With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?
The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).
The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.
The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.
One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)
The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.
Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)
Questions
- Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
- Go through each of the methods and consider the problems they are likely to create/have created.
- How important is it that monetary policy measures affect people’s expectations?
- What effects do the measures have on the distribution of income between borrowers and savers?
- What are annuities? How are these affected by policies of monetary easing?
- How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
- Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
Inflation is a key macroeconomic variable and governments typically aim for both low and stable rates of inflation. In the UK there are two main measures of the rate of inflation in the UK – the CPI and the RPI. Over the past few years there has been a growing gap between the two measures and this has led to consultations about how the RPI could be adapted to allow it to rise more slowly in the future. (Click here for a PowerPoint of the chart.)
The RPI and CPI measure inflation in different ways – they don’t measure the same basket of goods. The RPI measure includes the costs of housing, whereas the CPI does not include this. Furthermore, the RPI is an arithmetic mean and the CPI is a geometric mean, which will be lower than the arithmetic mean. The ONS says that a key advantage of using the geometric mean (i.e. the CPI) is that:
…it can better reflect changes in consumer spending patterns relative to changes in the price of goods and services.
Typically the RPI has been about 1% higher than the CPI and governments can benefit from this by linking state benefits to the CPI (the lower rate) and payments they receive to the RPI, thus maximising the difference between earnings and expenditure.
However, the gap between these two measures of inflation has been growing and this has been causing concern for the ONS and the Office for Budget Responsibility (OBR). This has led to the consultative process regarding making changes to the RPI. However, any change made to the RPI would put certain groups at a disadvantage. One such group is pensioners – many pensioners in the private sector have their pensions linked to the RPI and if a change were made to bring it more in line with the CPI (i.e. lower it) they would suffer. Ros Altman, director general of SAGA said:
After 30 years of retirement, someone who receives 0.6% lower inflation uprating will end up with a pension nearly 20% lower…Therefore, over time, pensioners will be able to afford less and less and pensioner poverty will increase once again.
There would be some beneficiaries of any change to the RPI – the government would benefit in some areas; company pension schemes might also see gains made; some students might benefit and even rail travellers.
An announcement was made by the National Statistician, Jil Matheson, on the 10 January. Much to the surprise of most experts, she has decided to keep the RPI measure unchanged. She did recommend, however, that a new index be introduced that would be published alongside RPI and CPI. The new index would better meet international standards.
The following articles look at the arguments for and against changing the RPI measure.
Articles prior to announcement
Pensioner backlash expected over pension reform The Telegraph, Philip Aldrick (9/1/13)
Inflation: Changes to the calculation of RPI expected BBC News (9/1/13)
RPI review ‘may hit pensioners’ Express and Star (9/1/13)
Q&A: Inflation changes BBC News (9/1/13)
Pension holders and savers: beware of an RPI inflation change The Economic Voice (9/1/13)
Pensioners and savers face ‘stealth attack’ on their income from change to the inflation index Mail Online (9/1/13)
Articles following announcement
Relief for pensions as ONS says leave RPI unchanged The Telegraph (10/1/13)
RPI review recommends new inflation index The Guardian (10/1/13)
Inflation: No change to RPI calculation BBC News, 10/1/13)
The ONS puts consistency first BBC News, Stephanie Flanders (10/1/13)
Q&A: Inflation changes BBC News (10/1/13)
Announcement by National Statistician
National Statistician announces outcome of consultation on RPI ONS (10/1/13)
Questions
- How are the RPI and CPI measured?
- Why is the RPI typically higher than the CPI?
- What changes to the RPI were suggested? What are the advantages and disadvantages of each?
- Who would have benefited from each of the proposed changes to the RPI?
- Who would have suffered from each of the proposed changes to the RPI?
- Why has there been a growing divergence between the two measures of inflation?
- Do interest rates affect the RPI and CPI measures of inflation to the same extent?
- Which measure of inflation is used for the Bank of England’s inflation target? Has it always been the measure used?
Should the object of monetary policy be simply one of keeping inflation within a target range? In a speech given on 9 October, the Governor of the Bank of England, Sir Mervyn King, questioned whether the interest-rate setting policy of the Monetary Policy Committee (MPC) has been too narrow.
He considered whether interest rates should have been higher before the financial crisis and crash of 2007–9. This could have helped to reduce the asset price bubble and discouraged people from taking out excessive loans.
But then there is the question of the exchange rate. Would higher interest rates have pushed the exchange rate even higher, with damaging effects on exports? Today the trade weighted exchange rate is some 20% lower than before the crash. The government hopes that this will encourage a growth in exports and help to fuel recovery in demand. But as Dr King said, “The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time.”
Then there is the question of economic growth. Should a target rate of growth be part of the MPC’s target? Should the MPC adopt a form of Taylor rule which targets a weighted average of the inflation rate and the rate of economic growth?
Certainly monetary policy today in the UK and many other countries is very different from five years ago. With interest rates being close to zero, there is little scope for further reductions; after all, nominal rates cannot fall below zero, otherwise people would be paid for borrowing money! So the focus has shifted to the supply of money. Several attempts have been made to control the money supply through programmes of quantitative easing. Indeed many economists expect further rounds of quantitative easing in the coming months unless there is a substantial pick up in aggregate demand.
So what should be the targets of monetary policy? The following articles look at Dr King’s speech and at various alternatives to a simple inflation target.
Articles
Mervyn King says must face up to monetary policy’s limits’ Reuters, David Milliken and Sven Egenter (9/10/12)
Bank of England’s Mervyn King defends low interest rates pre-crisis The Telegraph, Emma Rowley (9/10/12)
Banks should have had a leverage cap before crash, says Mervyn King The Guardian, Heather Stewart and Phillip Inman (9/10/12)
King Says BOE Must Keep Targeting Inflation as Tool Revamp Looms Bloomberg, Scott Hamilton and Svenja O’Donnell (9/10/12)
After 20 years, time to change Merv’s medicine? Channel 4 News blogs, Faisal Silam (9/10/12)
King signals inflation not primary focus Financial Times, Norma Cohen and Sarah O’Connor (9/10/12)
Should Bank start the helicopter? BBC News, Stephanie Flanders (12/10/12)
Speech
Twenty years of inflation targeting Bank of England speeches, Mervyn King (9/10/12)
Questions
- What are the arguments for using monetary policy to target a particular rate of inflation?
- Would it ever be a good idea to adjust the targeted rate of inflation up or down and if so when and why?
- Explain how a Taylor rule would work and in what ways it is superior or inferior to pursuing a simple inflation target.
- Are attempts to control the money supply through quantitative easing (or tightening) consistent or inconsistent with pursuing an inflation target? Explain.
- What are the arguments for and against abandoning targeting in monetary policy and replacing it with discretionary policy that takes a number of different macroeconomic indicators into account?
With the UK and eurozone economies in recession and with business and consumer confidence low, the Bank of England and the ECB have sprung into action.
The ECB has cut its main refinancing rate from 1% to an all-time low of 0.75%. Meanwhile, the Bank of England has embarked on a further round of quantitative easing (QE). The MPC voted to inject a further £50 billion through its asset purchase scheme, bring the total to £375 billion since QE began in March 2009.
And it is not just in Europe that monetary policy is being eased. In Australia and China interest rates have been cut. In the USA, there have been further asset purchases by the Fed and it is expected that the Japanese central bank will cut rates very soon, along with those in Korea, Indonesia and Sri Lanka.
But with consumers seeming reluctant to spend and businesses being reluctant to invest, will the new money in the UK and elsewhere actually be lent and spent? Or will it simply sit in banks, boosting their liquidity base, but doing little if anything to boost aggregate demand?
And likewise in the eurozone, will a 25 basis point reduction in interest rates (i.e. a 0.25 percentage point reduction) do anything to boost borrowing and spending?
It is like pushing on a string – a term used by Keynesians to refer to the futile nature of monetary policy when people are reluctant to spend. Indeed the evidence over the past few years since QE started is that despite narrow money having risen massively, M4 lending has declined (see chart).
For a PowerPoint of the chart, click here.
The following articles look at the conundrum
Articles
Draghi-King Push May Mean Bigger Step Into Zero-Rate Era BloombergBusinessweek, Simon Kennedy (4/7/12)
QE and rate cut as central banks play stimulus card Independent, Ben Chu (6/7/12)
QE is welcome, but not enough Independent, Leader (6/7/12)
Interest rates cut to spur growth China Daily, Wang Xiaotian, Ding Qingfen and Gao Changxin (6/7/12)
Rate cuts shake global confidence Sydney Morning Herald, Eric Johnston, Clancy Yeates and Peter Cai (7/7/12)
Global Policy Easing Presses Asia to Cut Rates BloombergBusinessweek, Sharon Chen and Justina Lee (6/7/12)
Economic slowdown raises alarm in China, Europe Globe and Mail, Kevin Carmichael (5/7/12)
Bank of England sets sail with QE3 BBC News, Stephanie Flanders (5/7/12)
The twilight of the central banker The Economist (26/6/12)
The case for truly bold monetary policy Financial Times, Martin Wolf (28/6/12)
Questions
- Is the world economy in a liquidity trap?
- What advice would you give politicians around the world seeking to boost consumer and business confidence?
- Are we witnessing “The twilight of the central banker”? (See The Economist article above.)
- Explain the following extracts from the Martin Wolf article: “In a monetary system, based on fiat (or man-made) money, the state guarantees the money supply in the interests of the public. In normal times, however, actual supply is a byproduct of lending activities of banks. It is, in brief, the product of privately operated printing presses… In the last resort, the power to create money rests properly with the state. When private sector supply is diminishing, as now, the state not only can, but should, step in, with real urgency.”
- Should monetary policy in the UK be combined with fiscal policy in providing a stimulus at a time when the government can borrow ultra cheaply from the Bank of England? Does this apply to other governments around the world?
- Why did Asian share prices fall despite the stimulus?
Original post (24/4/12)
The result of the first round of the French presidential elections on 22 April make it likely that François Hollande will be the new president.
M. Hollande can be described as an austerity sceptic. In other words, he questions the wisdom of trying to meet the target agreed by eurozone countries of reducing public-sector deficits to no more than 3% of GDP.
If elected, M. Hollande promises to adopt a more Keynesian stance of stimulating demand in order to prevent a slide into recession. This would mean a reversal of cuts and a growth, at least temporarily, of the public-sector deficit.
Currently France’s deficit is much higher than the 3% target. In 2010 it was 7.1%; in 2011 it had fallen somewhat to 5.2%. But it is set to rise in 2012, thanks to the slowing economy in France and most of the rest of Europe.
And it is not just in France that ‘austerity sceptics’ are on the ascendant. In the Netherlands the centre right government of Mark Rutte fell. He was unable to get his coalition partners to agree to sufficient cuts to achieve the 3% target. And yet, the Netherland’s deficit is considerably lower than most eurozone countries’. In 2012 it is projected to be just 4.6% of GDP.
So if doubts about the 3% target could lead to a change in policy in the Netherlands and France, what hope is there that the targets could be adhered to by countries with much larger deficits and where the pain of the cuts is already causing political turmoil?
The growth in austerity scepticism has spooked the markets. The day following M. Hollande’s first round victory and the fall of Mark Rutte’s government, stock markets around Europe plummeted and bond prices rose. The higher bond prices will make it even harder for governments to refinance maturing government debt. Take the case of France. As Robert Peston remarks in his article below:
According to IMF figures, 59% of France’s government debt is held overseas – which means that well over half of all lending to the French state is not motivated by sentimentality or patriotism in any way.
To put that figure into context, just 24.8% of UK general government debt is provided by foreigners.
Perhaps more relevantly, the French government has to borrow a colossal sum equivalent to 18.2% of GDP this year and 19.5% next year to finance debt that is maturing and the current deficit.
So what are the implications of the rise in austerity scepticism? Will it make deficits harder to finance? Will a collapse of confidence push the eurozone into a deep recession. Might the eurozone break apart? Or will a dose of Keynesian policies turn the tide and allow growth to resume, making it easier to service government debts? The following articles explore the issues?
Update (7/5/12)
François Hollande was indeed elected president on 6 May. The question now is to what extent he will be able to enact measures to simulate the economy. In his campaign he had talked about renegotiating the European treaty on budget discipline. Angela Merkel, responding to M. Hollande’s victory, said that the European fiscal treaty had been agreed and could not be renegotiated. Nevertheless, she said she was happy to consider new growth strategies that did not involve increased budget deficits.
Articles
François Hollande’s potential spending spree in France has caused concern in austerity Europe The Telegraph, Bruno Waterfield (23/4/12)
European turmoil, American collateral Guardian, Robin Wells (24/4/12)
Political risk returns to eurozone debt crisis Financial Times, Richard Milne (23/4/12)
The rise of Europe’s austerity foes Business Spectator, Karen Maley (23/3/12)
Europe: A crisis of the centre BBC News, Paul Mason (24/4/12)
Is Hollande enemy or prisoner of finance? BBC News, Robert Peston (23/4/12)
President Hollande and the IMF BBC News, Stephanie Flanders (23/4/12)
French Bond Yields Test Hollande’s Economic Fealty Bloomberg, Mark Deen and Anchalee Worrachate (24/4/12)
Dutch and French politics bring us back to reality BusinessDay (South Africa), Ron Derby (24/4/12)
Crisis topples governments like dominos Deutsche Welle, Bernd Riegert (24/4/12)
Eurozone leaders push for growth BBC News (25/4/12)
Additonal articles (after 6 May)
Francois Hollande to set France on new course after win BBC News (7/5/12)
Europe elections: German Chancellor Angela Merkel welcomes Francois Hollande but warns Greece The Telegraph, 7/5/12)
A Merkel-Hollande bust-up? Less likely than you might think Guardian, Philip Oltermann (7/5/12)
Merkel Rejects Stimulus in Challenge to Hollande BloombergBusinessweek, Patrick Donahue and Tony Czuczka (7/5/12)
François Hollande’s chemistry with Angela Merkel crucial for Europe Guardian, Ian Traynor (7/5/12)
Q&A: End of austerity? BBC News (7/5/12)
Austerity and the people’s verdict Guardian letters, Shanti Chakravarty and others (8/5/12)
Europe: The big debate BBC News, Stephanie Flanders (11/5/12)
Data
European Economy: Economic data Economic and Financial Affairs, European Commission
Eurozone Statistics ECB
French Economic Statistics INSEE, National Institute of Statistics and Economic Studies
Netherlands Statistics CBS, Statistics Netherlands
Questions
- Why do investors worry about the pursuit of Keynesian expansionary fiscal policies? Are their fears justified?
- How important is it for countries, such as the Netherlands, to retain their AAA credit rating?
- What determines bond yields?
- Do a search to find the policies advocated by M. Hollande. Assess the likely economic impact of these policies.
- What conditions are necessary for the pursuit of a tough austerity line to achieve economic growth in (a) the short term of 12 to 18 months; (b) the longer term of several years?
- Is an increased use of public-private partnerships a solution to finding a way of delivering greater infrastructure expenditure without increasing the short-term deficit?
