On 14 December, the US Federal Reserve announced that its 10-person Federal Open Market Committee (FOMC) had unanimously decided to raise the Fed’s benchmark interest rate by 25 basis points to a range of between 0.5% and 0.75%. This is the first rise since this time last year, which was the first rise for nearly 10 years.
The reasons for the rise are two-fold. The first is that the US economy continues to grow quite strongly, with unemployment edging downwards and confidence edging upwards. Although the rate of inflation is currently still below the 2% target, the FOMC expects inflation to rise to the target by 2018, even with the rate rise. As the Fed’s press release states:
Inflation is expected to rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.
The second reason for the rate rise is the possible fiscal policy stance of the new Trump administration. 
If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
However, just how much and when the Fed will raise interest rates again is highly uncertain. Future monetary policy measures will only become more predictable when Trump’s policies and their likely effects become clearer.
Articles
US Federal Reserve raises interest rates and flags quicker pace of tightening in 2017 Independent, Ben Chu (14/12/16)
US Federal Reserve raises interest rates: what happens next? The Telegraph, Szu Ping Chan (15/12/16)
Holiday traditions: The Fed finally manages to lift rates in 2016 The Economist (14/12/16)
US raises key interest rate by 0.25% on strengthening economy BBC News (14/12/16)
Fed Raises Key Interest Rate, Citing Strengthening Economy The New York Times, Binyamin Appelbaum (14/12/16)
US dollar surges to 14-year high as Fed hints at three rate hikes in 2017 The Guardian, Martin Farrer and agencies (15/12/16)
Questions
- What determines the stance of US monetary policy?
- How does fiscal policy impact on market interest rates and monetary policy?
- What effect does a rise in interest rates have on exchange rates and the various parts of the balance of payments?
- What effect is a rise in US interest rates likely to have on other countries?
- What is meant by ‘forward guidance’ in the context of monetary policy? What are the benefits of providing forward guidance?
- What were the likely effects on the US stock market of the announcement by the FOMC?
- Following the FOMC announcement, two-year US Treasury bond yields rose to 1.231%, the highest since August 2009. Explain why.
- For what reason does the FOMC believe that the US economy is already expanding at roughly the maximum sustainable pace?
We’ve considered Keynesian economics and policy in several blogs. For example, a year ago in the post, What would Keynes say?, we looked at two articles arguing for Keynesian expansionary polices. More recently, in the blogs, End of the era of liquidity traps? and A risky dose of Keynesianism at the heart of Trumponomics, we looked at whether Donald Trump’s proposed policies are more Keynesian than his predecessor’s and at the opportunities and risks of such policies.
The article below, Larry Elliott updates the story by asking what Keynes would recommend today if he were alive. It also links to two other articles which add to the story.
Elliott asks his imaginary Keynes, for his analysis of the financial crisis of 2008 and of what has happened since. Keynes, he argues, would explain the crisis in terms of excessive borrowing, both private and public, and asset price bubbles. The bubbles then burst and people cut back on spending to claw down their debts.
Keynes, says Elliott, would approve of the initial response to the crisis: expansionary monetary policy (both lower interest rates and then quantitative easing) backed up by expansionary fiscal policy in 2009. But expansionary fiscal policies were short lived. Instead, austerity fiscal policies were adopted in an attempt to reduce public-sector deficits and, ultimately, public-sector debt. This slowed down the recovery and meant that much of the monetary expansion went into inflating the prices of assets, such as housing and shares, rather than in financing higher investment.
He also asks his imaginary Keynes what he’d recommend as the way forward today. Keynes outlines three alternatives to the current austerity policies, each involving expansionary fiscal policy:
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Trump’s policies of tax cuts combined with some increase in infrastructure spending. The problems with this are that there would be too little of the public infrastructure spending that the US economy needs and that the stimulus would be poorly focused. |
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Government taking advantage of exceptionally low interest rates to borrow to invest in infrastructure. “Governments could do this without alarming the markets, Keynes says, if they followed his teachings and borrowed solely to invest.” |
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Use money created through quantitative easing to finance public-sector investment in infrastructure and housing. “Building homes with QE makes sense; inflating house prices with QE does not.” (See the blogs, A flawed model of monetary policy and Global warning). |
Increased government spending on infrastructure has been recommended by international organisations, such as the OECD and the IMF (see OECD goes public and The world economic outlook – as seen by the IMF). With the rise in populism and worries about low economic growth throughout much of the developed world, perhaps Keynesian fiscal policy will become more popular with governments.
Article
Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)
Questions
- What are the main factors determining a country’s long-term rate of economic growth?
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all countries rather than being the only country to pursue such a policy?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- What determines the size of the multiplier effect of such policies?
