In the current environment of low inflation and rising unemployment, the Federal Reserve Bank, the USA’s central bank, has amended its monetary targets. The new measures were announced by the Fed chair, Jay Powell, in a speech for the annual Jackson Hole central bankers’ symposium (this year conducted online on August 27 and 28). The symposium was an opportunity for central bankers to reflect on their responses to the coronavirus pandemic and to consider what changes might need to be made to their monetary policy targets and instruments.
The Fed’s previous targets
Previously, like most other central banks, the Fed had a long-run inflation target of 2%. It did, however, also seek to ‘maximise employment’. In practice, this meant seeking to achieve a ‘normal’ rate of unemployment, which the Fed regards as ranging from 3.5 to 4.7% with a median value of 4.1%. The description of its objectives stated that:
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.
The new targets
Under the new system, the Fed has softened its inflation target. It will still be 2% over the longer term, but it will be regarded as an average, rather than a firm target. The Fed will be willing to see inflation above 2% for longer than previously before raising interest rates if this is felt necessary for the economy to recover and to achieve its long-run potential economic growth rate. Fed chair, Jay Powell, in a speech on 27 August said:
Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.
Additionally, the Fed has increased its emphasis on employment. Instead of focusing on deviations from normal employment, the Fed will now focus on the shortfall of employment from its normal level and not be concerned if employment temporarily exceeds its normal level. As Powell said:
Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals
The Fed will also take account of the distribution of employment and pay more attention to achieving a strong labour market in low-income and disadvantaged communities. However, apart from the benefits to such communities from a generally strong labour market, it is not clear how the Fed could focus on disadvantaged communities through the instruments it has at its disposal – interest rate changes and quantitative easing.
Modern monetary theorists (see blog MMT – a Magic Money Tree or Modern Monetary Theory?) will welcome the changes, arguing that they will allow more aggressive expansion and higher government borrowing at ultra-low interest rates.
The problem for the Fed is that it is attempting to achieve more aggressive goals without having any more than the two monetary instruments it currently has – lowering interest rates and increasing money supply through asset purchases (quantitative easing). Interest rates are already near rock bottom and further quantitative easing may continue to inflate asset prices (such as share and property prices) without sufficiently stimulating aggregate demand. Changing targets without changing the means of achieving them is likely to be unsuccessful.
It remains to be seen whether the Fed will move to funding government borrowing directly, which could allow for a huge stimulus through infrastructure spending, or whether it will merely stick to using asset purchases as a way for introducing new money into the system.
- In landmark shift, Fed rewrites approach to inflation, labor market
Reuters, Jonnelle Marte, Ann Saphir and Howard Schneider (27/8/20)
- 5 Key Takeaways From Powell’s Jackson Hole Fed Speech
Bloomberg, Mohamed A. El-Erian (28/8/20)
- Fed adopts new strategy to allow higher inflation and welcome strong labor markets
Market Watch, Greg Robb (27/8/20)
- Fed to tolerate higher inflation in policy shift
Financial Times, James Politi and Colby Smith (27/8/20)
- Fed inflation shift raises questions about past rate rises
Financial Times, James Politi and Colby Smith (28/8/20)
- Dollar slides as bond market signals rising inflation angst
Financial Times, Adam Samson and Colby Smith (28/8/20)
- Wall Street shares rise after Fed announces soft approach to inflation
The Guardian, Larry Elliott (27/8/20)
- How the Fed Is Bringing an Inflation Debate to a Boil
Bloomberg, Ben Holland, Enda Curran, Vivien Lou Chen and Kyoungwha Kim (27/8/20)
- The live now, pay later economy comes at a heavy cost for us all
The Guardian, Phillip Inman (29/8/20)
- The world’s central banks are starting to experiment. But what comes next?
The Guardian, Adam Tooze (9/9/20)
- Find out how much asset purchases by the Fed, the Bank of England and the ECB have increased in the current rounds of quantitative easing.
- How do asset purchases affect narrow money, broad money and aggregate demand? Is there a fixed money multiplier effect between the narrow money increases and aggregate demand? Explain.
