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Posts Tagged ‘Central Banks’

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.

Russia – economic concerns.

March 31, 2017 Leave a comment

Part of the excellent Al Jazeera documentary series about Russia, which addresses the problems facing many Russians today. The global economic crisis, conflicts with neighbouring countries and the drop in oil prices all played their part in the demise of the Russian people. There is a very good interview with the former Central Bank Chairman Viktor Gerashchenk who held the position during Yelstin’s reign. He explains very simply how you grow your economy and that there must be money in the banks so that companies can borrow and invest. Buying US Treasury Bills was loaning money to the US and paying for their deficit. Meanwhile the infrastructure and public services declined rapidly causing a lot of anguish amongst the people. You can’t suddenly jump from a socialist system into the free market. Worth a look.

PBS: Mervyn King and the future of global finance.

October 18, 2016 Leave a comment

Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.

In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.

Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:

  1. Low interest rates around the world led to rising asset prices and trading looked very profitable.
  2. Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.

Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:

  1. Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
  2. Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.

He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.

Monetary Policy needs help

September 28, 2016 Leave a comment

In the 1970’s and 1980’s the global economy was battling the menace of stagflation – high inflation and high unemployment. In order to counteract this, monetary policy was seen as responsible for controlling the inflation rate through the adoption of targeting. The New Zealand government was the first country to introduce this through the Reserve Bank Act 1989 which gave the responsibility of the central bank to keep inflation between 0-2% (later changed to 1-3%). Monetary policy should therefore play the lead role in stabilizing inflation and unemployment with fiscal policy playing a supporting role with automatic stabilisers –  economic stimulus during economic downturns and economic contractions during high growth periods. Fiscal policy is therefore focused on long term objectives such as efficiency and equity.

In the post financial crisis world the usefulness  of monetary policy is dubious. The natural rate of interest has now dropped to historical low levels. The natural rate of interest being a rate which is neither expansionary or contractionary. The issue for the central banks is how to bring about a stable inflation rate when the natural rate of interest is so low.

Historical Natural Rates of Interest 

inflation-n-rate-of-interest

In the 1990’s the natural rate of interest globally was approximately between 2.5% and 3.5% but by 2007 these rates had decreased to between 2 – 2.5% – see graph. By 2015 the rate had dropped sharply and as can be seen from the graph near zero in the USA and below zero in the case of the euro zone. The reasons for this decline in the natural rate were related to the global supply and demand for funds:

 

  • Shifting demographics and the ageing populations
  • Slower trend productivity and economic growth
  • Emerging markets seeking large reserves of safe assets
  • Integration of savings-rich China into the global economy
  • Global savings glut in general

Therefore the expected low natural rate of interest is set to prevail when the economy is at full capacity and the stance of monetary policy in neutral. However this lower rate means that conventional monetary has less ammunition to influence the economy and this will mean a greater reliance and other unconventional instruments – negative interest rates. In this new environment recessions will tend to be more severe and last longer and the risks of low inflation will be more likely.

Future strategies by to avoid deeper recessions.

Governments and central banks need to be a lot more creative in coping with the low natural rate environment. Fiscal policy could be used in conjunction with monetary policy with the aim of raising the natural rate. Therefore long-term investments in education, public and private capital, and research and development could be more beneficial. More predictable automatic stabilisers could be introduced that support the economy during boom and slump periods. Additionally unemployment benefit and income tax rates could be linked to the unemployment rate. The reality is that monetary policy by itself is not enough especially as the natural rate of interest  and the inflation rate are so low. What can be done:

  1. The Central Bank would pursue a higher inflation target so therefore experiencing a high natural rate of interest which leaves more room to cut to stimulate demand. The logic of this approach argues that a 1% increase in the inflation target would offset the harmful effects of an equal-sized decline in the natural rate
  2. Inflationary targeting could be replaced by a flexible price-level of nominal GDP, rather than the inflation rate.

Conclusion

Monetary policy can only do so much but with global interest rates at approximately zero there needs to be the support of the politicians to enlist a much more stimulatory fiscal policy. Monetary policy has run out of ammunition and we cannot rely on central banks to fight recessions. However a less politicised fiscal policy, which is free to act immediately, has the ammunition to revive the economy.

Sources:

Monetary Policy in a low R-star World – FRBSF Economic Letter

The Economist: September 24th 2016 – The low-rate world

Yellen, Bernanke, Greenspan and Volcker interview – US economy is fine and dandy

April 14, 2016 Leave a comment

A HT to Yr 13 student Albere Schroder for alerting me to this interview with the four most recent US Federal Reserve chiefs.

  • Janet Yellen, the current Federal Reserve chairwoman was joined by:
  • Ben Bernanke (2006-2014)
  • Alan Greenspan (1987-2006)
  • Paul Volcker (1979-1987)

Although the Fed Reserve chiefs served during widely divergent eras and are known to have different political views, the most notable take-away of the evening was the extent of their deep agreement.

There was a consensus that the Fed’s post-crisis rescue efforts have been successful and the economy is currently on a steady growth path, rather than rising thanks to a bubble that will soon burst. The remarks were a sharp rebuttal to the conventional wisdom of the contemporary Republican party and many grassroots conservatives that excessive stimulus from the Fed is either on the verge of sparking a drastic uptick in inflation, or already fostering a stock market or asset bubble.

“I’m not saying that the government should always be spending,” Bernanke said. “But at certain times, particularly in a recession, when the central bank is out of ammunition or ammunition is relatively low, then fiscal policy does have a role to play, yes.” Ben Bernanke

Greenspan had other ideas in that he disagreed with the idea that government spending should be increased during a downturn as this impacts on the country’s longer-term debt problem. Worth a look.

Australia and China cut rates to stimulate economy

May 11, 2015 Leave a comment

The Reserve Bank of Australia lowered its cash rate by 25 basis points to two percent in early May. The Bank had already dropped the cash rate by 25 basis points in February this year. In announcing its decision, the Bank commented on the decline in international commodity prices over the past year, which had resulted in a decline in Australia’s terms of trade. As a result, business capital expenditure (especially in mining) is expected to be weak. The Bank is expecting stronger growth in employment and an improvement in household demand. Low mortgage rates are resulting in strong house price inflation, especially in Sydney, and the Bank is “…working with other regulators to assess and contain risks that may arise from the housing market”.

China’s third interest rate cut in six months has spurred concerns the mainland’s economic slowdown is hitting where it hurts: the labour market. The People’s Bank of China (POBC) reduced reserve requirement ratios in April (the proportion of funds that banks have to hold with the central bank) in an effort to promote lending growth in the country. It has been reported that the cut in the reserve requirements ratio will allow banks to increase lending by about 1.2 trillion yuan. The POBC also reduced both the benchmark lending and deposit rate by 25 basis points to 5.1 percent and 2.25 percent, respectively, in response to weaker-than-expected economic activity data, which has raised concerns that the government’s annual gross domestic growth (GDP) target of “around 7 percent” might not be accomplished. Maintaining stable employment has been a top priority for the Chinese government as it steers the world’s second largest economy away from an export-driven model to one based on consumption.

Source: CNBC, MONTHLY ECONOMIC REVIEW May 2015 – NZ Parliamentary Research Library.

Central Bank Rates - May 15

ECB and Negative Interest Rates

March 12, 2015 Leave a comment

The European Central Bank (ECB) recently announced that when banks now deposit money with them that it would pay -0.2%. In other words banks have to pay the central bank for the privilege of depositing money with them.

What is a negative real interest rate?
A real interest rate is the stated rate (2.5%) minus the inflation rate (2%) – real rate = 2.5% – 2% = 0.5%. As real rates fall it attracts more borrowing and less saving.

*Savers lose money each year to inflation
*Borrowing and consumption should rise.

Euro Zone – Interest rates 0.05%, inflation -0.6 = real rate of 0.65%

To get negative real rates, the nominal interest rate must be lower than the rate of inflation; if inflation is negative, the nominal interest rate must also fall below zero. As soon as the rate banks offer fall below that, savers have an incentive to withdraw their money and put it under the mattress. By charging negative rates the central banks are hoping that the trading banks will keep more of their money and therefore lend it out to investors. However the desire to reduce a banks reserves is futile as if someone borrows money from a bank and buys a new car the money is paid to the car company who will then deposit the money in their account which increases the reserves of the bank.

Central Bank Rates March 2015

Central Banks and Neutral Rates

November 21, 2013 Leave a comment

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. See table below of current rates of Central Banks and approximate neutral rates.

CB Interest Rate Nov 13

What indicators shoud you look at as to whether neutral interest rates might have changed? Here are 4 that are identified by John McDermott, Assistant Governor of the Reserve Bank of New Zealand:

1. World Conditions

Gowth of the major trading partners of any country can put pressure on aggregate demand which consequently causes inflationary conditions. With this and inflatinary expectations there could be pressure on a central bank to increase interest rates

2. Domestic productivity growth

A continued decrease in productivity growth will lower returns to investment, whcih means that investment is less attractive. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans.

3. Population growth

Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required.

4. Preferences for savings and investment

If people decide to save more and consume less a lower interest rate would be required to boost the pace of activity and inflation and reconcile saving and investment plans.

An implication of a lower neutral interest rate is that households and businesses will face lower interest rates ‘on average’, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. John McDermott, Assistant Governor of the Reserve Bank of New Zealand

Global Interest Rates

August 10, 2013 Leave a comment

Many thanks to Yr 13 student Alex Rasmussen for this image. Most recently the Reserve Bank of Australia lowered its cash rate by 25 basis points to 2.5 percent. It was the second time this year that the Australian Reserve Bank has reduced its cash rate. The Bank believes that economic growth in Australia will remain below trend in the near term, “…as the economy adjusts to lower levels of mining investment”. United States Federal Reserve Chairman Ben Bernanke said in his Semiannual Monetary Policy Report to the Congress in mid-July, that “…a highly accommodative monetary policy will remain appropriate in the foreseeable future”.

