## What will higher unemployment figures in NZ mean for monetary policy?

Although still low New Zealand’s unemployment figures today registered an increase of 0.1% to be at 3.4%. The labour market is still tight but there are signs that the reduction in job ads and monthly filled jobs are putting less pressure on the market. This may mean that the RBNZ, who sets monetary policy, sees that aggregate demand is starting to ease indicating a less aggressive stance with interest rates. With inflation at 7.2% and still well above the policy target agreement of 1-3%. the RBNZ might increase the OCR this February by 0.5% which is a reduction on the the previous increase of 0.75% on 23rd November. That would leave the OCR at a peak of 5.25% by May. However if high inflationary expectations become the norm the RBNZ might have to become more aggressive in its policy. Below is a mindmap on monetary policy which might be useful for revision purposes.

Source: ANZ Research 1st February 2023

Adapted from: A Level Economics Revision – Susan Grant.

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## Taylor rule and New Zealand interest rates (OCR) at 8%

The Taylor Rule is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. The rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p – 2) + 2
r = the short term interest rate in percentage terms per annum.
p = the rate of inflation over the previous four quarters.
y = the difference between real GDP from potential output.
This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Taylor argued that when:

• Real Gross Domestic Product (GDP) = Potential Gross Domestic Product
• Inflation = its target rate of 2%,
• Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).

If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 1.5%.
He stated that the real interest rates should be 1.5 times the inflation rate.

This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.

New Zealand and the Taylor rule
When the Taylor Rule is applied to the New Zealand economy it suggests an optimal, OCR of more than 8% – see graphic from live gross domestic product (GDP) tracker. A rate as high as this would do significant damage to the economy even if inflation did get down to the 2% target for inflation. Households and businesses would find it particularly hard with incomes being squeezed. An OCR of this level would have an unwieldly impact on households and businesses, squeezing incomes.

Criticisms of Taylor rule
The theory assumes that only the central bank can affect the equilibrium real rate of interest and there is a closed economy with households that have identical consumption patterns and the same declining marginal utility. However, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy. These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.

Source: Live GDP tracker

## How well do we understand inflationary expectations?

In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.

Higher wages = Higher labour costs = Higher prices

Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:

“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.

How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?

Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:

• a sharp increase in crude oil prices
• a rise in income taxes,
• a federal government spending increase,
• a rise in the Federal Reserve’s target interest rate.

All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:

higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑

Experts take the view that it is a demand-side issue:

higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓

Central Banks look to make communication more accessible

Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.

Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.

Source: Hall of Mirrors: How Consumers Think about Inflation by Carlo Pizzinelli
IMF F&D September 2022

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## Globalisation to regionalisation and its impact.

With the global economy experiencing supply chain pressures, inflationary problems, higher interest and geopolitical tensions are we seeing a move to more regionalisation rather than globalisation?

Part of this change has come about from the decoupling of the American, European and Japanese economies from China. This ultimately alters trade and investment flows around the global economy and will mean lower economic growth and less liquidity. For instance consider the restrictions on technology including complex microchips being placed by the US on China. Janet Yellen the US Treasury secretary referred to ‘friendshoring’ which means relocating production to countries that fall within the US economic sphere of influence. Apple’s recent announcement that it would begin sourcing sophisticated chips from North America is the signal that many global firms have been waiting for to begin reducing their exposure to China.

Furthermore as well as the impact of decoupling of trade with China, a shortage of labour will also add to production costs and will result in slower rates of growth. Labour force participation rates have dropped as there have been less migrant workers coming into countries. This scarcity of labour will put further pressure on wages and ultimately inflation. To counteract the latter interest rates will continue to climb and this will lead to further problems:

• The cost of financing economic expansion will become more expensive.
• Firms that have lived off 0% interest rates and negative real rates (nominal interest rate – inflation) will face increasing problems on their balance sheets

In the medium term interest rates are determined by inflationary expectations and rates tend to move lower in periods of disinflation and higher in periods of inflation. The risk for all central banks and policymakers is if the rate of inflation goes above that of expectations there can be a further tightening cycle.

Response to shocks – GFC and COVID-19

The GFC and COVID-19 saw the primary policy response of an expansionary monetary policy (near 0% interest) due to insufficient aggregate demand. The result of this policy has changed the economic landscape. Today things are quite different:

• insufficient aggregate supply,
• persistent supply shocks,
• higher inflation,
• higher interest rates
• slow growth.

After years of loose fiscal, monetary, and credit policies and major negative supply shocks, stagflationary pressures are now putting the squeeze on a massive mountain of public- and private-sector debt. Recession (negative GDP for two consecutive quarters) seems on the cards.

Source: The Real Economy Blog

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## Economics of Coronavirus – mindmap

Looking back at the start of the coronavirus, the mindmap above looks at the three different shocks that were/are prevalent and the policies that were implemented by governments. Could be a useful way of introducing the topic.

Supply shock – will become more visible in the coming weeks as importers from China maybe unable to source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate goods for production of final products cause a decline in revenue and consumer well-being. A good example of supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).

Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars, electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.

Financial shock – although the supply and demand shocks will eventually subside, the global financial system is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure for dealing with this and future crises.

Policy options

Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct trading banks to be more tolerant of economic conditions.

Fiscal policy will be a much more powerful weapon – the government can help households by expanding the social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have introduced ‘shock therapy’ and unleashed significant stimulus measures:

• Hong Kong – giving away cash to population – equivalent NZ\$2,120.
• China – infrastructure projects and subsidising business to pay workers.
• Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
• Italy – fiscal expansion and a debt moratorium including mortgages
• US – congress nearing stimulus package
• NZ – stimulus package industry based

Source: The Real Economy Blog

## US dollar strength a problem in fighting inflation

The US dollar hasn’t been stronger since 2000 – it has appreciated:

• 22% – Yen,
• 13% – Euro,
• 6% – emerging market economies.

The dominance of the US\$ has serious implications for the macroeconomy of almost all countries. Although US share of world trade has declined from 12% to 8% the US\$ share of world exports has remained around 40%. Therefore imports denominated in US\$ into countries have become more expensive and it is estimated that for every 10% US\$ appreciation adds 1% to the country’s inflation figure. For developing countries with a high dependency on US\$ denominated imports this is particularly worrisome.
Furthermore almost 50% of cross-border loans and international debt securities are in US\$ and although emerging market governments have made progress in issuing debt in their own currency, their private corporate sectors have high levels of dollar-denominated debt. As the US Fed continue to raise interest rates with a fourth consecutive 75 basis points rise on 2nd November financial conditions have tightened and the strong US\$ only compounds these pressures especially for many low income countries that are close to defaulting on their debt.

What should countries do?
Some countries and intervening in the foreign exchange buying their own currency with US\$ reserves – foreign reserves fell by over 6% in the first half of this year to support their currency. Intervention should not be a permanent policy as it could mean a loss of foreign reserves as well as alerting markets to your intentions which could play into the hand of foreign exchange dealers. Monetary policy needs to keep inflation close to its target rate and the higher price of imports should reduce demand and therefore prices but a lot depends on the elasticity of demand for a country’s imports – if inelastic there is increasing pressure on inflation. Fiscal policy should provide some support to those that are most vulnerable without jeopardising the inflation target.

Source: IMF Blog – How Countries Should Respond to the Strong Dollar.

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## New Zealand and Global Economy update.

New Zealand Economy

As we approach the external exam season 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 below.

• New Zealand’s gross domestic product (GDP) expanded by 1.7 percent in the June 2022 quarter, above market expectations.
• Coming from record low interest rates the RBNZ has recently increased the OCR by 50 basis points (0.5%). They did consider 75 basis points.
• A current account deficit of \$7.1 billion was recorded in the June 2022 quarter, compared with a deficit of \$8.8 billion in the previous quarter (in seasonally adjusted terms)
• Annual inflation remains high globally, with annual inflation within the OECD averaging 10.3 percent in August.

Global Economy – October 2022

Notice that global interest rates are on the rise as the countries tackle the current inflationary problem. Within OECD member countries, annual inflation ranged from 3% in Japan to 80.2% in Turkey. Global inflation is expected to moderate next year but likely to remain above inflation targets in many economies – RBNZ 1-3%. However with the tight monetary conditions expected to remain in place until mid 2023 GDP growth will be subdued.

## Why has the US dollar got so strong and problems associated?

There has been a lot of talk about global currency’s depreciating against the US dollar but why has the dollar been so strong? In times of uncertainty people gravitate to the US dollar for safety – it is the global reserve currency and the vast majority of global trade is done in US dollars. The uncertainty in the global economy has been due to:

• The pandemic
• Expansionary fiscal and monetary policy
• Supply side problems not being able to keep up with demand
• Ukraine War which has increased energy and food prices.

From the above there has been strong inflationary pressure in the US especially and this needs contractionary monetary policy intervention – higher interest rates. The US Fed Reserve has increased interest rates ahead of other developed economies.

Problems with a strong US dollar
When the US dollar appreciated – see image above – it has a contractionary impact on the global economy. The dollar and US capital markets are far more globally important than the US economy itself – the currency is the world’s safe haven and its capital markets are those of the world. Therefore the exchange rate is crucial when money goes into and out of the US. Also countries worry about the exchange rate in particular when inflation is high – weak currency makes imports more expensive and can feed inflation. For those that owe money in US dollars a weak currency becomes very expensive as they have to convert more of their currency into US dollars – this is prevalent in the developing world. With Fed Chair Jerome Powell determined to bring US inflation down there is the risk of further interest rate hikes which could put economies into recession.

Source: Financial Times – Why does the strength of the US dollar matter? Martin Wolf

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## UK Pound slumps as IMF advises against tax cuts

Below is a very good video from Al Jazeera that explains the Bank of England’s emergency intervention to calm the market after the UK’s government’s tax cut plans. Once these plans were announced the GB Pound slumped to it lowest level \$1.035 against the US Dollar since 1985. The BoE announced it is buying up long-dated UK government bonds to bring stability to financial markets but even higher interest rates are still likely and that is worrying news for the country’s property market. Good coverage of this below from Al Jazeera.

## Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

## Central Bank Interest Rates – more increases in the horizon

Jerome Powell US Fed Chair increased the Fed Funds Rate by 0.75% last week to 3.25% and has signalled that he will do what is required to get the inflation rate down to the 2% target. Policy rates are still negative almost everywhere, the main exceptions being China, Brazil, Hong Kong, and Saudi Arabia. Mexico and Indonesia are almost there, too.

If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate. If the interest rate is 2% and the inflation rate is 10%, then the borrower would gain 8% of every dollar borrowed per year. In the early 1970s, the US and UK both reduced their debt burden by about 30% to 40% of GDP by taking advantage of negative real interest rates.

It is possible to control inflation while keeping real rates well below zero but it is more likely that reducing demand will require raising real rates at least to 0%, and probably a bit higher. Higher interest rates globally are on the horizon as at present they aren’t high enough to significantly reduce inflation pressure in most countries. Central banks have work to do.

Source: Mauldin Economics

## A2 Economics – Liquidity Preference Curve

With mock exams this week here is something on Liquidity Preference – included is a mind map that has been modified from Susan Grant’s CIE revision book.

Demand for money

TRANSACTIONS DEMAND – T – this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual’s income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. (note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES – P – this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

SPECULATIVE BALANCES – S – this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑.

If a bond has a fixed return, e.g. \$10 a year. If the price of a bond is \$100 this represents a 10% return. If the price of the bond is \$50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by the summation of the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

## Global interest rates in sync

Below is a graphic from the IMF showing both developing and developed countries interest rate movements. Obviously during the the COVID pandemic interest rates were lowered to stimulate aggregate demand and reduce the debt burden on consumers and businesses. However with inflation now being well above the 2% threshold that most countries have as their target, interest rates have been on the rise. Central banks need to act resolutely to bring inflation back to their target, avoiding a de-anchoring of inflation expectations that would damage credibility built over the past decades. Although the war in Ukraine and the supply chain disruptions can’t be resolved by central banks, higher interest rates can slow aggregate demand and therefore reduce inflationary pressure.

## Causes of recessions and how do you manipulate the economy for a ‘soft landing’?

Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.

“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.

## Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

## Strong US dollar is a problem for other economies

This year the US dollar has appreciated by 10% against other major currencies. The main reason behind this is the US Fed increasing interest rates in tackling the inflationary pressure in its economy – since the beginning of the year the Fed Funds rate has increased from 0% to 2.25-2.5%. This increase in interest rates has been quicker than other major economies which has led to the strengthening of the US dollar. This stronger dollar makes US exports less competitive and imports cheaper as the US dollar buys more of the other currency. However even if a country doesn’t trade with the US it can still be impacted by the US dollar when pricing goods and services. The problem lies in the invoicing of fuel and food which is usually quoted in US dollars – an IMF paper suggested that approximately 40% of invoices are in US dollars – see Figure 4 below. Furthermore they also found prices for businesses doing trade between two distant countries can be much more sensitive to the value of the US dollar than the relative levels of the tow local currencies.

With the US Fed focused on inflation further interest rate increases on the cards which could lead to further strengthening of the US dollar. To counter this action other countries central banks could increase their interest rates ahead of time to protect their currency.

The graph above reveals that the share of global exports invoiced in dollars is much larger than the share of exports destined to the US. This difference indicates that the dollar plays an outsized role in the invoicing of global exports; the patterns for imports are quite similar. The right panel of Figure 4 establishes that the dollar’s leading role reflects more than its use for the invoicing of commodity exports: once exports of commodities are removed from both the invoicing and export shares, the dollar share of invoicing (23%) still exceeds – by a sizeable margin – the share of exports destined for the US (10%). Figure 4 also reveals that the euro’s share in global export invoicing is an impressive 46%. While this appears as a very large number, recall that a currency’s vehicle currency role can be gauged only by comparing its share in global invoicing to the share of global exports that involve the jurisdiction issuing the currency. This comparison reveals that the euro’s share in global export invoicing is not much larger than its share, 37%, of exports destined to EA countries.

Sources:

Strong dollar is a major headache for other countries. FT 30th July 2022

IMF – Patterns in Invoicing Currency in Global Trade. Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl, Tra Nguyen. July 2020

## Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about expectations”
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

• a sharp increase in crude oil prices as a result of falling world supply,
• a rise in income taxes,
• an increase in government spending,
• a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

## BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

How to Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a \$1000 bond = annual return of \$100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays \$100 as compared to \$120 with the a new bond. The value of the new bond is effectively reduced to \$833 as in order to give it annual payment of \$100 a year the price would have to be \$833 to it a market based return.
100/833 = 12%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Sources:

• The Economist: – BoJ v the markets. June 25th 2022.
• Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

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## Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

• With the threat of inflation should banks have increased their rates earlier?
• If they tighten too quickly will that tip their economy into recession and a hard landing?
• What is the right rate increase for the current inflation figure?
• How long (pipeline effect) will it take for interest changes to impact the inflation figure?
• These are the challenging questions that central bankers face in today’s environment.

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