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Global Liquidity Trap

April 4, 2017 Leave a comment

The FT had an excellent article back in April last year that covered many concepts which are a part of Unit 4 of the CIE A2 Economics course. It covers the liquidity trap, deflation, MV=PT, circular flow, Monetary Policy, Quantitative Easing etc.

The article focuses on the liquidity trap with Monetary Policy being the favoured policy of central banks. However by pushing rates into negative territory they are actually encouraging a deflationary environment, stronger currencies and slower growth.  The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X 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.

Liquidity Trap

Normally lower interest rates lead to:

  • savers spending more
  • capital being moved into riskier investments
  • cheaper borrowing costs for business and consumers
  • a weaker currency which encourages exports

But when interest rates go negative the speed at which money goes around the circular flow (Velocity of Circulation) slows which adds to deflationary problems. Policymakers pump more money into the circular flow to try to stimulate growth but as price fall consumer delay purchases, reducing consumption and growth.

The article concludes by saying Monetary Policy addresses cyclical economic problems, not structural ones. Click below to read the article.

The global liquidity trap turns more treacherous.

Bank of Japan sits on its hands

May 15, 2016 Leave a comment

Central Bank Rates 6th May 2016Been teaching a lot on the problems that economies have in trying to stimulate more growth to get out of the deflationary threat that is prevalent in many countries. Central Banks around the world running are out of ammunition (cutting interest rates – see rates below) and one wonders what is the next step that economies can take?

Back in February the Bank of Japan (BOJ) pushed interest rates into negative territory with the uncollateralised overnight rate being -0.10%. After saying that it would do everything in its power to get inflation to reach 2% (its target rate) and with inflation expectations moving down from 0.8% to 0.5%, markets were very surprised that it didn’t ease rates further. Two of Japan’s measures of inflation are moving away from the the target rate of 2% – see graph below.

Japan inflation 2016

With this decision the Yen strengthened and it is becoming exceedingly difficult to tell if a central bank has run out of ammunition especially when it doesn’t fire a shot. So why have the BOJ held off on easing?

  1. When rates are cut – especially if they go negative – it takes six to twelve months to judge its impact on the economy. This is something referred to as the ‘Pipeline Effect’.
  2. Governor Haruhiko Kuroka may be concerned with the strengthening of the Yen after the last cut in February. This makes exports more expensive and imports cheaper.
  3. The Governor is waiting for the government fiscal stimulus to kick in with the impending cancellation of an increase in value-added-tax.

There is plenty of room to push interest rates further into negative territory and with the next scheduled BOJ meeting in June they will be watching what the US Fed reserve do. An increase in the US Fed rate will mean a stronger US dollar which might achieve more for Japan than further negative interest rates.

Low inflation in New Zealand not just about falling oil prices.

March 15, 2016 Leave a comment

The 0.1% inflation rate in New Zealand has largely been attributed to the 50% drop in oil prices since the start of last year – see chart. Although oil prices are referred to as a volatile item they have been low for sometime and are expected to remain subdued. Lower fuel costs have reduced prices for services such as air travel, and have dampened prices on shop floors as the distribution costs for retail items have declined.

World Commod Prices

However low inflation doesn’t just reflect movements in the price of oil. Even excluding petrol prices, inflation has been below 1% for most of the past year, and it’s set to remain low through 2016. The weak inflation figure has also been due to the low global inflation holding prices down and with the trend likely to continue for some time given the deterioration in global trade and widespread falls in commodity prices. Add to this the slowing growth of the Chinese economy and with its importance to global growth (see chart) you have a serious threat of deflation. This is particularly a concern if the Chinese authorities decide to further devalue their currency – the Renminbi. The RBNZ will have a tough job ahead of it to generate a sustained increase in inflation.

Screen Shot 2016-03-13 at 11.48.53 PM

Winners and Losers of lower oil prices

January 22, 2016 Leave a comment

With lower oil prices below is a table looking at the winners and losers.

Oil - Winners Losers

Categories: Deflation, Supply & Demand Tags:

Supply Side policies Chinese style

January 11, 2016 Leave a comment

The names of Reagan and Thatcher are identified with supply-side policies of the 1980’s in the US and the UK. Now the Chinese authorities are suggesting the need to implement supply side policies as the country looks poised to post its slowest annual economic growth rate in a quarter century.

During the 1980’s the concern in the US was production bottlenecks fuelling inflation and stifling growth. However, in contrast the Chinese have the opposite issues – excess production, the threat of deflation and unsustainably rapid growth. In classic supply-side economics, the government should reduce its role in economic activities, but in the Chinese context, the government will continue to play a big role in making supply-side changes.”

The differences between US and Chinese Supply Side Policies

US v China supply side

Categories: Deflation Tags: ,

Sweden’s negative interest rates.

November 15, 2015 Leave a comment

To boost spending in any economy you would assume that the central bank would reduce interest rates – encourages borrowing and reduces saving. But very low interest rates could encourage people to hold cash rather than keep the money in the bank – this could slow economic activity in the economy.

Sweden’s central bank – Riksbank – has gone negative with interest rates. Sweden has the third highest savings rate in the developed world but there is a significant positive output gap. With inflation at 0.2% it remains well below the central bank’s 2% target but the mandate from the Swedish government encourages radical measures to rectify the threats of deflation. 

But with lower rates in the eurozone to stimulate growth this has weakened the Euro against the Swedish krona making Swedish imports cheaper and putting further deflation pressure on the economy. Therefore the Riksbank has had to cut its own rates in response in an attempt to avoid deep deflation. Switzerland has also go the negative way with a rate of -0.75%.

Swedish Interest Rates

OECD Deflation

January 7, 2015 Leave a comment

In 2014, 9 of the 34 members of the OECD experienced deflation whilst 3 others had zero inflation. Over the whole area consumer prices rose by only 1.7% mainly due to the fall in oil prices.

However in the Euro area inflation was only 0.4% over the year which is worrying especially as the European Central Bank (ECB) targets an annual rate of 2%. With interest rates at the ECB at 0.05% there is little scope for any stimulatory activity to increase inflation. Furthermore they are also charging banks deposits on money in the bank through a negative rate of 0.2%. Although lower oil prices will benefits businesses and consumers alike it maybe paradoxical if people expect lower inflation as cheaper energy pushes the headline rate into negative territory. So, the ECB has taken a leaf out of the US Fed’s book and decided on a form of quantitative easing by purchasing covered bonds and asset-backed securities.

Mario Draghi, President of the ECB, has not ruled out using additional measures “should it become necessary to further address risks of too prolonged a period of low inflation”.

Although Japan has an annual rate of inflation of 2.9% this has been largely due to an increase in the retail sales tax – if you exclude it from the calculation the inflation rate would be 0.9%. The Japanese Central Bank has a target of 2% inflation. As with the ECB interest rates in Japan are very low – 0.1% – so this leaves no scope for any stimulatory cuts. They are hoping that a further stimulus package of ¥3.5 trillion (NZ$ 37.41billion) on 27th December will boost the economy.

In New Zealand the annual inflation rate in September was 1% – the Reserve Bank Act 1989 stipulates a band of 1-3% while targeting future inflation at 2%. Unlike their counterparts at the ECB and the Bank of Japan they do have scope for stimulatory cuts as the official cash rate is currently 3.5%.

Deflation OECD

Categories: Deflation Tags: , , ,
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