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.
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.
In doing most introductory courses in economics you will have come across the four functions of money which are:
Medium of exchange
Unit of Account
Store of Value
Means of deferred payment
Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:
60% of the world’s currency reserves are in US dollars
50% of cross-border interbank claims
After the GFC, purchases of the US dollar increased significantly – store of value.
Around 90% of forex trading involves the US dollar
Approximately 40% of the world’s debt is issued in dollars
n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.
So why therefore is there pressure on the US dollar as the reserve currency?
The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:
Deposits in yuan = 1trn yuan = US$144bn
Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
China settles 15% of its foreign trade in yuan
France settles 20% of its trade with China in yuan
The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%
However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.
Source: The Economist – China wants to make the yuan a central-bank favourite 7th May 2020
With the A2 mock exam next week here is a post on the theory and applied aspects of monetary policy. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.
Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. See mind map of Monetary Policy below.
What have caused US interest rates to increase?
The US economy has been at the forefront of the global upswing in the last couple of years and compared to other countries they are imposing a contractionary monetary policy – see graph.
The central bank in the USA, the Federal Reserve, are confident that the economy is nearly at full capacity and that inflationary pressures are starting to become evident. The main factors behind this are as follows and they all point towards an increase in aggregate demand.
Higher GDP growth
Rising investment in oil and gas industry
Strong consumer spending
Strong employment growth
Tight labour market
The US is the only major economy to impose a significant contractionary monetary policy and the Fed has increased its interest rate six times in the last two years, and four more rate hikes are expected over the next 12 months. The UK and Canada have raised their policy rates tentatively, while Europe and Japan are still in the midst of unconventional easing programmes and interest rate hikes are a distant prospect. Whilst the Reserve Bank in New Zealand don’t expect rates to rise until early 2020.
From the Espresso app by The Economist I came across a useful graph showing inflation figures in emerging economies. I used this with my NCEA Level 2 class when we discussed inflation and how if the inflation rate is below the target rate there may be room to loosen monetary policy and cut interest rates. This should stimulate demand in the economy and increase output and employment.
In America investors are experiencing the novelty of an inflation scare. But in many emerging economies, including several of the biggest, price pressures are at unusual lows. In China and Indonesia inflation is below target. In Brazil, for the first time this century, it has remained under 3% for seven straight months. And in Russia, where the central bank is meeting today, prices are rising at their slowest pace since the fall of the Soviet Union. This lack of inflationary pressure gives central bankers some welcome room for monetary manoeuvre. Even if America’s Federal Reserve turns hawkish, emerging markets need not slavishly follow its lead.
How important is it to have an economics background to run the Federal Reserve? The FT’s US economics editor Sam Fleming talks to several leading economists on whether being versed in the theory is a basic requirement for a Fed chair.
Current US Fed Chair Janet Yellen could be heading into the final six months of her first term at Fed Chair. If Donald Trump does not give her a second term it may usher in new thinking from the US Government. There is no requirement for Donald Trump to appoint someone who is from the academic world of economics. They mention the success of Paul Volcker as Fed Chair who didn’t have a PhD in Economics but had a Masters Degree and also experience in banking (Chase) and commercial sector. From the left you have – Janet Yellen, Paul Volcker, Alan Greenspan and Ben Bernanke.
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.
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.
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.
The TED spread is the difference in rates between the interest rate that the US Government is charging for cash (three-month Treasury-Bills – the “T”) and three-month Eurodollars (the “ED”) contract as represented by the London Interbank Offered Rate (LIBOR).
The TED measures the rate of return the banks are requiring over the risk-free Treasury Bill rate to lend to other banks. If the economy is healthy the TED spread tends to be at low levels as there is a lot more trust in the market and the risk of default or bankruptcy is low. On the contrary, when the economy goes through a downturn levels tend to be higher as banks become more prudent in their lending and this reflects some sort of risk or liquidity premium. As the spread increases, the risk of default is considered to be growing. Ultimately TED illustrates the level of anxiety banks have that other banks are going to default – some liken it to a kind of measure of the financial sector’s blood pressure.
In 2006 and for half of 2007 the TED was consistently under 1%, which is historically low. However in August 2007 with the advent of the sub-prime crisis there were indications that all was not okay on financial markets. This was soon followed by the freezing of funds by investment bank BNP Paribas and consequently the TED spiked at 1% for the first time in a decade. From this point on the credit crunch was accelerating and markets were becoming extremely volatile. With the collapse of Lehman Bros the credit market became very explosive and the TED went through the 3% level, which exceeded levels last seen in the crash of 1987. Subsequently, a number of US and European banks collapsed and interbank lending just about came to halt. Liquidity was reduced dramatically and the TED peaked at 4.65%, a point never witnessed previously. To counter this problem Governments around the world promised trillions of dollars in bailouts and bank guarantees that, in the end, restored some confidence in credit markets – the Ted fell from its peak to about 2.25%.
