This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:
The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.
Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.
Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.
Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.
Going over monetary policy with my A2 class and have modified a mind map done by Susan Grant from a CIE Economics Revision Guide. Useful for those who are sitting the June AS and A2 Economics papers.
Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Monetary Policy. Immediate feedback and trackedresults allow students to identify areas of strength and weakness vital for student-centred learning and understanding.
The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.
A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.
“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London
Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022
Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on exchange rates and monetary policy. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.
In New Zealand the recently published CPI figures published yesterday saw the yearly inflation rate climb to 6.9%. The main points to note are:
Tradeables inflation (imported) – makes up 40% of CPI – 8.5%
Non-tradeables (domestic) – makes up 60% of CPI – 6.0%
Housing and household utilities increased 8.6 %,
Transport increased 14 %,
Food prices increased 6.7 %,
Petrol prices 32.3%
The continued rise in domestic inflation means that the RBNZ will probably look at another 50 basis points rise later in the year.
Ukraine War adds another supply shock – are higher interest rates the way to go? With a second supply shock and inflation globally on the rise (see graphs) central banks have raised interest rates. However the Russian invasion of Ukraine and the subsequent increase in food and energy prices has asked questions of how central banks should approach monetary policy in what is unusual circumstances. Martin Sandbu in the FT suggest that they should rethink how they look at the operation of an economy. He made 3 main points:
Are central banks committed to aggressively increasing increasing rates every time there is a supply shock? This has a huge impact on households and businesses.
Do central banks know how their monetary policy works? Higher interest rates reduce aggregate demand and therefore easing the pressure on the supply side. However this is difficult to vindicate in that nominal spending has only just returned to pre-pandemic levels and still fell short in the EU and the UK.
These supply-shocks are ‘out of left field’. COVID caused greater spending on durable goods and non-durable goods by 25% and 10% respectively. Services remained depressed.
With the energy shortages arising from the Ukraine War there will be a movement away from production and consumption that use coal, oil and gas. Russian coal is already banned and it is likely that oil and gas will follow. Sandbu asks how monetary policy should approach a supply shock of this nature. If lower interest rates makes it easier to relocate resources then that is the best option for central banks. A tightening of monetary policy would make investments in new capacity both more expensive and less attractive as demand growth slows.
Today there are abnormal circumstances – COVID, Climate Crisis, Ukraine War, supply chain problems. These will mean huge structural shifts which can improve an economy’s productivity and lower inflationary expectations. If there are still higher interest rates productive potential would be reduced which would mean added pressure on inflation. Heading into a time of global supply chain problems monetary policy seems to be less effective.
Source: Central bankers should think twice before pressing the brake even harder – Martin Sandbu – FT 20th April 2022
Just starting to go through this part of the course with my A2 class and came across a table from some old A Level notes produced by an ex-colleague Russell Tillson (ex Epsom College Economics and Politics Department) to help them understand the principal differences.
Here is a really funny video by the students of Columbia Business School (CBS) – you may have seen it before but I find it very useful when you start teaching monetary policy and interest rates.
Back in 2006 Alan Greenspan vacated the role of chairman of the US Federal Reserve and the two main candidates for the job were Ben Bernanke and Glenn Hubbard. Glen Hubbard was (and still is) the Dean at Columbia Business School and was no doubt disappointed about losing out to Ben Bernanke. His students obviously felt a certain amount of sympathy for him and used the song “Every Breath You Take” by The Police to voice their opinion as to who should have got the job. They have altered the lyrics and the lead singer plays Glenn Hubbard.
Some significant economic words in it are: – interest rates, stagflate, inflate, bps, jobs, growth etc.
Doing quantitative easing (QE) with my A2 class last period today and showed a humourous video with the late John Clarke about ‘What is Quantatitive Easing?’ – Point your printer out the window and make sure the wind is blowing in the right direction. Below is an explanation but Clarke and Dawe have an interesting take on it.
Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Governments and central banks like there to be “just enough” growth in an economy – not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called “Goldilocks economy” – not too hot, but not too cold. One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.
But when interest rates are almost at zero, central banks need to adopt different tactics – such as pumping money directly into the economy. This process is known as quantitative easing or QE.
