The Federal Reserve chair, Janet Yellen, has been giving strong signals recently that the US central bank will probably raise interest rates at its December 16 meeting or, if not then, early in 2016. ‘Ongoing gains in the labor market’ she said, ‘coupled with my judgement that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2%.’ This, as for many other central banks, is the target rate of inflation.
In anticipation of a rise in US interest rates, the dollar has been appreciating. Its (nominal) exchange rate index has risen by 24% since April 2014 (see chart below).
In the light of the sluggish eurozone economy, the ECB president, Mario Draghi, has been taking a very different stance. He has indicated that he stands ready to cut interest rates further and increase quantitative easing.
At the meeting on 3 December, the ECB did just that. It announced a further cut in the deposit rate, from –0.2 to –0.3 and an extension of the €60 billion per month QE programme from September 2016 to March 2017 (bringing the total by that time to €1.5 trillion – up from €1.1 trillion by September 2016).
Stock market investors had been expecting more, including an increase in the level of monthly asset purchases above €60 billion. Consequently stock markets fell. Both the German DAX and the French CAC 40 stock market indices fell by 3.6%. The euro also appreciated against the dollar by 2.7% on the day of the announcement. Nevertheless, since April 2014, the euro exchange rate index has fallen by 13%. Against the US dollar, the euro has depreciated by a massive 31%.
So what will be the consequences of the very different monetary policies being pursued by the Fed and the ECB? Are they simply the desirable responses to a lack of convergence of the economic performance of the US and eurozone economies? In other words, will they help to bring greater convergence between the two economies?
Or will the desirable effects of convergence be offset by other undesirable effects for the USA and the eurozone and also for the rest of the world?
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Will huge amounts of dollar-denominated debt held by many emerging economies make it harder to service these debts with an appreciating dollar? |
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How much will US exporters suffer from the dollar’s rise and what will the US authorities do about it? |
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Will currency volatility lead to currency wars and, if so, what will be their economic effects? |
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Will the time lags involved in the effects of the continuing programme of QE in the eurozone eventually lead to overheating? Already euro money supply is rising, on both narrow and broad measures. |
The following articles address these issues.
Articles
The Fed and the ECB: when monetary policy diverges The Guardian, Mohamed El-Erian (2/12/15)
European stocks slide after ECB dashes hopes of major QE expansion The Guardian, Heather Stewart and Graeme Wearden (3/12/15)
Mario Draghi riles Germany with QE overkill The Telegraph, Ambrose Evans-Pritchard (3/12/15)
How the eurozone missed its shot at a recovery The Telegraph, Peter Spence (3/12/15)
Yellen Signals Economy Nearly Ready for First Interest-Rate Hike Bloomberg, Christopher Condon (3/12/15)
Exchange rate data
Effective exchange rate indices Bank for International Settlements
Exchange rates Bank of England
Questions
- What would be the beneficial effects to the US and eurozone economies of their respective monetary policies?
- Explain the exchange rate movements that have taken place between the euro and the dollar over the past 19 months. How do these relate to the various parts of the balance of payments accounts of the two economies?
- Is it possible for the USA to halt the rise in the dollar while at the same time raising interest rates? Explain.
- Why are some members of the ECB (e.g. the German and Dutch) against expanding QE? Assess their arguments.
- What will be the impact of US and eurozone monetary policies on emerging economies?
- What will be the impact of US and eurozone monetary policies on the UK?
- Why did the euro appreciate after the Mario Draghi’s press statement on 3 December? What has happened to the dollar/euro exchange rate since and why?
There is a select group of countries (areas) that have something in common: the USA, the UK, Japan and the eurozone. The currency in each of these places is one of the IMF’s reserve currencies. But is China about to enter the mix?
The growth of China has been spectacular and it is now the second largest economy in the world, behind the USA. It is on the back on this growth that China has asked the IMF for the yuan to be included in the IMF’s basket of reserve currencies. The expectation is that Christine Lagarde, the IMF’s Managing Director, will announce its inclusion and, while some suggest that the yuan could become one of the major currencies in the world over the next decade following this move, others say that this is just a ‘symbolic gesture’. But that doesn’t seem to matter, according to Andrew Malcolm, Asia head of capital at Linklaters:
“The direct impact won’t be felt in the near term, not least because implementation of the new basket won’t be until Q3 2016. However the symbolic importance cannot be overlooked…By effectively endorsing the renminbi as a freely useable currency, it sends a strong signal about China’s importance in the global financial markets.”