- Why did the dollar exchange rate fall following the announcement of the new measures by Jay Powell?
- The Governor of the Bank of England, Andrew Bailey, also gave a speech at the Jackson Hole symposium. How does the approach to money policy outlined by Bailey differ from that outlined by Jay Powell?
- What practical steps, if any, could a central bank take to improve the relative employment prospects of disadvantaged groups?
- Outline the arguments for and against central banks directly funding government expenditure through money creation.
- What longer-term problems are likely to arise from central banks pursuing ultra-low interest rates for an extended period of time?
Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.
When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.
The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).
But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?
In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).
But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.
Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).
But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.
A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.
If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.
There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.
- Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
- What determines the price elasticity of demand for shares?
- Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
- Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
- What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
- Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.
Is there a ‘magic money tree’? Is it desirable for central banks to create money to finance government deficits?
The standard thinking of conservative governments around the world is that creating money to finance deficits will be inflationary. Rather, governments should attempt to reduce deficits. This will reduce the problem of government expenditure crowding out private expenditure and reduce the burden placed on future generations of having to finance higher government debt.
If deficits rise because of government response to an emergency, such as supporting people and businesses during the Covid-19 pandemic, then, as soon as the problem begins to wane, governments should attempt to reduce the higher deficits by raising taxes or cutting government expenditure. This was the approach of many governments, including the Coalition and Conservative governments in the UK from 2010, as econommies began to recover from the 2007/8 financial crisis.
‘Modern Monetary Theory‘ challenges these arguments. Advocates of the theory support the use of higher deficits financed by monetary expansion if the money is spent on things that increase potential output as well as actual output. Examples include spending on R&D, education, infrastructure, health and housing.
Modern monetary theorists still accept that excess demand will lead to inflation. Governments should therefore avoid excessive deficits and central banks should avoid creating excessive amounts of money. But, they argue that inflation caused by excess demand has not been a problem for many years in most countries. Instead, we have a problem of too little investment and too little spending generally. There is plenty of scope, they maintain, for expanding demand. This, if carefully directed, can lead to productivity growth and an expansion of aggregate supply to match the rise in aggregate demand.
Government deficits, they argue, are not intrinsically bad. Government debt is someone else’s assets, whether in the form of government bonds, savings certificates, Treasury bills or other instruments. Provided the debt can be serviced at low interest rates, there is no problem for the government and the spending it generates can be managed to allow economies to function at near full capacity.
The following videos and articles look at modern monetary theory and assess its relevance. Not surprisingly, they differ in their support of the theory!
- Modern monetary theory: the rise of economists who say huge government debt is not a problem
The Conversation, John Whittaker (7/7/20)
- Modern Monetary Theory: How MMT is challenging the economic establishment
ABC News, Gareth Hutchens (20/7/20)
- What is Modern Monetary Theory and is it THE answer?
Sydney Morning Herald, Jessica Irvine (2/7/20)
- MMT: what is modern monetary theory and will it work?
MoneyWeek, Stuart Watkins (14/7/20)
- MMT: the magic money tree bears fruit
MoneyWeek, Stuart Watkins (17/7/20)
- Modern Monetary Theory is no Magic Money Tree
Adam Smith Institute, Matt Kilcoyne (20/5/20)
- “Modern Monetary Theory” Goes Mainstream
Forbes, Nathan Lewis (10/7/20)
- How Boris Johnson’s Conservatives have become Magic Money Tree huggers
The Scotsman, Bill Jamieson (16/7/20)
- Ignore the impacts of debt-fuelled stimulus at your peril
Livewire, David Rosenbloom (14/7/20)
- Modern Monetary Theory, explained
Vox.com, Dylan Matthews (16/4/19)
- Compare traditional Keynesian economics and modern monetary theory.
- Using the equation of exchange, MV = PY, what would a modern monetary theorist say about the effect of an expansion of M on the other variables?
- What is the role of fiscal policy in modern monetary theory?
- What evidence might suggest that money supply has been unduly restricted?