Today, not surprisingly, the RBNZ increased the official cash rate (OCR) by 25 basis points – 0.25% – to 1%. There was a suggestion in the RBNZ Monetary Statement that the increase could be 50 basis points but noted a preparedness to move in bigger steps than 25bp“if required”. The RBNZ forecast endpoint for the OCR has been increased to 3.35%. and expect annual CPI inflation to peak at 6.6% in the March 2022 year and to fall back to the 1-3% inflation midpoint by mid 2024. The reduction in inflation should come from the easing of supply chain disruptions, lower commodity prices and tradable inflation. But the question that needs to be asked is, will this tightening be sufficient to dampen the following:
domestic pressure from the housing market,
wage pressure with 5.9% inflation and unemployment at a very low 3.2%,
prices of locally produced products (non-tradable inflation)
The Neutral Interest Rate
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.
The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.
OCR > Neutral Rate = Contractionary and slowing down the economy OCR < Neutral Rate = Expansionary and speeding up the economy
The RBNZ’s estimate of the neutral OCR is between 0.9% and 3.1% – see below. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.
Since the GFC neutral rates around the world have been falling which reflects the following:
Lower expectations about growth in the economy = reduces the return to investment
Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.
Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.
Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Monetary Policy. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.
Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)
LSAP – this is the buying of up $100 billion of government bonds – quantitative easing FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.
With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.
For more on Monetary Policy view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.
A good example of the output gap from the RBNZ Monetary Policy Statement last week – see graph above. There are strong capacity pressures which are the result of the unleashing of domestic demand and supply chain disruptions. Although the latter has increased it is presently unable to keep up with the the overall aggregate demand of the economy and subsequently this has driven inflation up to 4.9% above the 1 to 3% remit target band.
With unemployment at 3.4% and *underutilisation of 9.2%, annual employment growth of 4.3% (September 2021) cannot be maintained with this pressure on the labour market. There has been strong demand for more workers in some sectors, but it has been difficult for businesses to recruit extra staff. This has seen wages rise as firms compete for workers. However it is important to remember that on 29th October there were still 1,282,152 jobs being supported by a wage subsidy. A total of NZ$3,719.7 million had been paid via the COVID-19 Wage Subsidy August 2021. With the continued demand for labour, wage pressure and salary costs are expected to increase. Consequently a rising unemployment rate could be evident.
*underutilisation – measures spare capacity in New Zealand’s labour market. People do not have a job, but are available to work and are actively seeking employment
Notes on the output gap
If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.
With the A2 essay paper next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:
What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)
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. The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.
OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy
This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:
2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level 2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.
What determines the neutral rate of interest in an economy?
Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%. Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates. Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest. Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises. Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates. Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced. Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too. Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.
Outlook With the COVID-19 lockdown, increasing levels of debt amongst households and business and record low interest rates there is an expectation the RBNZ will increase the OCR. But with the OCR at such a low level already the RBNZ is running out ammunition if it wishes to stimulate the economy through conventional monetary policy.
Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank
Latin American countries are now struggling to control inflation and have succumbed to raising interest rates despite having slow growth economies. Inflation in this part of the world has a bad track record with Argentina, Bolivia and more recently Venezuela experiencing hyperinflation. Furthermore, these countries have been hit hard by the pandemic and their economy’s need to develop more economic growth to create jobs and higher incomes. Rising interest rates is the last thing they require especially after government stimulus programmes are winding down and the revenue from commodity prices is starting slow.
Latin America is struggling with the combined health and economic impact of COVID-19 than any other region. Inflation rates are currently – Brazil – 9.7% Venezuela – 5,500% Mexico – 6.1% Chile – 4.8% Peru – 4.95% Columbia – 4.4%
Source: FT – The spectre of high inflation returns to haunt Latin America. 11th September 2021
There is concern that the current mix of expansionary monetary (near 0% interest rates) and fiscal (lower taxes and increasing government spending with COVID-19) policies will excessively stimulate aggregate demand and lead to inflationary overheating. Add to this negative supply shocks and you have an increase in production costs. This combination could lead to a 1970’s stagflation – rising inflation and unemployment – see graph below. Since the days of stagflation in the US and UK in the 1970’s inflation has been the number one target for central bankers. The main cause of inflation during this period was the price of oil –
1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
1979 – 200%↑ – supply-side – Iran Iraq War
US President Jimmy Carter’s attempts to follow Keynes’s formula and spend his way out of trouble were going nowhere and the newly appointed Paul Volcker (US Fed Governor in the 1970’s) saw inflation as the worst of all economic evils. Below is an extract of an interview from the PBS series “Commanding Heights”
“It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon.”