Concerns about the yuan being included have previously focused on China’s alleged under-valuation of its currency, as a means of boosting export demand, as we discussed in What a devalued yuan means to the rest of the world. However, China has made concerted efforts for the IMF to make this move and China’s continuing financial reforms may be essential. The hope is that with the yuan on the IMF’s special list, it will boost the use of the yuan as a reserve currency for investors. It will also be a contributor to the value of the special drawing right, which is used by the IMF for pricing its emergency loans.
Although the Chinese stock market has been somewhat volatile over the summer period, leading to a devaluation of the currency, it is perhaps this move towards a more market based exchange rate that has allowed the IMF to consider this move. We wait for an announcement from the IMF and the articles below consider this story.
Chinese yuan likely to be added to IMF special basket of currencies The Guardian, Katie Allen (29/11/15)
‘Chinese yuan set for IMF reserve status BBC News (30/11/15)
IMF to make Chinese yuan reserve currency in historic move The Telegraph, James Titcomb (29/11/15)
China selloff pressure Asia stocks, yuan jumpy before IMF decision Reuters, Hideyuki Sano (30/11/15)
IMF’s yuan inclusion signals less risk taking in China Reuters, Pete Sweeney and Krista Hughes (29/11/15)
Did the yuan really pass the IMF currency test? You’ll know soon Bloomberg, Andrew Mayeda (29/11/15)
Questions
- What is meant by a reserve currency?
- Why do you think that the inclusion of the yuan on the IMF’s list of reserve currencies will boost investment in China?
- One of the reasons for the delay in the yuan’s inclusion is the alleged under-valuation of the currency. How have the Chinese authorities allegedly engineered a devaluation of the yuan? To what extent could it be described as a ‘depreciation’ rather than a ‘devaluation’?
- Look at the key tests that the yuan must pass in order to be included. Do you think it has passed them given the report produced a few months ago?
- The weighting that a currency is given in the IMF’s basket of currencies affects the interest rate paid when countries borrow from the IMF. How does this work?
It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.
According to conventional economic theory, investment is inversely related to the rate of interest: the lower the rate of interest, the higher the level of investment. In other words, the demand-for-investment curve is downward sloping with respect to the rate of interest. It is true that in recent years investment has been low, but that, according to traditional theory, is the result of a leftward shift in demand thanks to low confidence, not to quantitative easing and low interest rates.
In a recent article, however, Michael Spence (of New York University and a 2001 Nobel Laureate) and Kevin Warsh (of Stanford University and a former Fed governor) challenge this conventional wisdom. 
According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.
“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”
This analysis has been challenged by several eminent economists, including Larry Summers, Harvard Economics professor and former Treasury Secretary. He criticises them for confusing correlation (low investment coinciding with low interest rates) with causation. As Summers states:
“This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation. …If, as Spence and Warsh assert, QE has raised stock prices, this should tilt the balance toward real investment.”
Not surprisingly Spence and Warsh have an answer to this criticism. They maintain that their critique is less of low interest rates but rather of the form that QE has taken, which has directed new money into the purchase of financial assets. This then has driven further asset purchases, much of it by companies, despite high price/earnings ratios (i.e. high share prices relative to dividends). As they say:
“Economic theory might have something to learn from recent empirical data, and from promising new thinking in behavioral economics.”
Study the arguments of both sides and try to assess their validity, both theoretically and in the light of evidence.
Articles
The Fed Has Hurt Business Investment The Wall Street Journal, Michael Spence and Kevin Warsh (26/10/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
I just read the ‘most confused’ critique of the Fed this yea Washington Past, Lawrence H. Summers (28/10/15)
A Little Humility, Please, Mr. Summers The Wall Street Journal, Michael Spence and Kevin Warsh (4/11/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Do ultra-low interest rates really damage growth? The Economist (12/11/15)
It’s the Zero Bound Yield Curve, Stupid! Janus Capital, William H Gross (3/11/15)
Is QE Bad for Business Investment? No Way! RealTime Economic Issues Watch, Joseph E. Gagnon (28/10/15)
Department of “Huh!?!?”: QE Has Retarded Business Investment!? Washington Center for Equitable Growth, Brad DeLong (27/10/15)
LARRY SUMMERS: The Wall Street Journal published the ‘single most confused analysis’ of the Fed I’ve read this year Business Insider, Myles Udland (29/10/15)
The Fed’s Loose Money, Financial Markets and Business Investment SBE Council, Raymond J. Keating (29/10/15)
How the QE trillions missed their mark AFR Weekend, Maximilian Walsh (4/11/15)
Financial Markets In The Era Of Bubble Finance – Irreversibly Broken And Dysfunctional David Stockman’s Contra Corner, Doug Noland (8/11/15)
Questions
- Go through the arguments of Spence and Warsh and explain them.
- Explain what are meant by the ‘yield curve’ and ‘zero bound yield curve’.