- When, according to modern monetary theory, is a rising government deficit (a) not a problem; (b) a problem?
- Is there any truth in the saying, ‘There’s no such thing as a magic money tree’?
- Provide a critique of modern monetary theory.
At its meeting on 6 May, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate at 0.1%. Due to the significant impact of COVID-19 and the measures put in place to try to contain the virus, the MPC voted unanimously to keep Bank Rate the same.
However, it decided not to launch a new stimulus programme, with the committee voting by a majority of 7-2 for the Bank to continue with the current programme of quantitative easing. This involves the purchase of £200 billion of government and sterling non-financial investment-grade corporate bonds, bringing the total stock of bonds held by the Bank to £645 billion.
The Bank forecast that the crisis will put the economy into its deepest recession in 300 years, with output plunging 30 per cent in the first half of the year.
Monetary policy and MPC
Monetary policy is the tool used by the UK’s central bank to influence how much money is in the economy and how much it costs to borrow. The Bank of England’s main monetary policy tools include setting the Bank Rate and quantitative easing (QE). Bank Rate is the interest rate charged to banks when they borrow money from the BoE. QE is the process of creating money digitally to buy corporate and government bonds.
The BoE’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target. Maintaining a low and stable inflation rate is good for the economy and it is the main monetary policy aim. However, the Bank also has to balance this target with the government’s other economic aims of sustaining growth and employment in the economy.
Actions taken by the MPC
It is challenging to respond to severe economic and financial disruption, with the UK economy looking unusually uncertain. Activity has fallen sharply since the beginning of the year and unemployment has risen markedly. The current rate of inflation, measured by the Consumer Price Index (CPI), declined to 1.5% in March and is likely to fall below 1% in the next few months. Household consumption has fallen by around 30% as consumer confidence has declined. Companies’ sales are expected to be around 45% lower than normal and business investment 50% lower.
In the current circumstances, and consistent with the MPC’s remit, monetary policy is aimed at supporting businesses and households through the crisis and limiting any lasting damage to the economy. The Bank has used both main monetary tools to fulfil its mandate and attempt to boost the economy amid the current lockdown. The Bank Rate was reduced to 0.1% in March, the lowest level in the Bank’s 325-year history and the current programme of QE was introduced in March.
What is next?
This extraordinary time has seen the outlook for the all global economies become uncertain. The long-term outcome will depend critically on the evolution of the pandemic, and how governments, households and businesses respond to it. The Bank of England has stated that businesses and households will need to borrow to get through this period and is encouraging banks and building societies to increase their lending. Britain’s banks are warned that if they try to stem losses by restricting lending, they will make the situation worse. The Bank believes that the banks are strong enough to keep lending, which will support the economy and limit losses to themselves.
In the short term, a bleak picture of the UK economy is suggested, with a halving in business investment, a near halving in business sales, a sharp rise in unemployment and households cutting their spending by a third. Despite its forecast that GDP could shrink by 14% for 2020, the Bank of England is forecasting a ‘V’ shaped recovery. In this scenario, the recovery in economic activity, once measures are softened, is predicted to be relatively rapid and inflation rises to around the 2 per cent target. However, this would be after a dip to 0.5% in 2021, before returning to the 2 per cent target the following year.
However, there are some suggestions that the Bank’s forecast for the long-term recovery is too optimistic. Yael Selfin, chief economist at KPMG UK, fears the UK economy could shrink even more sharply than the Bank of England has forecast.
Despite the stark numbers issued by the Bank of England today, additional pressure on the economy is likely. Some social distancing measures are likely to remain in place until we have a vaccine or an effective treatment for the virus, with people also remaining reluctant to socialise and spend. That means recovery is unlikely to start in earnest before sometime next year.
There are also additional factors that could dampen future productivity, such as the impact on supply chains, with ‘just-in-time’ operations potentially being a thing of the past.
There is also the ongoing issue of Brexit. This is a significant downside risk as the probability of a smooth transition to a comprehensive free-trade agreement with the EU in January is relatively small. This will only increase uncertainty for businesses along with the prospect of increased trade frictions next year.