The policy of the time was Keynesian – inject more money into the system in order to get the economy moving again. This was also the case in the UK in the early 1970’s but Jim Callaghan’s (Labour PM in the UK ousted by Thatcher in 1979) speech in 1976 had reluctantly recognised that this policy had run its course and a monetarist doctrine was about to become prevalent. Below is an extract from the speech.
“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment. That is the history of the last twenty years”
With this paranoia about inflation central bankers began to implement a monetary policy targeting inflation in the medium term. In NZ the Reserve Bank Act 1989 established “price stability” as the main objective of the RBNZ. “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (originally 0-2%) – measured by the percentage change in CPI. Around the world central banks were adopting a more independent approach to policy implementation and with targeting inflation a new prevailing attitude seemed to be like an osmosis and suggesting that low prices = macro-economic stability as well. Also, raising interest rates is an unpopular political move and governments could now blame the central bank for this contractionary measure.
So are we now concerned that we will be entering another period of stagflation? Like the 1970’s we do have a supply-side issue (although not oil based) and expansionary demand side. The following are concerns:
Growth – Supply bottlenecks have led to growth slowdown in the US, China, Europe and the other major economies. Furthermore the Delta variant is increasing production costs as well as impacting the labour supply and ultimately reducing output growth. There is also the problem of moral hazard in that generous unemployment benefits are reducing the incentive to find work.
Demand Side – Excessive fiscal stimulus for an economy that already appears to be recovering faster than expected and it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay.
Supply Side – Again Delta is impacting many global supply chains, ports and logistical systems. Shortages of semi-conductors impacts the car industry as well as electronic goods thus increasing in inflation. Will the global supply side be positively influenced by better use of technological innovation in artificial intelligence and the return to normality on global supply distribution networks. Also will demand pressure eventuate especially when the threat of unemployment is ever present.
Although there are negative price shocks which could deter potential growth, expansionary fiscal and monetary policy could still increase the inflation rate. The resulting wage-price spiral could lead to astagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflationary debt crisis will continue to loom over the medium term.
Source: The Stagflation Threat Is Real – Nouriel Roubini – Project Syndicate 30th August 2021
I listened to a very good interview on the David McWilliams podcast in which he talks with Dario Perkins the super cycle and the end of neoliberalism. A lot of the discussion was around the paper that Dario Perkins had written – A New Supercycle Running on MMT – in which he sees MMT as delivering a superior fiscal-monetary mix. The fact that fiscal policy must take over from monetary policy has been the apparent with the range of policies that were implemented after the GFC. Since the late-19th century the super cycle can be placed into three phases of Capitalism influenced by macro-financial-political regimes – see chart below. MMT could provide the intellectual rationale for a new form of capitalism – Capitalism 4.0. Over the last century the pendulum has swung between extreme fiscal and extreme monetary policy with the global economy primed for another change.
1920’s – Monetary policy dominated but ineffective during the Great Depression 1930’s – Fiscal policy dominated as there was a need for government intervention to get the economy moving after the Great Depression 1940’s – 1960’s – Fiscal Policy – with the 2nd World War and the recovery process post-war. 1970’s – Stagflation and fiscal policy is no longer effective and Keynesian economics as government spending just causes higher inflation and higher unemployment. 1980’s – Monetary policy gains traction and inflation is brought under control. Central Banks become independent and fiscal policy and government intervention is seen as a restriction to growth. With Reagan and Thatcher Neoliberalism was the ideology of the day
Have we reached a new regime – Capitalism 4.0? The GFC was a warning that capitalism in its present form was not working and there was potential for a new regime change. However governments adopted austerity and QE which made inequality worse. The issue was that there was no alternative to the neoliberalism Capitalism 3.0 but with the arrival of COVID-19 governments have been forced to spend up large and there is a belief that the old system doesn’t work and that maintaining Capitalism 3.0 will not make the situation any better. Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending.
Modern Monetary Theory (MMT) MMT states that a government that can create its own money therefore:Cannot default on debt denominated in its own currency;
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;
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;
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;
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.
