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Posts Tagged ‘Monetary Policy’

Have Central Bankers’ got it wrong?

October 30, 2017 Leave a comment

Below is very good video from the FT – here are the main points:

  • Central Banks – by lowering interest rates they could make savings less attractive and spending more attractive
  • After GFC low interest rate and asset purchases increased lending and avoided a global depression.
  • Now the world economy is not behaving as the central bankers’ said it would
  • Their theory was that with lose credit (lower interest rates) the economy would grow and inflation would rise.
  • Inflation is stagnant (unlike the 1960’s – see graph below) and this is worrying as a little inflation is required to lubricate the economy. It allows prices to fall in real terms.
  • The missing inflation may mean that the bankers’ theories are wrong.
  • Cheap money may have encouraged high asset prices and debt levels but it may undermine the economy without doing much for growth.

Inflation Unemployment.png

A2 Revision – New Classical to Extreme Keynesian

October 27, 2017 Leave a comment

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

Types of Macroeconomic Policies

August 30, 2017 Leave a comment

Just been doing some revision with my CIE AS class and discovered this diagram on macro policies. Mind maps like this are very useful ways of revising topics.

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply, lending rates and interest rates and is often administered by a central bank.

Supply-side policies are mainly micro-economic policies aimed at making markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output

Macro Policies.png

Reserve Bank of Australia – Neutral Rate

August 20, 2017 Leave a comment

An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.

Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending

How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.

Aus - Neutral rate

The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.

More saving will tend to lower interest rates
More investment will tend to increase interest rates

Debelle indicates that you can group these factors into 3 main categories:

1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.

“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle

A2 Economics – Keynesians vs Monetarists

March 29, 2017 Leave a comment

Just been going through this part of the course with my A2 class and came across a table from some old A Level notes produced by Russell Tillson (ex Epsom College Economics and Politics Department) to help them understand the principal differences.

Monetary policy – not too tight in New Zealand?

October 26, 2016 Leave a comment

Brian Fallow of the New Zealand Herald wrote a very informative article on the inflationary target that the Reserve Bank of New Zealand keeps missing – the CPI has been below the bottom of the bank’s 1 to 3% target band. Some will say that the RBNZ has been too tight with its monetary policy stance – maintaining high interest rates for too long. Assistant Governor John McDermott has defended the bank’s position for the following reasons:

  1. Nearly half the CPI consists of tradables where the price of goods is impacted by competition from outside New Zealand. For the last four years the global economy has been in a disinflationary environment caused by excess supply and in particular low commodity prices especially oil. Year ending September 2016 Tradables = -2.1%. This offset almost all of the +2.1% rise in non-tradables prices. See graph below.
  2. The recovery form the GFC has been quite weak and with the NZ$ strengthening (imports cheaper) accompanied by lower world prices has meant that import prices have been very low.
  3. The growth of the supply-side of the economy has been particularly prevalent which again has led to less scarcity and lower prices.
  4. Recent years has seen immigration boost the demand side of the economy but because the age composition is between 15-29 rather than 30-40 in previous years, the former has a much less impact on demand as they don’t tend to have the accumulated cash for spending.
  5. The RBNZ reckon that the output gap is now in positive territory (actual growth being higher than potential growth) which will start to put pressure on prices as capacity constraints become more prominent.
  6. Statistically with a weak inflation rate in the December 2015 quarter the December 2016 quarter is most likely to be higher as the percentage change is taken on the CPI of the previous year.

nz-cpi-2004-2016

The spectre of deflation hitting the New Zealand economy does not seem to be a concern at this stage especially with the longer-term inflationary expectations being in the mid range of the target bank i.e. 2%.

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’s Taylor Rule suggest Fed Funds rate of 1.33%.

September 7, 2016 Leave a comment

From her Jackson Hole speech US Fed Chair Janet Yellen used the Taylor Rule to suggest that the Fed Funds rate today should already be around 1.33% – currently at 0.50%. She also used the Taylor rule to explain how US interest rates should have been negative after the Global Financial Crisis. This same rule suggests that the rate should already have been 1.25% in June – see Chart below.

Taylor Rule

Source: National Australia Bank: Australian Markets Weekly – 5th September

What is the The Taylor Rule?

This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:

Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and

Inflation = its target rate of 2%, then the 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 0.5%.

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.