- What criticisms of their arguments are made by Summers and others?
- Apart from the effects of QE, why else have long-term interest rates been low?
- In the light of the arguments on both sides, how effective do you feel that QE has been?
- How could QE have been made more effective?
- What is likely to happen to financial markets over the coming months? What effect is this likely to have on the real economy?
Interest rates in the UK have been at a record low since 2009, recorded at just 0.5%. In July, the forward guidance from Mark Carney seemed to indicate that a rate rise would be likely towards the start of 2016. However, with the recovery of the British economy slowing, together with continuing problems in Europe and slowdowns in China, a rate rise has become less likely. Forward guidance hasn’t been particularly ‘guiding’, as a rate rise now seems most likely well into 2016 or even in 2017 and this is still very speculative.
Interest rates are a key tool of monetary policy and one of the government’s demand management policies. Low interest rates have remained in the UK as a means of stimulating economic growth, via influencing aggregate demand. Interest rates affect many of the components of aggregate demand, such as consumption – through affecting the incentive to save and spend and by affecting mortgage rates and disposable income. They affect investment by influencing the cost of borrowing and net exports through changing the exchange rate and hence the competitiveness of exports.
Low interest rates therefore help to boost all components of aggregate demand and this then should stimulate economic growth. While they have helped to do their job, circumstances across the global economy have acted in the opposite direction and so their effectiveness has been reduced.
Although the latest news on interest rates may suggest some worrying times for the UK, the information contained in the Bank of England’s Inflation Report isn’t all bad. Despite its predictions that the growth rate of the world economy will slow and inflation will remain weak, the predictions from August remain largely the same. The suggestion that interest rates will remain at 0.5% and that any increases are likely to be at a slow pace will flatten the yield curve, and, with predictions that inflation will remain weak, there will be few concerns that continuing low rates will cause inflationary pressures in the coming months. Mark Carney said:
“The lower path for Bank Rate implied by market yields would provide more than adequate support to domestic demand to bring inflation to target even in the face of global weakness.”
However, there are many critics of keeping interest rates down, both in the UK and the USA, in particular because of the implications for asset prices, in particular the housing market and for the growth in borrowing and hence credit debt. The Institute of Directors Chief Economist, James Sproute said:
“There is genuine apprehension over asset prices, the misallocation of capital and consumer debt…Borrowing is comfortably below the unsustainable pre-crisis levels, but with debt once against rising there is a need for vigilance…The question is, will the Bank look back on this unprecedented period of extraordinary monetary policy and wish they had acted sooner? The path of inaction may seem easier today, but maintaining rates this low, for this long, could prove a much riskier decision tomorrow.”
hanges in the strength of the global economy will certainly have a role to play in forming the opinions of the Monetary Policy Committee and it will also be a key event when the Federal Reserve pushes up its interest rates. This is certainly an area to keep watching, as it’s not a question of if rates will rise, but when.
Articles
Bank of England dampens prospects of early UK rate rise BBC News (5/11/15)
Bank of England Governor gets his forward guidance on interest rates wrong Independent, Ben Chu (6/11/15)
Interest rates set to remain at rock-bottom right through 2016 as Bank of England cuts UK growth and inflation forecasts This is Money, Adrian Lowery (5/11/15)
Pound slides as Bank of England suggests interest rates will stay low for longer – as it happened 5 November 2015 The Telegraph, Peter Spence (5/11/15)
UK’s record low interest rates should be raised next Februrary says NIESE The Telegraph, Szu Ping Chan (4/11/15)
Fresh signs of slowdown will force interest rates rise to be put on hold The Guardian, Katie Allen (2/11/15)
The perils of keeping interest rates so low The Telegraph, Andrew Sentence (6/11/15)
Time to ask why we are still in the era of ultra-low rates Financial Times, Chris Giles (4/11/15)
No interest rate rise until 2017: Joy for homeowners as Bank of England delays hike in mortgage costs again Mail Online, Matt Chorley (5/11/15)
Pound tumbles after Carney warns its strength threatens recovery Bloomberg, Lucy Meakin (5/11/15)
Is Carney hurt by wrong rate steer? BBC News, Robert Peston (5/11/15)
Data and Reports
Inflation Report Bank of England (August 2015)
Inflation Report Bank of England (November 2015)
Historical Fan Chart Data Bank of England (2015)
Questions
- Use and AD/AS diagram, explain how low interest rates affect the key components of aggregate demand and in turn how this will affect economic growth.
- What is meant by the ‘yield curve’? How has it been affected by the latest release from the Monetary Policy Committee?
- Why has the value of the pound been affected following the decision to keep interest rates at 0.5%?