- What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
In two recent speeches, the Governor of the Bank of England, Mark Carney, and the Bank’s Chief Economist, Andy Haldane, have reflected on the growing inequality in the UK and other countries. They have also answered criticisms that monetary policy has exacerbated the problem. As, Andy Haldane puts it:
It is clear monetary policy has played a material role in lifting all boats since the financial crisis broke. …[But] even if monetary policy has lifted all boats, and could plausibly do so again if needed, that does not mean it has done so equally. In particular, concerns have been expressed about the potential distributional effects of monetary policy.
Jan Vlieghe [member of the Monetary Policy Committee] has recently looked at how monetary policy may have affected the fortunes of, among others, savers, pension funds and pensioners. The empirical evidence does not suggest these cohorts have been disadvantaged to any significant degree by the monetary policy stance. For most members in each cohort, the boost to their asset portfolios and the improved wages and profits due to a stronger economy more than offset the direct loss of income from lower rates [of interest on savings accounts].
Andy Haldane’s speech focused largely on regional inequality. He argued that productivity has grown much more rapidly in the more prosperous regions, such as London and the South East. This has resulted in rising inequality in wages between different parts of the UK. Policies that focus on raising productivity in the less prosperous regions could play a major role in reducing income inequality.
Mark Carney’s speech echoed a lot of what Andy Haldane was saying. He argued that expansionary monetary policy has, according to Bank of England modelling, “raised the level of GDP by around 8% relative to trend and lowered unemployment by 4 percentage points at their peak”. And the benefits have been felt by virtually everyone. Even savers have generally gained:
That’s in part because, to a large extent, the thrifty saver and the rich asset holder are often one and the same. Just 2% of households have deposit holdings in excess of £5000, few other financial assets and don’t own a home.
But some people still gained more from monetary policy than others – enough to contribute to widening inequality.
Losers from the lost decade
Mark Carney looked beyond monetary policy and argued that the UK has experienced a ‘lost decade’, where real incomes today are little higher than 10 years ago – the first time this has happened for 150 years. This stalling of average real incomes has been accompanied by widening inequality between various groups, where a few have got a lot richer, especially the top 1%, and many have got poorer. Although the Gini coefficient has remained relatively constant in recent years, there has been a widening gap between the generations.
For both income and wealth, some of the most significant shifts have happened across generations. A typical millennial earned £8000 less during their twenties than their predecessors. Since 2007, those over 60 have seen their incomes rise at five times the rate of the population as a whole. Moreover, rising real house prices between the mid-1990s and the late 2000s have created a growing disparity between older home owners and younger renters.
This pattern has been repeated around the developed world and has led to disillusionment with globalisation and a rise in populism. 
Globalisation has been “associated with low wages, insecure employment, stateless corporations and striking inequalities”. (Click here for a PowerPoint of the chart.)
And populism has been reflected in the crisis in Greece, the Brexit vote, Donald Trump’s election, the rise of the National Front in France, the No vote in the Italian referendum on reforming the constitution and the rise in anti-establishment parties and sentiment generally. Mainstream parties are beginning to realise that concerns over globalisation, inequality and a sense of disempowerment must be addressed.
Solutions to inequality
As far as solutions are concerned, central must be a rise in general productivity that increases potential real income.
Boosting the determinants of long-run prosperity is the job of government’s structural, or supply-side policies. These government policies influence the economy’s investment in education and skills; its capacity for research and development; the quality of its core institutions, such as the rule of law; the effectiveness of its regulatory environment; the flexibility of its labour market; the intensity of competition; and its openness to trade and investment.
But will this supply-side approach be enough to bring both greater prosperity and greater equality? Will an openness to trade be accepted by populist politicians who blame globalisation and the unequal gains from international trade for the plight of the poor? Carney recognises the problem and argues that:
For the societies of free-trading, networked countries to prosper, they must first re-distribute some of the gains from trade and technology, and then re-skill and reconnect all of their citizens. By doing so, they can put individuals back in control.
For free trade to benefit all requires some redistribution. There are limits, of course, because of fiscal constraints at the macro level and the need to maintain incentives at the micro level. Fostering dependency on the state is no way to increase human agency, even though a safety net is needed to cushion shocks and smooth adjustment.
Redistribution and fairness also means turning back the tide of stateless corporations.
… Because technology and trade are constantly evolving and can lead to rapid shifts in production, the commitment to reskilling all workers must be continual.
In a job market subject to frequent, radical changes, people’s prospects depend on direct and creative engagement with global markets. Lifelong learning, ever-greening skills and cooperative training will become more important than ever.
But whether these prescriptions will be accepted by people across the developed world who feel that the capitalist system has failed them and who look to more radical solutions, whether from the left or the right, remains to be seen. And whether they will be adopted by governments is another question!
Webcast
Roscoe Lecture Bank of England on YouTube, Mark Carney (5/12/16)
Speeches
One Car, Two Car, Red Car, Blue Car Bank of England, Andrew Haldane (2/12/16)
The Spectre of Monetarism: Roscoe Lecture, Liverpool John Moores University Bank of England, Mark Carney (5/12/16)
Articles: Andrew Haldane speech
Bank of England chief economist says monetary stimulus stopped ‘left behind’ from drowning Independent, Ben Chu (2/12/16)
BoE’s Andrew Haldane warns of regional growth inequality BBC News (2/12/16)
‘Regions would have faced contraction’ without rate cuts and money printing Belfast Telegraph (2/12/16)
Bank of England chief: UK can be transformed if it copies progress on Teesside Gazette Live, Mike Hughes (2/12/16)
Articles: Mark Carney speech
Governor’s ‘dynamite’ warning on wages and globalisation Sky News, Ed Conway (6/12/16)
Mark Carney warns Britain is suffering first lost decade since 1860 as people across Europe lose trust in globalisation The Telegraph, Szu Ping Chan and Peter Foster (5/12/16)
Mark Carney: we must tackle isolation and detachment caused by globalisation The Guardian, Katie Allen (6/12/16)
Bank of England’s Carney warns of strains from globalization Reuters, William Schomberg and David Milliken (6/12/16)
CARNEY: Britain is in ‘the first lost decade since the 1860s’ Business Insider UK, Oscar Williams-Grut (7/12/16)
Carney warns about popular disillusion with capitalism BBC News (5/12/16)
Some fresh ideas to tackle social insecurity Guardian letters (7/12/16)
Report
Monitoring poverty and social exclusion 2016 (MPSE) Joseph Rowntree Foundation, Adam Tinson, Carla Ayrton, Karen Barker, Theo Barry Born, Hannah Aldridge and Peter Kenway (7/12/16)
Data
OECD Income Distribution Database (IDD): Gini, poverty, income, Methods and Concepts OECD
The effects of taxes and benefits on household income Statistical bulletins ONS
Questions
- Has monetary policy aggravated the problem of inequality? Explain.
- Comment on Charts 11a and 11b on page 19 of the Haldane speech.
- Does the process of globalisation help to reduce inequality or does it make it worse?
- If countries specialise in the production of goods in which they have a comparative advantage, does this encourage them to use more or less of relatively cheap factors of production? How does this impact on factor prices? How does this affect income distribution?
- How might smaller-scale firms “by-pass big corporates and engage in a form of artisanal globalisation; a revolution that could bring cottage industry full circle”?
- Why has regional inequality increased in the UK?
- What types of supply-side policy would help to reduce inequality?
- Explain the following statement from Mark Carney’s speech: “For free trade to benefit all requires some redistribution. There are limits, of course, because of fiscal constraints at the macro level and the need to maintain incentives at the micro level”.
- Mark Carney stated that “redistribution and fairness also means turning back the tide of stateless corporations”. How might this be done?
The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
Questions
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
The article below looks at the economy of Brazil. The statistics do not look good. Real output fell last year by 3.8% and this year it is expected to fall by another 3.3%. Inflation this year is expected to be 9.0% and unemployment 11.2%, with the government deficit expected to be 10.4% of GDP.
The article considers Keynesian economics in the light of the case of Brazil, which is suffering from declining potential supply, but excess demand. It compares Brazil with the case of most developed countries in the aftermath of the financial crisis. Here countries have suffered from a lack of demand, made worse by austerity policies, and only helped by expansionary monetary policy. But the effect of the monetary policy has generally been weak, as much of the extra money has been used to purchase assets rather than funding a growth in aggregate demand.
Different policy prescriptions are proposed in the article. For developed countries struggling to grow, the solution would seem to be expansionary fiscal policy, made easy to fund by lower interest rates. For Brazil, by contrast, the solution proposed is one of austerity. Fiscal policy should be tightened. As the article states:
Spending restraint might well prove painful for some members of Brazilian society. But hyperinflation and default are hardly a walk in the park for those struggling to get by. Generally speaking, austerity has been a misguided policy approach in recent years. But Brazil is a special case. For now, anyway.
The tight fiscal policies could be accompanied by supply-side policies aimed at reducing bureaucracy and inefficiency.
Article
Brazil and the new old normal: There is more than one kind of economic mess to be in The Economist, Free Exchange Economics (12/10/16)
Questions
- Explain what is meant by ‘crowding out’.
- What is meant by the ‘liquidity trap’? Why are many countries in the developed world currently in a liquidity trap?
- Why have central banks in the developed world found it difficult to stimulate growth with policies of quantitative easing?
- Under what circumstances would austerity policies be valuable in the developed world?
- Why is crowding out of fiscal policy unlikely to occur to any great extent in Europe, but is highly likely to occur in Brazil?
- What has happened to potential GDP in Brazil in the past couple of years?
- What is meant by the ‘terms of trade’? Why have Brazil’s terms of trade deteriorated?
- What sort of policies could the Brazilian government pursue to raise growth rates? Are these demand-side or supply-side policies?
- Should Brazil pursue austerity policies and, if so, what form should they take?
If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
