Lower Interest Rates – what should be happening?

With near zero interest rates in the US and the promise of them to remain until 2015 those that are living off the interest on savings, mainly the retired, are finding their incomes squeezed. According to The Economist personal interest income has plummeted by 30% which equates to a $432bn annually and more than 4% of disposable income. Former IMF chief economist Raghuram Rajan describes the Fed’s policy as:

“expropriating responsible savers in favour of irresponsible banks”

How should lower interest rates work according to the textbook?

However today it seems that even with these really low interest rates businesses and consumers don’t want to borrow or cannot qualify due to the more stringent requirements required. Furthermore with less consumption in the circular flow you would think that there is less need to fuel anymore investment spending.

AS & A2 – Global and New Zealand Update for November exams

It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.

Indicators that you might want to mention are as follows:

The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.

The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.

QE3 and ECB bond purchase is not the elixir for recovery – Stiglitz

Nobel Laureate Joseph Stiglitz came out strongly against the recent QE3 by the US Fed and the ECB’s announcement that it would buy government bonds of indebted eurozone member countries. With this announcement stock prices in the US reached post-recession highs although some worried about future inflation and significant government spending. According to Stiglitz these concerns are unwarranted as there is so much underutilisation and no serious risk of inflation. But the US Fed and the ECB sent three clear messages:

1. Previous actions didn’t work – ie QE1 and 2
2. The US Fed announcement that it will keep rates low until 2015 and buy $40bn worth of mortgage backed securities suggested the recovery is not going to take place soon.
3. The Fed and the ECB are saying that the markets won’t restore full employment soon – fiscal stimulus is needed.

In textbook economics increased liquidity means more lending, mostly to investors thereby shifting the AD curve to the right and thereby increasing demand and employment. But if you consider Spain an increase in liquidity will be cancelled out by an austerity package.

For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending. Joseph Stiglitz

New Zealand Dollar in September

Here is a great graphic from the BNZ showing how the NZ dollar performed in September. You could say that it strengthened on the back of notably QE3 from the US Fed and the improving global growth sentiment. Furthermore the NZ economy has performed well under trying circumstances.

June quarter GDP accounts revealed the NZ economy finished Q2 1.6% bigger than where it began the year. That is solid economic growth under ordinary circumstances. But given the ongoing challenging and uncertain global economic environment we should not under sell this achievement. It is the strongest six month expansion we have seen in the past five years. Source: BNZ

WSJ Graphic – Federal Reserve Stimulus And Its Impact On Yields

Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index

Click WSJ Interactive Graphic to go to the page.

Bernanke turns on the taps once again – NZ$ on the rise

It is the US Fed’s intention to buy volumes of mortgage backed securities and keep borrowing rates at near zero (0-0.25%) until the job market and broader economy pick up. Basically they are going to print money until there is some improvement in unemployment figures. Unemployment is at 8.1% and the Fed estimate that it will fall no lower than 7.6% in 2013 and 6.7 in 2014. Inflation is forecast to remain at or below 2% until 2015.

How does it work?
The Fed will buy $40 billion a month in mortgages and will keep doing this until unemployment starts to fall. This will have a couple of effects:

1. It might lower mortgages rates by another 0.25% (already quite low). The 30-year mortgage rate is 3.5% and could go down to 3.25%
2. When mortgage rates go down, the price of houses tends to go up which is beneficial even if you are not refinancing a mortgage
3. Investors tend to move out of low interest earning investments and put their money into stocks. The DJIA closed up more than 200 points and was 625 points off its all-time high.

Impact on NZ$
With the flood of US$ into the market this has put downward pressure on the US$ which will make its export market more competitive and imports more expensive. However risk currencies like the NZ$ and AUS$ have rallied. Looking at the NZ$, this has appreciated considerably against the US$ and will make NZ exports more expensive and NZ imports cheaper. This will not only hurt the export industry as the price of goods become more expensive but the domestic sector have now got to compete with cheaper imports. The NZ$ reached US$0.84 yesterday.

Stimulus doesn’t get unemployment figures down

Here is an interesting graph from the Economist “Free Exchange” column. What the article states is that all these stimulus actions haven’t led to any sort of growth but higher levels of unemployment – see graph.