Global Interest rates

Categories: Interest Rates Tags:

The US Fed needs to be aware of its actions

December 3, 2012 Leave a comment

With current central bank interest rates at very low levels there is concern that these policies have been fueling credit and asset price booms in some emerging economies. However, potentially there could be significant fallout of the unwinding of these booms on developed nations.

How do Capital Flows impact on an economy?
When you have long periods of loose monetary policy (including low interest rates), like that in the US 0-0.25% – since September 11 2001 the US Federal Reserve has implemented a near zero rate policy which is now expected to last until 2014. According to Stanford University Professor John Taylor this results in the following:

1 Investors look elsewhere to gain higher returns and buy foreign securities and
2 Low interest rates encourage overseas firms to borrow in US dollars rather than in their domestic currency – US branch offices of foreign banks raised over $645 billion to make loans in overseas countries.

This flow of money means that the strength of the local currency starts to appreciate as foreign firms exchange their borrowed US$ and for the domestic currency. With this appreciation, the central bank becomes concerned with the affect the higher currency is having on the exchange rate and therefore export competitiveness.

Central Bank Rates

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The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.

econoMAX

WSJ Graphic – Central Bank Interest Rates

August 6, 2012 Leave a comment

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.

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

November 11, 2011 Leave a comment

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.

QE or QT

April 1, 2011 Leave a comment

I have blogged quite a lot on QE – Quantitative Easing – which has been extremely prevalent in the developed world. However, what about QT – Quantitative Tightening? Remember:

QE – putting more money in the circular flow to stimulate demand
QT – taking money out of the circular flow to slow down the economy

According to the Business Insider website the developing world are trying to slowdown their economies. Here are some approaches from central banks:

China
The Chinese strategy is the most well known, as the PBOC has been trying to slow down credit growth through a series of bank reserve requirement ratio (RRR) hikes. Therefore if the RRR rate goes up it means that the bank has to hold more cash in reserve and has less to lend out.

Brazil
They have increased their IOF tax – the IOF tax applies upon conversion of foreign currency into Brazilian reals related to equity or debt investments by foreign investors on the Brazilian stock exchange. This dampens the Carry Trade and means less speculative money is put into the Brazilian Real. They have also increased the reserve requirement in banks to reduce liquidity in money markets to slow economic activity in the market.

Carry Trade – a situation where an investor borrows money in one country that has very low interest rates and then invests it in another country with higher interest rates. This can be precariuous as exchange rates vary.

Turkey
Here interest rates and reserve ratio requirements have actually gone in different directions.
Reserve requirements have climbed 8% for deposits maturing up to three months. These changes affect institutions with a local presence in Turkey. In order to sharply reduce the incentives for foreign players sending portfolio flows into Turkey, the policy rate was cut by 0.75% in conjunction with reserve requirement hikes in order to weaken the currency. The signaling aspect of such a cut has clearly played a strong role in driving market perception because investors tend to see Turkey’s monetary policy as expansionary. However, the net result of QT and policy rate cuts has likely been to make Turkish monetary policy tighter, not looser.

A new global reserve currency?

February 23, 2011 Leave a comment

Dominque Straus-Kahn, the managing director of the IMF, has signaled the recommendation of a new global currency. Member countries hold with the IMF reserves that are referred to as Special Drawing Rights (SDR). His intention is the SDR could act as an alternative to the US$ in central banks’ foreign currency reserves.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about $308 billion, converted using the rate of August 31, 2010). SDR’s are based on a basket of currencies – US$, £, €, ¥ – and should be broadened to include the Chinese Yuan.

Using the SDR would act as a safeguard from exchange rate volatility while issuing SDR-denominated bonds could create a potentially new class of reserve assets.

International policy makers have become increasingly concerned about the threat of currency wars. This is where governments have been trying to reduce the value of their currency to increase the competitiveness of their exports and claw its way out of recession.

Categories: Exchange Rates Tags: ,

Further tightening in the UK

February 17, 2011 Leave a comment

Bank of England Governor, Mervyn King, has warned households to prepare for further increases in interest rates as inflation creeps higher. Mervyn King’s comments came after the Bank published its February Inflation Report, in which it lowered its forecast for economic growth this year from 2.6% to around 2% and confirmed that inflation could reach 5% before June – the UK has a target rate of 2% for the Consumer Price Index.

Currently the UK Bank Rate (equivalent to OCR in NZ) is at 0.5% but is expected to rise to 0.75% in the next four months and be at 1% by the end of the year. Projections for 2012 is 2% and by the end of 2013 the rate will be at 3%. Mervyn King also acknowledged that an 0.25% increase in the Bank Rate would not damage growth. “There’s one camp that says even a small rise in Bank rate, no matter how small, will plunge us back into recession and mean that hopes of recovery are dashed forever. I don’t really understand the logic behind that,” he said.

Compared to Australia and New Zealand rates in the UK, and US for that matter, are still very stimulatory – see table above. Interesting to note that the economies with higher interest rates are those that are more commodity based. It would be a useful exercise to draw a business cycle graph and look at the relationship between each country’s key interest rate and where they are on the business cycle.

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