It will be interesting to see if MMT can enjoy the same presence in economic policy that monetarism and Milton Friedman experienced in the post-stagflation time period. Back then there was a political revolution primed to embrace monetarism and neoliberal ideas and an electorate that had experienced a serious economic crisis – stagflation. Subsequently the influence of MMT will come down to politics.
Joe Biden seems to have embarked on a more radical macro-economic policy which has various instruments that are found in MMT. Will there be other political leaders who embrace this paradigm like Reagan and Thatcher in the 1980’s with Friedman and monetarism?
Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the 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:
Circular Flow and the Multiplier
Diagrammatic Representation of Multiplier and Accelerator
I always encourage students to be aware of what is happening in the global economy as well as their own. Below are growth, unemployment and interest rates for the main economies. Note the high rates of quarterly economic growth which indicates a bounce back from the previous quarter when most of the world was in a serious lockdown. The unemployment rates you would expect to be a lot higher with COVID-19 and a 4.9% rate in NZ was a surprise. An area of employment growth in the December quarter was Construction, along with many government-dominated industry types. Monetary policy been very accommodative and although rates have been very low note that in Japan and the Euro zone areas it has been like this since 2016. These figures could be used for discussion purposes in you class.
Source: Monthly Economic Review – February 2021 – NZ Parliamentary Service
Below is a useful flow chart for anyone studying monetary policy. Both the NCEA Level 3 and CIE A2 courses cover this topic.
Negative – lower interest rates might depress spending by some retirees who rely on interest income. But these counterproductive channels are small compared to the Positive – lower interest rates = a lower propensity to save and a higher propensity to spend.
The side effects of monetary policy. Falling interest rates = accelerating house prices = social problems and political anxiety. If RBNZ kept interest rates at around 8% as in the 2000s to prevent the house price = New Zealand in deflationary spiral.
The economic and social consequences of deflation would be far worse than the (undeniable) problems with rising house prices. The low inflation / falling interest rate dynamic of the past two decades has been a global phenomenon, ultimately caused by a global change in the balance between savings and investment. The Reserve Bank of New Zealand could not have prevented this global trend from affecting New Zealand interest rates without causing severe damage to the economy. In New Zealand, the most important transmission channels are asset prices and the exchange rate. Falling interest rates tend to push asset prices up, which stimulates consumer spending. Falling interest rates also tend to reduce the exchange rate, which generates inflation via the prices of internationally-traded goods and services.
Japan is top of the table in accumulating government debt and with a record stimulus to cushion the impact of COVID-19 it is approaching debt levels of 250% of GDP. So how does Japan manage to keep its government bond yields so low (see graph below) and investor confidence high that it can avoid default?
To finance this debt, the Japanese government issues bonds known as JGBs. These are snapped up in enormous volumes by the Bank of Japan (BoJ), the country’s central bank that is officially independent but in practice closely co-ordinates economic policy with the government.
Bond Prices vs Yield
Like any investment the buyer of the bond wants to get the greatest return. Bond prices and interest rates (yield) move in opposite directions and an easy way to consider this is zero-coupon bonds. Here the interest is derived by the difference between the purchase price of the bond and the value of the bond on maturity. Bond price $920 – Maturity value $1000. The bond’s rate of return = (1000-80 ÷ 920) x 100 = 8.7% return. However a lot depends on what else is happening in the bond market. If interest were to increase and newly issued bonds were giving a return of 10% the 8.7% return is no longer attractive. To match the 10% the original bond price would have to decrease to $909. The bond’s rate of return = (1000-909 ÷ 909) x 100 = 10% return
Reasons for low rates on JGB’s
Japanese Government Bond (JGB) is a bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.
The BoJ has recently been buying up billions dollars of Japanese government bonds keeping interest rates around 0% in the hope of increasing the inflation rate to its 2% target. Therefore any rise in bond yields triggers a buy action from the BoJ. As of 2019, the central bank owns over 40% of Japanese government bonds. The BOJ’s government bond holdings rose 3.4% from a year ago to 486 trillion yen ($4.5 trillion) as of March 2020, roughly 90% the size of the country’s economy, according to the central bank’s earnings report for the previous fiscal year.
Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.
Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money V = Income Velocity of Circulation P = Average Price level T = Volume of Transactions or Output
Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.
Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.
Secular stagnation Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro