Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.
Today’s world involves economies that are increasingly interdependent, hence the spread of the world economic slowdown. As such, with weak global demand, Australia has started to feel the effects, with demand for its goods and raw materials falling. This has led Australia’s central bank – the Reserve Bank of Australia – to cut its key interest rate (the ‘cash rate’) by more than expected. The rate had been at 4.25% and it was widely believed that a 0.25 percentage point cut would occur. However, the central bank cut the cash rate rate to 3.75% to counter the weakening conditions. The Reserve Bank said:
“This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated …Growth in the world economy slowed in the second half of 2011, and is likely to continue at a below-trend pace this year.”
Banks’ interest rates have been falling in Australia for the past few months and this latest cut will do much to help financially squeezed households. Data show that Australian house sales have fallen, as have house prices, and retail sales have fared little better.
Lower interest rates are often a tool used to steer inflation and the Australian central bank may not have been as willing to cut rates had the inflation rate not come down in recent months. Keeping consumer prices under control remains a top priority for the central bank and so it will be interesting to see the impact that these rate cuts will have on the Australian economy.
Articles
Australia cenbank surprises with aggressive half point rate cut Reuters, Wayne Cole (1/5/12)
Australia cuts rates by than forecast to 3.75% BBC News (1/5/12)
Banks unlikely to pass on full rate cut The Australian, Wall Street Journal, Peter Trute (1/5/12)
Australia cuts rate to support economy Financial Times, Neil Hume (1/5/12)
Australia slashes interest rates by 0.5pc to boost economy The Telegraph (1/5/12)
Australia cuts interest rates as economy slows Guardian, Phillip Inman (1/5/12)
Banks must pass on rate cut: businesses Sydney Morning Herald, Ehssan Veiszadeh (1/5/12)
Bond prices rally after rate cut Sydney Morning Herald (1/5/12)
Surplus remains appropriate: Swan Sydney Morning Herald, Colin Brinsden (1/5/12)
Webcasts
Reserve Bank of Australia Cuts Rates by 50 Basis Points to 3.75% CNBC video, Lauren Rosborough (1/5/12)
Further `Modest’ RBA Easing Possible, ANZ Says Bloomberg, Tony Morriss (1/5/12)
Australia’s central bank shifts focus to growth BBC News, Duncan Kennedy (1/5/12)
Questions
- Which factors will a central bank consider when setting interest rates?
- Explain the components of aggregate demand that will be affected by a lower rate of interest.
- Using diagrams to illustrate the process, explain both the interest-rate and the exchange-rate transmission mechanisms of the fall in interest rates.
- How are interest rates used to target inflation?
- How will lower rates of interest help the Australian economy recover from weakening global economic conditions?
- Why are Australia’s banks unlikely to pass on the full rate cut to consumers?
- Why did bond prices rise and the Australian dollar depreciate after the rate cut? Why does this suggest that a 0.5% cut was greater than anticpated by markets?
Between December 2007 and March 2009, the Bank of England reduced Bank Rate on several occasions in order to stimulate the economy and combat recession. By March 2009, the rate stood at a record low of 0.5%. Each month the Monetary Policy Committee meets to decide on interest rates and since March 2009, the members’ decision has consistently been that Bank Rate needs to remain at 0.5%.
Although the UK economy has been making tentative steps towards recovery, it is still in a very vulnerable state. Last month, the Bank of England extended its programme of quantitative easing to a total £325bn stimulus. This, together with the decision to keep interest rates down and with the shock fall in manufacturing output contributing towards first quarter growth of just 0.1%, is a key indication that the UK economy is still struggling, even though the central bank thinks it unlikely that the UK will re-enter recession this year.
Monetary policy in the UK has been very much geared towards stimulating economic growth, despite interest rates typically being the main tool to keep inflation on target at 2%. The problem facing the central bank is that economic growth and inflation are in something of a conflict. Low interest rates to stimulate economic growth also create a higher inflation environment and that is the trade-off the economy has faced. Inflation has been well above its target for some months (a high of 5.2% in September 2011), and the low interest rate environment has done little to deflate the figure. After all, low interest rates are a monetary instrument that can be used to boost aggregate demand, which can then create demand-pull inflation. However, inflation is now slowly beginning to fall, but this downward trend could be reversed with the sky high oil prices we are recently experiencing. If inflation does begin to creep back up, the Monetary Policy Committee will once again face a decision: keep Bank Rate low and continue with quantitative easing to stimulate the economy or increase Bank Rate to counter the higher rate of inflation.
The data over recent months has been truly inconsistent. Some indicators suggest improvements in the economy and the financial environment, whereas others indicate an economic situation that is moving very quickly in the wrong direction. A key factor is that the direction the UK economy takes is very much dependent on the world economy and, in particular, on how events in the eurozone unfold. The following articles consider some of the latest economic developments.
UK economy grew 0.1% to avoid recession, says NIESR Guardian, Katie Allen (5/4/12)
UK interest rates held at 0.5% BBC News (5/4/12)
UK just about avoided recession in Q1, NIESR says Telegraph, Angela Monaghan (5/4/12)
Bank of England keeps interest rates on hold at 0.5pc Telegraph (5/4/12)
UK economy ‘weak but showing signs of improvement’ BBC News (3/4/12)
Bank of England holds on quantitative easing and interest rates Guardian, Katie Allen (5/4/12)
Faith on Tories on economy hits new low Financial Times, Helen Warrell (6/4/12)
Questions
- Which factors will the Monetary Policy Committee consider when setting interest rates?
- Using a diagram to help your answer, illustrate and explain the trade-off that the MPC faces when choosing to keep interest rates low or raise them.
- What is quantitative easing? How is it expected to boost economic growth in the UK?
- Which factors are likely to have contributed towards the low growth rate the UK economy experienced in the first quarter of 2012?
- Explain the trends that we have seen in UK inflation over the past year. What factors have caused the figure to increase to a high in September and then fall back down?
- What do you expect to happen to inflation over the next few months? To what extent is your answer dependent on the MPC’s interest rate decisions?
- Although the official figures suggest that the UK avoided a double-dip recession, do you agree with this assessment? Explain your answer.
With the financial crisis came accusations towards the banking sector that they had taken on too many bad risks. Banks were lending money on more and more risky ventures and this in part led to the credit crunch. Since then, bank lending has fallen and banks have been less and less willing to take on risky investments.
Small businesses tend to fall (rightly or wrongly) into the category of high risk and it is this sector in particular that is finding itself struggling to make much needed investments. All businesses require loans for investments and improvements and if the banking sector is unable or unwilling to lend then these improvements cannot take place.
Quantitative easing has been a key response across the world to the credit crisis to encourage banks to begin lending to each other and to customers. A new government backed scheme worth £20bn aims to increase bank lending to small and medium sized enterprises (SMEs). By guaranteeing £20bn of the participating banks’ own borrowing, lenders will be able to borrow more cheaply than normal. As the banks (so far including Barclays, Santander, RBS and Lloyds Banking Group) can borrow at a cheaper rate, they will therefore be able to pass this on to the businesses they lend to. Under this National Loan Guarantee Scheme (NLGS), businesses will be able to borrow at interests rates that are 1 percentage point lower than those outside the scheme. £5bn will initially be made available with subsequent installments each of £5bn to come later.
With the Budget looming, the Chancellor is keen to show that the government is delivering on its promise to give smaller businesses access to finance at lower interest rates. If this initiative does indeed stimulate higher lending, it may be a much needed boost for the economy’s faltering economic growth. Criticisms have been leveled at the scheme, saying that although it is a step in the right direction, it can by no means be assumed that it will be sufficient to solve all the problems. In particular, the NLGS is unlikely to provide much help for those small businesses that can’t get finance in the first place, irrespective of the cost of the borrowing. Furthermore some banks, notably HSBC, have chosen not to participate in the scheme, due to it not being commercially viable. The overall effect of this scheme will take some time be seen, but if it is effective, it could give the economy and the small business sector a much needed boost.
Banks to join credit-easing scheme Associated Press (20/3/12)
Credit easing: small businesses to get £20bn of guaranteed cheap loans Telegraph, Harry Wilson (20/3/12)
Bank lending scheme targets small businesses BBC News (20/3/12)
Move over Merlin, credit easing has arrived Independent, Ben Chu (20/3/12)
Credit easing injects £20bn into small firms Sky News (20/3/12)
UK launches small firm loan scheme, critics want more Reuters, Fiona Shaikh (20/3/12)
Osborne’s big plan: £20bn for small businesses Independent, Andrew Grice and Ben Chu (20/3/12)
George Osborne launches new scheme to boost lending to businesses Guardian, Larry Elliott (20/3/12)
Questions
- What is credit easing? Has the government’s previous credit easing had the intended effect?
- Why are small and medium sized enterprises normally seen as risky investments?
- Briefly explain the thinking behind this National Loan Guarantee Scheme.
- What are the criticisms currently levelled at this scheme? To what extent are they justified?
- Why has HSBC said that the scheme is not commercially viable for the bank?
- Explain why this scheme could provide a stimulus to the UK economy.
When governments run deficits, these must be financed by borrowing. The main form of borrowing is government bonds. To persuade people (mainly private-sector institutions, such as pension funds) to buy these bonds, an interest rate must be offered. Bonds are issued for a fixed period of time and at maturity are paid back at face value to the holders. Thus new bonds are issued not just to cover current deficits but also to replace bonds that are maturing. The shorter the average term on existing government bonds, the greater the amount of bonds that will need replacing in any one year.
In normal times, bonds are seen as a totally safe asset to hold. On maturity, the government would buy back the bond from the current holder at the full face value.
In normal times, interest rates on new bonds reflect market interest rates with no added risk premium. The interest rate (or ‘coupon’) on a bond is fixed with respect to its face value for the life of the bond. In other words, a bond with a face value of £100 and an annual payment to the holder of £6 would be paying an interest rate of 6% on the face value.
As far as existing bonds are concerned, these can be sold on the secondary market and the price at which they are sold reflects current interest rates. If, for example, the current interest rate falls to 3%, then the market price of a £100 bond with a 6% coupon will rise to £200, since £6 per year on £200 is 3% – the current market rate of interest. The annual return on the current market price is known as the ‘yield’ (3% in our example). The yield will reflect current market rates of interest.
These, however, are not ‘normal’ times. Bonds issued by many countries are no longer seen as a totally safe form of investment.
Over the past few months, worries have grown about the sustainability of the debts of many eurozone countries. Bailouts have had to be granted to Greece, Ireland and Portugal; in return they have been required to adopt tough austerity measures; the European bailout fund is being increased; various European banks are having to increase their capital to shield them against possible losses from haircuts and defaults (see Saving the eurozone? Saving the world? (Part B)). But the key worry at present is what is happening to bond markets.
Bond yields for those countries deemed to be at risk of default have been rising dramatically. Italian bond yields are now over 7% – the rate generally considered to be unsustainable. And it’s not just Italy. Bond rates have been rising across the eurozone, even for the bonds of countries previously considered totally safe, such as Germany and Austria. And the effect is self reinforcing. As the interest rates on new bonds are driven up by the market, so this is taken as a sign of the countries’ weakness and hence investors require even higher rates to persuade them to buy more bonds, further undermining confidence and further driving up rates.
So what is to be done? Well, part of the problem is that the eurozone does not issue eurobonds. There is a single currency, but no single fiscal policy. There have thus been calls for the eurozone to issue eurobonds. These, it is argued would be much easier to sell on the market. What is more, the ECB could then buy up such bonds as necessary as part of a quantitative easing programme. At present the ECB does not act as lender of last resort to governments; at most it has been buying up some existing bonds of Italy, Spain, etc. in the secondary markets in an attempt to dampen interest rate rises.
The articles below examine some of the proposals.
What is clear is that politicians all over the world are trying to do things that will appease the bond market. They are increasingly feeling that their hands are tied: that they mustn’t do anything that will spook the markets.
Articles
Bond market hammers Italy, Spain ponders outside help Reuters, Barry Moody and Elisabeth O’Leary (25/11/11)
German Bonds Fall Prey to Contagion; Italian, Spanish Debt Drops Bloomberg Businessweek, Paul Dobson and Anchalee Worrachate (26/11/11)
Rates on Italian bonds soar, raising fears of contagion Deutsche Welle, Spencer Kimball (25/11/11)
Brussels unveils euro bond plans Euronews (23/11/11)
Germany faces more pressure to back eurobonds Euronews on YouTube (24/11/11)
Bond markets Q&A: will the moneymen hit the panic button? Guardian, Jill Treanor and Patrick Collinson (7/11/11)
Why we all get burnt in the bonfire of the bond markets Observer, Heather Stewart, Simon Goodley and Katie Allen (20/11/11)
Retaining the confidence of the bond market is the key to Britain’s success in the EU treaty renegotiations The Telegraph, Toby Young (19/11/11)
Boom-year debts could bust us BBC News, Robert Peston (25/11/11)
UK’s debts ‘biggest in the world’ BBC News, Robert Peston (21/11/11)
Markets and the euro ‘end game’ BBC News, Stephanie Flanders (24/11/11)
The tricky path toward greater fiscal integration The Economist, H.G. (27/10/11)
The tricky path toward greater fiscal integration, take two The Economist, H.G. (23/11/11) and Comments by muellbauer
Data
European Economy, Statistical Annex Economic and Financial Affairs DG (Autumn 2011) (see Tables 76–78)
Monthly Bulletin ECB (November 2011) (see section 2.4)
Bonds and rates Financial Times
UK Gilt Market UK Debt Management Office
Questions
- Explain the relationship between bond yields and (a) bond prices; (b) interest rates generally.
- Using the data sources above, find the current deficit and debt levels of Italy, Spain, Germany, the UK, the USA and Japan. How do eurozone debts and deficits compare with those of other developed countries?
- Explain the various proposals considered in the articles for issuing eurobonds.
- To what extent do the proposals involve a moral hazard and how could eurobond schemes be designed to minimise this problem?
- Examine German objections to the issue of eurobonds.
- Does the global power of bond markets prevent countries (including non-eurozone ones, such as the UK and USA) from using fiscal policy to avert the slide back into recession?
The Brazilian economy is an emerging superpower (see A tale of two cities), but even its growth slowed in the second quarter of the year, although the economy still appears to be growing above capacity. In reaction to that latest economic data, the central bank slashed interest rates by 50 basis points to 12%. The Central Bank said:
‘Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed up, for example, by large and widespread reductions to the growth forecasts of the main economic regions.’
Rates had previously been hiked up 5 times in the year to tackle rising inflation, which has been some way above its inflation target. Such tightening policies have become commonplace in many emerging economies to prevent overheating. However, following this reversal of policy, questions have been raised about the independence of the central bank, as some politicians have recently been calling for a cut in rates, including President Rousseff himself. As Tony Volpon at Nomura Securities said:
‘They gave in to political pressure. The costs will likely be much higher inflation and a deterioration of central bank credibility…It has damaged the inflation-targeting regime.’
Many believe the rate cut is premature and the last thing the economy needs given the inflationary pressures it’s been facing. Huge spending cuts have been announced to bring inflation back under control, together with the previous rate rises, so this cut in interest rates to stimulate growth is likely to put more pressure on costs and prices. Only time will tell exactly how effective or problematic this new direction of monetary policy will be.
Brazil’s growth slows despite resilient consumers Reuters, Brian Ellsworth and Brad Haynes (2/9/11)
Brail in surprise interest rate cut to 12% BBC News (1/9/11)
Rousseffl’s ‘Risky’ rate cut means boosting Brazil GDP outweighs inflation Bloomberg, Arnaldo Galvao and Alexander Ragir (2/9/11)
Brazil makes unexpected interest rate cut Financial Times, Samantha Pearson (1/9/11)
Brazil rate cut stirs inflation, political concerns Reuters (1/9/11)
Questions
- What is the relationship between the macroeconomic objectives of inflation and economic growth?
- Why are there concerns that the recent reduction in the interest rate may worsen inflation? Do you think that a decision has been made to sacrifice Brazil’s inflation-targeting regime to protect its economic growth?
- Why are there questions over the independence of the central bank and how will this affect its credibility? What are the arguments for central bank independence?
- Growth in Brazil, although lower this year, still remains very strong. Why has the Brazilian economy been able to continue its strong growth, despite worsening economic conditions worldwide?
- What type of inflation are emerging economies experiencing? Explain how continuous hikes in interest rates have aimed to bring it back under control.
- What is meant by overheating? How will the central bank’s past and current policies contribute towards it?
Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.