The predictions from the Bank of England are based on many assumptions, one of which is that the economy will only be gradually released from lockdown. Its numbers contain the expectations that consumer and worker behaviour will change significantly, and continue for some time, with forms of voluntary social distancing. On the other hand, Mr Bailey expects the recovery to be much faster than seen with the financial crisis a decade ago. However, again this is based on the assumption that measures put in place from the public health side prevent a second wave of the virus.
It also assumes that the supply-side effects on the economy will be limited in the long run. Many economists disagree, arguing that the ‘scarring effects’ of the lockdown may be substantial. These include lower rates of investment, innovation and start ups and the deskilling effects on labour. They also include the businesses that have gone bankrupt and the dampening effect on consumer and business confidence. Finally, with a large increase in lending to tide firms over the crisis, many will face problems of debt, which will dampen investment.
The Bank of England does recognise these possible scarring effects. Specifically, it warns of the danger of a rise in equilibrium unemployment:
It is possible that the rise in unemployment could prove more persistent than embodied in the scenario, for example if companies are reluctant to hire until they are sure about the robustness of the recovery in demand. It is also possible that any rise in unemployment could lead to an increase in the long‑term equilibrium rate of unemployment. That might happen if the skills of the unemployed do not increase to the same extent as they would if they were working, for example, or even erode over time.
What is certain, however, is that the long-term picture will only become clearer when we start to come out of the crisis. Bailey implied that the Bank is taking a wait-and-see approach for now, waiting on the UK government to shed some light about easing of lockdown measures before taking any further action with regards to QE. The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target. Paul Dales, chief UK economist at Capital Economics, suggested that the central bank is signalling that ‘more QE is coming, if not in June, then in August’.
Bank of England publication
- How could the BoE use monetary policy to boost the economy?
- Explain how changes in interest rates affect aggregate demand.
- Define and explain quantitative easing (QE).
- How might QE help to stimulate economic growth?
- How is the pursuit of QE likely to affect the price of government bonds? Explain.
- Evaluate the extent to which monetary policy is able to stimulate the economy and achieve price stability.
The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.
The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.
Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.
With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.
Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.
Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.
Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.
Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.
While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.
How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.
- Coronavirus: Global growth ‘could halve’ if outbreak intensifies
BBC News (2/3/20)
- Coronavirus: Eight charts on how it has shaken economies
BBC News, Lora Jones, David Brown & Daniele Palumbo (4/3/20)
- The economic ravages of coronavirus
BBC News, Douglas Fraser (7/3/20)
- What Coronavirus Could Mean for the Global Economy
Harvard Business Review, Philipp Carlsson-Szlezak, Martin Reeves and Paul Swartz (3/3/20)
- Coronavirus escalation could cut global economic growth in half – OECD
The Guardian, Richard Partington and Phillip Inman (2/3/20)
- U.S. Fed Cuts Rates, There Are Still Strategies The ECB Can Follow
Forbes, Stephen Pope (3/3/20)
- A coronavirus recession could be supply-side with a 1970s flavour
The Guardian, Kenneth Rogoff (3/3/20)
- Coronavirus will wreak havoc on the US economy
CNN, Mark Zandi (3/3/20)
- UK factories feel the effects of coronavirus spread – PMI
Reuters, William Schomberg (2/3/20)
- The first economic modelling of coronavirus scenarios is grim for Australia, the world
The Conversation, Australia, Warwick McKibbin and Roshen Fernando (3/3/20)
- Extraordinary complacency: the coronavirus and emerging markets
Financial Times, Geoff Dennis (2/3/20)
- Coronavirus Economic Impact On Global Economy
Seeking Alpha, Mark Bern (1/3/20)
- OECD warns coronavirus could halve global growth
Financial Times, Chris Giles, Martin Arnold and Brendan Greeley (2/3/20)
- BoE’s Carney sees ‘powerful and timely’ global response to coronavirus
Reuters, David Milliken, Elizabeth Howcroft (3/3/20)
- Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
- Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
- What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
- What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
- Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
- What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
- What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
- Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.