stimulate the US economy?
- Why would quantitative easing increase the monetary base while Operation Twist would not? Would they both increase broad money? Explain.
- What is meant by the liquidity trap? Are central banks in such a trap at present?
- To what extent would a further round of quantitative easing in the UK drive up inflation?
- Why are monetary and fiscal policy as much about affecting expectations as ‘pulling the right levers’?
Each month the Monetary Policy Committee of the Bank of England meets to set Bank Rate – the Bank’s repo rate, which has a direct impact on short-term interest rates and an indirect effect on other interest rates, such as mortgage rates and bond yields. Ever since March 2009, Bank Rate has been 0.5%. So each month the MPC has met and decided to do nothing! The latest meeting on 4 and 5 May was no exception.
And it is not just the Bank of England. The Fed in the USA has kept interest rates at between 0 and 0.25% ever since December 2008. The ECB had maintained its main interest rate at 1% for two years from May 2009. Then last month (April) it raised the rate to 1.25%, only to keep it unchanged at that level at its meeting on 5 May.
So is all this ‘doing nothing’ on interest rates (or very little in the case of the ECB) a sign that the economies of the UK, the USA and the eurozone are all ticking along nicely? Are they in the ‘goldilocks’ state of being neither too hot (i.e. too much demand and excessive inflation) or too cold (i.e. too little demand and low growth, or even recession)? Or does the apparent inaction on interest rates mask deep concerns and divisions within the decision-making bodies?
The three central banks’ prime concern may be inflation, but they are also concerned about the rate of economic growth. If inflation is forecast to be above target and growth to be unsustainably high, then central banks will clearly want to raise interest rates. If inflation is forecast to be below target and economic growth is forecast to be low or negative, then central banks will clearly want to reduce interest rates.
But what if inflation is above target and will probably remain so and, at the same time, growth is low and perhaps falling? What should the central bank do then? Should it raise interest rates or lower them? This is the dilemma facing central banks today. With soaring commodity prices (albeit with a temporary fall in early May) and the economic recovery stalling or proceeding painfully slowly, perhaps keeping interest rates where they are is the best option – an ‘active’ decision, but not an easy one!
Articles
Central Banks Leave Rates Unchanged News on News (8/5/11)
European Central Bank set for a bumpy ride City A.M., Guy Johnson (9/5/11)
Euro Tumbles Most Against Dollar Since January on Rate Signal; Yen Climbs Bloomberg, Allison Bennett and Catarina Saraiva (7/5/11)
Rates outlook Financial Times, Elaine Moore (6/5/11)
Interest rates on hold amid fears economy is stalling Independent, Sean Farrell (6/5/11)
The decision to hold back on increasing interest rates may turn out to be wrong Independent, Hamish McRae (6/5/11)
Bank of England: Inflation threat from fuel bills BBC News. Hugh Pym (11/5/11)
Andrew Sentance loses last battle over interest rates Guardian, Heather Stewart (5/5/11)
Interest rates: what the experts say Guardian (5/5/11)
King’s Defense of Record-Low Rates in U.K. Is Bolstered by Economic Data Bloomberg, Svenja O’Donnell (5/5/11)
BoE holds rates: reaction The Telegraph, Joost Beaumont, Abn Amro (5/5/11)
UK interest rates kept on hold at 0.5% BBC News (5/5/11)
Bank of England Signals Rate Increase This Year as Inflation Accelerates Bloomberg, Svenja O’Donnel (11/5/11)
ECB: Clearing the way for an Italian hawk? BBC News blogs: Stephanomics, Stephanie Flanders (5/5/11)
Ben and the Fed’s excellent adventure BBC News blogs: Stephanomics, Stephanie Flanders (27/4/11)
Inflation up. Growth down. Uncertainty everywhere BBC News blogs: Stephanomics, Stephanie Flanders (11/5/11)
Inflation report: analysts expecting a rate rise are wide of the mark Guardian, Larry Elliott (11/5/11)
May’s Inflation Report – three key graphs The Telegraph, Andrew Lilico (11/5/11)
The Errors Of The Inflation Hawks, Part I Business Insider, John Carney (9/5/11)
Errors of Inflation Hawks, Part II CNBC, John Carney (9/5/11)
Data and information
Inflation Report Bank of England
Inflation Report Press Conference Webcast Bank of England (11/5/11)
Monetary Policy ECB
ECB Interest Rates ECB
Monetary Policy Federal Reserve
US interest rates Federal Reserve
Questions
- Why is it exceptionally difficult at the current time for central banks to “get it right” in setting interest rates?
- What are the arguments for (a) raising interest rates; (b) keeping interest rates the same and also embarking on another round of quantitative easing?
- Should central banks respond to rapidly rising commodity prices by raising interest rates?
- Why is inflation in the UK currently around 2 percentage points above the target?
- What is likely to happen to inflation in the coming months and why?
- Explain the following comment by John Carney in the final article above: “To put it differently, the textbook money multiplier doesn’t exist anymore. This means that Fed attempts to juice the economy by raising the quantity of reserves—the basic effect of quantitative easing—are bound to fail.”.
- What has been the recent relationship in the UK between (a) growth in the monetary base and growth in broad money; (b) growth in the monetary base and inflation and economic growth?
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?
This podcast is from the Library of Economics and Liberty’s EconTalk site. In it, Scott Sumner of Bentley University discusses with host Russ Roberts the role of monetary policy in the USA since 2007 and whether or not it was as expansionary as many people think.
In fact, Sumner argues that monetary policy was tight in late 2008 and that this precipitated the recession. He argues that the standard indicators of the tightness or ease of monetary policy, namely the rate of interest and the growth in the money supply, were misleading.
Sumner on Monetary Policy EconTalk podcast (9/11/09)
Questions
- Why is it important to look at the velocity of circulation of money when deciding the effect of interest rate changes or changes in the monetary base? Can the Fed’s failure to take velocity sufficiently into account be seen as a cause of the recession?
- Is there evidence of a liquidity trap operating in the USA in late 2008?
- How could the Fed have pursued a more expansionary policy, given that interest rates were eventually cut to virtually zero and the monetary base was expanded substantially?
- Why does Sumner argue that monetary policy should focus on influencing the growth in aggregate demand?
- How useful is the quantity equation, MV = PT (or MV = PY) in understanding the role and effectiveness of monetary policy?
- What is the Keynesian approach to monetary policy in a recession? How does this differ from the monetarist approach? Are both approaches focusing on the demand side and thus quite different from supply-side analysis of recession?
- Why is the consumer prices index (CPI) a poor indicator of a nominal shock to the economy? Should the central bank focus on nominal GDP, rather than CPI, as an indicator of the state of the economy and as a guide to the stance of monetary policy?
- What are the strengths and weaknesses of using a Taylor rule as a guide to monetary policy? Would nominal GDP futures be a better target for monetary policy?
This podcast is from MSN’s Slate magazine. It is an interview with David Wessel, author of the book In Fed We Trust: Ben Bernanke’s War on the Great Panic. The book and the podcast consider the recent history of the Federal Reserve Bank of America (the USA’s central bank) and its handling of the sub-prime crisis and the credit crunch.
In Fed We Trust: A podcast with author David Wessel MSN Slate (10/8/09)
Questions
- What actions were taken by the Fed as the credit crisis unfolded?
- According to David Wessel, what mistakes were made by the Fed in handling the credit crisis?
- How successful was the Fed in steering the economy through the credit crisis and subsequent recession?
- How is the role of the Fed likely to change in the future?