There has been many research papers as to why this has happened. Here are some of the findings from them:

1. One school of thought is that a high unemployment rate is structural and immune to the stimulative effects of monetary policy.

2. That the US Fed commit to keeping policy easy until the economy reaches a particular target, such as nominal GDP (ie, output unadjusted for inflation) returning to its pre-recession path.

3. The Bank of England is doing by providing subsidised credit to banks that lend more.

4. Monetary easing usually works by encouraging businesses and households to move future consumption and investment forward to today. But it also has “redistributive” effects. For example, low short-term interest rates redistribute income from depositors to banks, which allows them to rebuild capital and encourages them to lend more.

5. Raising banks’ profits has not done much to restart demand because the real problem is that indebted households cannot or will not borrow. There is evidence that retail spending and car sales have been weaker in states that entered the recession with higher household debt.

With the Fed now looking at QE3 and the ECB discussing a resumption in purchases of bonds of peripheral euro-zone members one wonders if “more of the same” will have any impact on unemployment.

Every Breath You Take – Every Change of Rate (Fed Funds Rate)

Here is a really funny video by the students of Columbia Business School (CBS) – you may have seen it before but I find it very useful when you start teaching monetary policy and interest rates.

Back in 2006 Alan Greenspan vacated the role of chairman of the US Federal Reserve and the two main candidates for the job were Ben Bernanke and Glenn Hubbard. Glen Hubbard was (and still is) the Dean at Columbia Business School and was no doubt disappointed about losing out to Ben Bernanke. His students obviously felt a certain amount of sympathy for him and used the song “Every Breath You Take” by The Police to voice their opinion as to who should have got the job. They have altered the lyrics and the lead singer plays Glenn Hubbard.

Some significant economic words in it are: – interest rates, stagflate, inflate, bps, jobs, growth etc.

WSJ Graphic – Central Bank Interest Rates

If you are teaching monetary policy in any course the graphic below shows a significant expansionary monetary policy. Remember in New Zealand the RBNZ changes interest rates to influence the level of economic activity in order to achieve price stability. Note the following:

• Implementation of monetary policy is one of the roles of the RBNZ
• The Reserve Bank Act established “price stability” as the main objective of the RBNZ. The RBNZ is therefore responsible for achieving “price stability”
• “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (measured by the percentage change in CPI)

In order to stimulate the economy the ECB cut benchmark interest rates to 0.75%. Chinese authorities cut one year yuan lending rate to 6% (still has ammunition left). The Bank of England reduced rates to 0.5%. This is in the hope that businesses will use the cheaper sources of credit to invest in their business and therefore create jobs. Lower rates would also ease the burden of those on floating interest rates.

Central Bank Policy Rates – China cuts for first time since GFC

The Chinese authorities have cut interest rates for the time since the Global Financial Crisis (GFC). One year lending and deposit rates were cut by 0.25%.

Lending rate – 6.31%
Deposit rate – 3.25%

Although this should encourage spending with an increase in the money velocity in the circular flow some commentators are concerned that the Chinese authorities know something about their economy that the rest of world is in the dark about.

It is interesting to see the reaction of main central banks in the aftermath of the GFC and how aggressive they were in cutting rates – US, EU, UK – relative to the other countries on the graph, namely China, India and Australia. Furthermore notice that some economies seem to have been at a different part of the economic cycle namely Australia, India, and the EU as their central bank rates have risen in order to slow the economy down. This is especially in India as they have had strong contractionary measures in place but have now started to ease off on the cost of borrowing.

Indian growth has slowed to 5.3% this year and although this seems very healthy it is the lowest level in 7 years. A developing nation like this needs higher levels of growth to create the jobs for their vast working age population and without employment there could be a situation not unliike that of Spain where over 50% of those under 25 don’t have a job. The main cause of the slowdown seems to be from a lack of private investment.

Also look how low rates are in the US, UK, and EU. With little growth in these economies the policy instrument of lower interest rates has been ineffective and they are in a liquidity trap. Increases or decreases in the supply of money do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Professor Bernanke v Chairman Bernanke

In a recent edition of The New York Times magazine Paul Krugman wrote an article discussing the role of Ben Bernanke as an academic versus that of being the Fed Chairman.