RBNZ cut OCR but NZ$ on the rise

August 15, 2016 Leave a comment

Last Thursday it was no real surprise that the RBNZ cut the official cash rate to 2%. With this cut you would have expected some fall in the value of the $NZ but instead it appreciated. So why did the $NZ appreciate? Graeme Wheeler was interviewed by NZ Herald reporter Liam Dann and explained to him that we live in a phenomenal situation. Global interest rates have been incredible low especially in countries like Japan, the UK and Australia – see table below. Add to that the impact of quantitive easing since 2009 and negative interest rates in countries which account for 25% of world GDP and you have a very unusual situation.

CB Rate Aug 16

Some key assumptions from the RBNZ are that:

The global economy will start to pick-up which will mean that there will be less pressure on the NZ$ as investors look to other currencies to invest in. Remember that the NZ$ is the 10th most traded currency in the world and at uncertain times in the global economy it is seen as safe place to ‘park’ your money. This therefore increases the demand for NZ$’s appreciating its value.

Also the growth of the domestic economy with GDP expanding by 2.4 percent over the year ended in the March 2016 quarter, could mean a rise in inflationary expectations which should bring the inflation rate closer to the 2% mid point method in the policy target agreement. However this is a drop from 3.2% from the previous year.

According to Stephen Toplis of the BNZ 

Clearly, the NZD is already higher than anticipated and inflation expectations could well be constrained for longer as annual headline inflation falls, potentially, sub-zero. It was also interesting that the RBNZ did not repeat its upside scenario for interest rates due to higher house prices. This reaffirms the Bank’s easing bias.

All things considered then, and noting there is still significant uncertainty as to the exact way ahead, we can reasonably comfortably conclude that:

–  There will be at least one more rate cut;

–  The balance of risk is for even more;

–  The cash rate is going to be at least as low as it is now for a long time;

–  Inflation is likely to continue surprising to the downside in the near term;

–  Only when the rest of the world plays ball will the NZD wilt.

Does the RBNZ need to cut the OCR?

August 7, 2016 Leave a comment

With the RBNZ to announce the Official Cash Rate next Thursday there is common agreement that there will be a 0.25% cut to leave the OCR at 2.00%. However with 2.8% growth and a favourable PMI do the RBNZ need to cut rates? With inflation at 0.4% it is still not between the 1-3% target range (as outlined by the Policy Target Agreement in the Reserve Bank Act 1989), and there is pressure for the central bank to hit a target of 2% inflation. With the global economy in an era of very low inflation (even a threat of deflation) one wonders the logic of keeping the PTA at 1-3%. In fact it is being reviewed by the RBNZ in the next month. The logic behind the lower OCR will be to stimulate more spending but also trying to make the NZ$ less attractive for foreign investors.

NZ Economy

With NZ rates being significantly higher than other developed countries the NZ$ is seen as a good investment and ultimately attracts a lot of ‘Hot Money’ into the economy. The NZ$ is the 10th most traded currency in the world and this is also due to the stable environment in the NZ economy as well as relatively high interest rates. But have the lower rates had the effect of reducing the value if the NZ$? A lower dollar makes exports prices more competitive and increases the price of imports.

Interest Rates NZ$

If you contrast the OCR with the TWI over the last year you will see that a lower OCR doesn’t necessarily mean a lower NZ$. Furthermore the lower rates do nothing to halt the rise in the property market especially in Auckland.

The RBNZ faces potentially conflicting outcomes as it tries maintain financial stability and price stability. The Policy Targets Agreement demands lower interest rates in a bid to raise CPI inflation while financial stability concerns, especially with the housing market,  probably demands higher rates.

Images from ANZ Bank

Monetary Policy – the OCR and how it works

June 21, 2016 Leave a comment

Below is a very good video from the Reserve Bank of New Zealand outlining how the Official Cash Rate (the key rate of the Central bank) works in maintaining price stability. This is part of the Internal Assessment for NCEA Level 2. Remember the following:

Reserve Bank Act 1989 – made price stability the sole aim of monetary policy.

  • The RBNZ, who implements monetary policy, was made responsible for keeping prices “stable”.
  • “Price Stability” is defined in the Policy Target Agreement (PTA) as keeping the inflation rate between 1 and 3%.
  • “Inflation” is measured by the percentage change in the Consumer Price Index (CPI). Statistics NZ calculates the CPI.

 

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.

Keynes v Monetarist – Powerpoint download

March 31, 2016 Leave a comment

Here is a powerpoint on “Keynesian and Monetarist Theory” that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

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

New Zealand inflation not expected to hit 2% until March 2018

March 10, 2016 Leave a comment

Today Graeme Wheeler the RBNZ governor announced at 0.25% cut in the OCR – now 2.25%. He listed the following reasons for the cut:

  • Significant fall in inflationary expectations. The RBNZ has forecast that inflation will only reach 0.5% by September this year and 2% in March 2018. Since the GFC in 2008 weak inflation has been prevalent in the world economy and with the collapse in oil prices it has got weaker in the second half of last year.
  • Globally there is also decline in core inflation – a measure of inflation that excludes certain items that face volatile price movements. Therefore there is little or no imported inflation to talk about. A depreciation of the $NZ could mean an increase in the price of imports but would make New Zealand exports more price competitive – something that Graeme Wheeler is keen on given the weakness of New Zealand export prices.
  • A decline in the global outlook – interest rate cuts in Japan, EU and the UK accompanied by weaker growth in China. See graph below of Central Bank rates.

Surprisingly enough he said that the lower Fonterra milk payout was not a major factor in the bank’s decision as it was just a reflection of weaker global demand. Graeme Wheeler did suggest that one more rate cut might be on the cards – ‘monetary policy will continue to be accommodative’

CB rates

US economy – was it right to raise interest rates?

January 7, 2016 Leave a comment

Interest RatesData out of the US seemed to warrant the Federal Reserve’s decision to raise its benchmark interest rate by a quarter of a percentage point to between 0.25 percent and 0.50 percent on December 16th 2015. Below is the data:

  • Unemployment – was at 5% although the US lost 8.7m jobs during the recession it has gained 13m since then.
  • Wages – have been increasing to 4% in the Q3 2015 suggest that there is little surplus labour available.
  • Oil prices – may have bottomed out so this suggests inflation may pick up in 2016. As there is a pipeline effect with the impact of higher interest rates it may be prudent to increase rates sooner.

What are the concerns?

  • Wages increases maybe temporary especially if young workers are enticed back into the labour market.
  • Inflation is 0.2% which is well below the 2% target. Even when you take out energy and food prices core inflation is only 1.3%
  • Interest rates are still very low and there is little scope for cutting them if the increase has a slowing effect on the economy
  • With most Americans on fixed mortgages the interest rate increase has a limited impact on the cost of borrowing.
  • A higher US dollar will make exports less competitive and Americans manufacturers will struggle evenmore trying to sell in overseas markets.

Stanley Fischer, the Fed’s vice-chair, recently estimated that a 10% rise in the dollar reduces core inflation by half a percentage point within six months. The US Fed chair Janet Yellen is unlikely to persist with rapid rate rises if they push inflation too far below target in the short term.

Source: The Economist – 18th December 2015

AS and A2 Macroeconomics: Internal and External Balances

October 15, 2015 Leave a comment

In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

In the diagram right the point of internal and external balance is the intersection of the two axes, with neither boom nor slump, and with neither a current account surplus nor a deficit.

The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.

The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.

In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.

RBNZ – 25 basis points drop works out!

September 10, 2015 Leave a comment

Just had a great day at the RBNZ for the Monetary Policy Statement this morning – as you may know the RBNZ dropped interest rates by 25 basis points. Below is a bit of humour as to how they arrived at their decision.

NY cartoon

And they say we are not thinking practically!

How much wriggle room do countries have?

July 21, 2015 Leave a comment

The Economist has devised a composite measure of interest rates, deficits and debt which are mechanism that tend to be used by a country’s policymakers to cope with a recession.

Interest Rates
They assign a value of 100 which is maximum wriggling room – that is interest rates that are 10% or above. A value of 0 means there is no room to drop interest rates i.e. interest rate are 0%.

Deficits
They assign a value of 100 to those countries that have budget surplus of 5% of GDP or above. A value of 0 is given to deficits of 15% of GDP or more.

Debt
They assign 100 to a country that, in the IMF’s view, can borrow a further 250% of GDP or more and 0 to those, including Greece, Italy and Japan, that it judges to be testing markets’ faith.

The chart below shows how countries rank. Norway, South Korea and Australia are top and have all kept their interest well clear of 0% and have very low debt levels. On average the rich world’s wriggle room has fallen by about a third since 2007. The leeway of hard-pressed countries such as Italy and Spain has shrunk by nearly half.
Wriggle Rom

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

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