- How has the sterling exchange rate changed and how might this affect UK exports?
- What are the main concerns expressed by those who think that there is a danger from keeping interest rates low for too long?
- Why is the outlook of the global economy so important for the direction of interest rate changes?
Economic growth is vital to an economy: it helps to create jobs and is crucial in stimulating confidence, both for businesses and consumers. Growth comes from various sources, both domestic and external, and so for each individual country it’s not just its growth rate that is important, but the growth rates of other countries, in particular those it trades with.
Recent data suggest that the global economy could be on the downturn and here we consider three countries/continents.
The US economy has been doing relatively well and we saw discussion by the Federal Reserve as to whether the economy was in a position to be able to handle an increase in interest rates. Although rates didn’t rise, there was a general consensus that a rate rise would not significantly harm the economy. However, perhaps those opinions may now be changing with the latest information regarding US growth. In the second quarter of 2015, growth was recorded at 3.9%, but according to the Department of Commerce, it fell to 1.5% for the third quarter. Though it’s still a solid growth rate, especially compared to other economies, it does represent a significant fall from quarter to quarter.
Many analysts suggest that this slowing is just a blip, partly the result of running down stocks, but it’s also a trend that has occurred in the UK. Although the fall in growth in the UK (see series IHYR) has been less than in the USA, it is still a fall. Annual growth was recorded at 2.7% in quarter 1, but fell to 2.4% in quarter 2 and to 2.3% in quarter 3 (with GDP in quarter 3 only 0.5% higher than in quarter 2). A big cause of this slowdown in growth has been a fall in manufacturing output and it is the service sector that prevented an even larger slowdown.
And it’s not just the West that is experiencing declining growth. The IMF has warned of a slowdown in economic growth in Africa. Although the absolute annual rate of growth at 3.75% is high compared to the UK, it does represent the slowest rate of growth in the past six years. One key factor has been the lower oil prices. Although this has helped to stimulate consumer spending in many countries, it has hit oil-producing countries.
With some of the big players experiencing slowdowns, world economic growth may be taking something of a dive. The Christmas period in many countries is when companies will make significant contributions to their annual sales, and this year these sales are going to be vital. The following articles consider the slowdowns in growth around the world.
Articles
US growth slows despite spending free Financial Times, Sam Fleming and Richard Blackden (29/10/15)
US economic growth slows in third quarter as businesses cut back The Guardian, Dominic Rushe (30/10/15)
US economic growth slows sharply BBC News (29/10/15)
US Q3 gross domestic product up 1.5% vs 1.6% growth expected CNBC, Reuters (29/10/15)
US growth cools in third quarter Wall Street Journal, Eric Morath (29/10/15)
UK economic growth slows to 0.5% in third quarter BBC News (27/10/15)
GDP growth in the UK slows more than expected to 0.5% The Guardian, Julia Kollewe (27/1015)
UK growth slows as construction and manufacturing output shrinks The Telegraph, Szu Ping Chan (27/10/15)
UK economy loses steam as GDP growth slows to 0.5% Financial Times, Ferdinando Giugliano (27/10/15)
No UK growth without services BBC News, Robert Peston (27/10/15)
IMF warns of African economic slowdown BBC News (27/10/15)
African growth feels the strain from China’s slowdown Financial Times, Andrew England (27/10/15)
Tax credits: George Osborne ‘comfortable’ with ‘judgement call’ BBC News (22/10/15)
IMF revises down Sub-Saharan Africa 2015 growth Wall Street Journal, Matina Stevis (27/10/15)
WEO publications
World Economic Outlook, October 2015: Adjusting to Lower Commodity Prices IMF (6/10/15)
Global Growth Slows Further, IMF’s latest World Economic Outlook IMF Podcast, Maurice Obstfeld (6/10/15)
Transcript of the World Economic Outlook Press Conference IMF (6/10/15)
World Economic Outlook Database IMF (October 2015 edition)
Questions
- How do we measure economic growth?
- Using an AD/AS diagram, explain why economic growth has fallen in (a) the US, (b) the UK and (c) Africa.
- How have oil prices contributed towards recent growth data?
- Why has the IMF forecast slowing growth for Africa and how dependent is the African economy on growth in China?
- Which sectors are contributing towards slower growth in each of the 3 countries/continents considered? Can you explain the reason for the downturn in each sector?
- What do you think should be done regarding interest rates in the coming months?
The Federal Reserve chair, Janet Yellen, has been giving strong signals recently that the US central bank will probably raise interest rates at its December 16 meeting or, if not then, early in 2016. ‘Ongoing gains in the labor market’ she said, ‘coupled with my judgement that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2%.’ This, as for many other central banks, is the target rate of inflation.