When the financial crisis happened in 2008 it seemed that there could be no better person to be Fed Chairman. Having studied the Great Depression and written various academic papers on this and the crisis in Japan in 1990’s economists felt that Bernanke was the man for the job. Although the Fed has done a lot to rescue the financial system there is still major concerns about the labour market and the rising long-term rate of unemployment. Remember that the Fed has a dual mandate of Price Stability and Maximum Employment. In order to stimulate growth in the economy, especially when inflation is low, central banks lower interest rates but when the Fed Funds Rate reached 0 – 0.25% on the 16th December 2008 they basically ran out of ammunition as rates couldn’t go any lower. Here you tend to get stuck in what we call a “liquidity trap” in that monetary policy is no longer effective. When Japan was going through very slow growth in the 1990‘s, in which it experienced deflation, Professor Bernanke stated that Japanese policy makers should be a lot more active in trying to stimulate growth and inflation. With interest rates already at 0% he suggested that monetary authorities were not proactive enough to experiment with other policies even though they might have been radical. This all harks back to the days of FDR (Franklin D Roosevelt) in which he created work schemes, infrastructure projects etc, in order to boost employment. I have summarised Paul Krugman’s article below in a table format which shows Bernanke policies for the US economy as a Professor v Chairman.

So why hasn’t he taken on the role of the Academic Bernanke? Krugman suggests that:

this is the effect of bullies and the Fed Borg*, a combination of political intimidation and the desire to make life easy for the Fed as an institution. Whatever the mix of these motives the result is clear: faced with an economy still in desperate need of help, the Fed is unwilling to provide that help. And that, unfortunately, make the Fed part of the broader problem.

*Krugman is a keen “Star Trek” fan and compares the Federal Reserve to a Borg — a race of beings that act based on the wishes of a hive mind, and present major threats to the Starfleet and the Federation.

US income gains since 1979

Here is an interesting graph from Paul Solman of PBS. The top earners in the US have disproportionately been rewarded from the last 30 years of right wing free-market policies – starting in the early 1980′s with the ideologies of UK Prime Minister Margaret Thatcher and US President Ronald Reagan. However the significant increase from 2002 can in part be due to deregulation of financial markets and a very loose monetary policy by the US Fed. Also, in 1999 the Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits – the Glass Stegal Act of 1933. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks.

Global Interest Rates – 2004 – 2012

Here is a useful interactive from the WSJ. As the global economy slowly starts to recover from a major slowdown, the WSJ has put together a great interactive that shows which countries have been implementing an exansionary or contractionary monetary policies. Red = rates up Green = rates down. Start at 2004 and see rates change up to 2012. Click here to go to the WSJ interactice.

What has the 1930′s Depression got in common with today’s crisis?

Got the link to this clip from Geoff Riley at Tutor2u. Paul Mason, Economics Editor of the BBC 2 ‘Newsnight’ programme looks at the similarities between the Depression of the 1930′s and the current economic crisis. The sailient features he talks about are:

1. Credit-fueled bubbles.
2. Government interventionist policies.
3. Wall Street the epicentre of the financial contraction
4. Cross border banking crisis
5. Social unrest
6. Countries reneging on their debts
7. Breakdown of an international currency system.

Updated figures on NZ economy – useful for AS & A2 essay questions

When examiners mark essays they always like you to mention the current state of economic indicators in your economy. Below are the figures for the NZ economy as of 7th November from the Parliamentary Library.

Below shows the key rates of the the world’s central banks.

Bernanke needs to follow Volcker

US Fed Chairman Ben Bernanke could really take a leaf out of former US Fed Chairman Paul Volcker’s book. In the 1970‘s the US economy was going through a period of stagflation – high unemployment and high inflation (both over 10%). Volcker believed that inflation was one of the worst of all economic evils and that it hinged on the growth of the money supply. He therefore began to target inflation which in turn would break people’s inflationary expectations. With this in mind he tightened the money supply and the prime interest rate reached 21.5% – the economy went into a nosedive. However the policy worked and inflation fell from 11% in 1979 to 3% in 1983 and subsequently with this lower inflation rate unemployment fell to 5.3% by 1989.

Today the US economy has 2.6% inflation and 9.6% unemployment and the current Fed policy, like that used in the pre-Volcker era, doesn’t seem to be working. According to Professor Christina Romer in the New York Times, Bernanke needs to be like Volcker and set a new policy framework which, this time, targets nominal gross domestic product which in turn would favour job creation. In the US normal output growth is around 2.5% and the inflation around the 2% so a target of 4.5% GDP would seem appropriate. How Professor Romer would see it operate would be like this:

The Fed would start from some normal year — like 2007 — and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap.

How would this help to heal the economy? Like the Volcker money target, it would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth.

The expected increase in inflation would effect inflationary expectations but a small increase in inflation would be beneficial as it would lower borrowing costs and encourage spending a large budgetary items.

Even if we went through a time of slightly elevated inflation, the Fed shouldn’t lose credibility as a guardian of price stability. That’s because once the economy returned to the target path, Fed policy — a commitment to ensuring nominal G.D.P. growth of 4 1/2 percent — would restrain inflation. Assuming normal real growth, the implied inflation target would be 2 percent — just what it is today.

Other policies within the framework include:

Quantitative Easing – printing more money
Lower the US$ – makes exports more competitive

Would this work today to reduce unemployment? I suppose the US Fed are currently running out of policy options and like Volcker in the 1980’s there needs to be a quiet revolution in the Fed’s thinking. I don’t mean the shock therapy used in Latin American countries but a realigning of the objectives of ecoomic policy. It seems that the bold measures of Volcker in 1980’s and Roosevelt in the 1930’s actaully brought the US economy out of its depressed state but in both periods of time the process involved a lot hardship and protest. I just wonder if the US Fed is prepared to go through this pain again? As President Reagan said about the recession the US economy was about to go through in the 1980’s -

“If not now, when? If not us, who?”

However The Economist has a different point of view with regard to targeting nominal gross domestic product – NGDP.

Asking central banks to ditch inflation targeting and to pursue another goal could do more harm than good particularly if it left people less certain about the central bank’s ultimate commitment to prudence and stability. That is why a switch to NGDP targeting, whatever its virtues, should not be undertaken lightly.

Data backs up OWS claims

Here is a great graphic from the Economic Policy Institute in the US. The Occupy Wall Street protesters claims are backed up when you look at the graph below. Data is inflation-adjusted.

1979-2007:
Bottom 90% of households saw a 5% increase in income
Top 1% of households saw a 224% increase in income
Top 0.1% of households saw a 390% increse in income

The major increases happened during the Clinton Administration especially with the repeal of the Glass Stegal Act in 1997 – 0.1% and 1% incomes increased dramatically after this period. The drop in the % increase was no doubt due to the Dot Com collapse but picked up considerably with an aggressive expansionary policy from the US Fed after 9/11.

Do we have anything like this in NZ?
NZIER economist Shamubeel Eaqub stated that the wage income gap between high and low income has been broadly stable over the past decade and there is nothing in the figures to suggest massive increases in inequality or inequity.

Do Central Banks need to reinvent policy?

To some the role of central banks was of prime importance in the financial crisis and the substantial increases in the incomes of those employed in the financial sector.

Since the days of stagflation in the US and UK in the 1970’s inflation has been the number one target for central bankers. US President Jimmy Carter’s attempts to follow Keynes’s formula and spend his way out of trouble were going nowhere and the newly appointed Paul Volcker (US Fed Governor in the 1970’s) saw inflation as the worst of all economic evils. Below is an extract of an interview from the PBS series “Commanding Heights”

“It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon.”

The policy of the time was Keynesian – inject more money into the system in order to get the economy moving again. This was also the case in the UK in the early 1970’s but Jim Callaghan’s (Labour PM in the UK ousted by Thatcher in 1979) speech in 1976 had reluctantly recognised that this policy had run its course and a monetarist doctrine was about to become prevalent. Below is an extract from the speech.

“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment. That is the history of the last twenty years”

With this paranoia about inflation central bankers began to implement a monetary policy targeting inflation in the medium term. In NZ the Reserve Bank Act 1989 established “price stability” as the main objective of the RBNZ. “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (originally 0-2%) – measured by the percentage change in CPI. Around the world central banks were adopting a more independent approach to policy implementation and with targeting inflation a new prevailing attitude seemed to be like an osmosis and suggesting that low prices = macro-economic stability as well. Also, raising interest rates is an unpopular political move and governments could now blame the central bank for this contractionary measure.

However, the rise of asset prices were largely ignored by central banks and although inflation remained relatively stable, this was in part due to the disinflation of the emerging markets that were now becoming more a part of the global market. Therefore with low inflation, central banks could afford to lower interest rates and ultimately stimulate a lot of borrowing which increased asset prices. The Rethinking Central Banking report (written by a group of economists, financiers and policy makers) recommend an “international monetary policy committee” which can look at the bigger picture in the global economy.

According to Jeremy Warner in the Daily Telegraph:

The bottom line is that central banks need to be much more open about precisely what their objectives are, mindful of the international implications of what they do, and clear about what circumstances would trigger particular courses of action.

NZ dollar on the slide

Source:BNZ

With the downgrade of the at the end of September the NZD/USD will remain volatile and the BNZ reckon that the price range for the NZ$ will remain between 0.7608-0.8573.

Standard & Poors – long-term foreign-currency credit rating – from AA+ to AA
Fitch – long-term foreign-currency credit rating – from AA+ to AA
Mooody’s – long-term foreign-currency credit rating – remains at Aaa

What is affecting the NZ$?
* concerns about European Sovereign Debt
* Decline in dairy prices – although a weaker NZ$ against the US$ can actually increase prices in NZ$ terms (milk powder is traded in US$).
* Investors now moving to the safe haven of US Treasuries – Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are few alternative safe-haven assets out there that can match the depth and liquidity of the Treasury market

However with still relatively higher interest rates than most other developed nations (see table) there is the chance that the NZ$ will appreciate. Today the Reserve Bank of Australia (RBA) held its target cash rate at 4.75% as current global economic conditions have put the brakes on growth and inflation.

European Central Bank – hit them when they’re down?

With the CIE and NCEA exam fast approaching there is usually a question that refers to economic policy in economies. Monetary and Fiscal Policy are two that are covered in significant detail and you will be aware of the following:

Monetary Policy - the way in which interest rates and money supply are used to manage the overall level of economic activity and achieve government targets for inflation, unemployment, economic growth and balance of payments.

Fiscal Policy – the use taxes and spending by the government to manipulate aggregate demand and influence the overall economic activity in the economy.

It is puzzling to observe the implementation of monetary policy by the European Central Bank when you consider the correlation between the interest rates movements and the economic environment in the euro area. I have put together a flow diagram below that shows the steps taken by the ECB since 9th July 2008.

* 9th July 2008 ECB IR↑= 3.75% – Just before finaincial crisis – ECB concerned about inflation
* 21st Jan 2009 ECB IR↓ = 2% – Sept 2008 – global economy collapses and inflation not an issue
* 13th April 2011 ECB IR↑ = 1.25% – Europe – high unemployment, low growth, debt crisis. ECB raises interest rates?
* 13th July 2011 ECB IR↑ = 1.50% – Debt crisis worsens and no growth. ECB raises interest rates again?
* Austerity measures – slash gov’t spending and raise taxes = little or no growth.

The euro zone’s concerns are that debts levels are too high and economic growth is too low. But are the debt levels this large because of too slow growth or the fact that some countries don’t have an efficient tax collection system – eg. Greece? When you relate the ECB policy with that of the US Federal Reserve there are differing opinions on how to use monetary and fiscal policy.

US Fed Model
Expansionary Fiscal Policy – extension in unemployment benefits and temporary tax breaks for low and middle-income households.
Expansionary Monetary Policy – low interest rates and quantitive easing.

ECB Model
Contractionary Fiscal Policy- strong austerity measures
Contractionary Monetary Policy – higher interest rates

The ECB might be concerned with dampening inflation but with the CPI at 2.5% prices are not really unstable. Are they repeating the mistakes of the early 1930′s? Then the tight monetary policy and austerity measures led to the Depression. Furthermore it appears that neither the policies of the US Federal Reserve nor the ECB are actually working.