Recently the TED Spread moved from 0.21% at the end of 2015 to 0.43% on 11th January 2016 . That is its highest level since 2012, when markets were pressured by fears of a sovereign-debt crisis in Europe.
Treasury Bill Yields – down
In order to protect themselves from runs during market turbulence, investment companies are shifting funds to government stock which is more secure. That adds to demand for T-bills which increases their price and reduces their yield
Libor – up
Rising demand for T-Bills has reduced downward pressure on the Libor. Furthermore the increase in the US Fed rate last month resulted in a rise in the Libor and a number of other benchmarks.
However the TED spread’s surge is a mechanical result of its two components moving in different directions for reasons mostly unrelated to the creditworthiness of banks. Treasury-bill yields are down, Libor is up, so the TED spread is up, too. ‘Wall Street Journal’.
Data 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.
John Cassidy wrote a piece in The New Yorker which focused on the US Fed targeting the threat of bubbles rather than inflation when implementing policy instruments. In the mid 1990’s and early 2000’s the Fed set interest rates based on the supposed threat of inflation. However price rises never materialised so the low interest rates fueled borrowing especially for purchasing property.
In the past, expansionary monetary policy (low interest rates) would have acted as a catalyst to the real danger of a wage price spiral in which rising wages and prices become self-reinforcing, pushing inflation up. This was very apparent in the winter of 1974 in the US when inflation reached 12% and 15% by 1980. But today with the annual rate of inflation in the US at less than 2% for the past three years the threat of another wage price spiral is fairly dormant. It was forecast that that wage and price inflation would start to rise but average hourly earning rose by just 0.1% in January. Over the course of the past year, it has risen by 2%, which is a very modest rate of increase.
Economists have never been able to pin down the jobless rate at which inflation takes off—the so-called NAIRU, or Non-Accelerating Inflation Rate of Unemployment. Theoretically, the concept makes sense. Empirically, it’s extremely elusive, because it depends on many other things, such as the rate of productivity growth, tax rates, the labor-force participation rate, and the level of unionisation.
However higher wages will eventually surface with a tight labour market but the real dilemma for the Fed is the tradeoff between cheap money and financial instability. Keep interest rates too low for too long and you ignite another asset bubble or raise interest rates to alleviate the bubble risk but dampen growth in the economy?
The US Fed currently have an interesting problem which other central bank would be happy to have. They have a dual mandate of Price Stability – 2% inflation and Full Employment – 5% unemployment. The current unemployment rate is 5.8%, the lowest level since 2008, and if it drops below 5% there could be labour shortages which will help to put pressure on wages and ultimately inflation. However the current inflation rate is only 1.3% and it is heading below 1% next year. There are two main reasons for this:
* The significant drop oil prices and
* A stronger US$ making imports cheaper
The concern for the US Fed is that inflation over the next couple of years stays well below the 2% threshold and interest rates remain close to 0%. As pointed out by The Economist the problem will be when the next recession rears its ugly head and Fed has no room to cut rates further as they cannot fall below 0%, since savers would simply convert their deposits into cash.
An option might be to let unemployment fall below 5% which make the labour supply more scarce bidding up wages and prices – with inflation reaching the target of 2%. Furthermore higher wages should entice workers back into the labour force. The risk is that with close to 0% interest rates inflation could rebound suddenly forcing the Fed to raise interest rates. How the Fed cope with the dual mandate next year will be interesting although the safe option could be to increase rates in the June this year. Below is a clip from Paul Solmon of PBS which explains the concern that the Fed have. It also stars Merle Hazard with a song about the dual mandate.
Following on from Merle Hazard’s Dual Mandate song, here is a report from Paul Solman of PBS looking at the role of the Federal Reserve with the end of its QE money creation programmes. The US economy is still in recovery mode and the role of the Federal Reserve is being debated. While most central banks have one mandate – price stability – the US Fed has two:
1. Maintaining stable prices
2. Full employment
Paul Krugman doesn’t think the Fed is achieving either of their mandates and would have liked to have seen them continue their bond buying last longer since employment rates and wages are still depressed.
Another video by Paul Solman in which he discusses how the NYSE record high doesn’t reflect the fundamentals of the US economy. With interest rates at virtually 0% the US Federal Reserve is trying to lower unemployment by stimulating the economy. But, by doing so there has been a tendency for it to overstimulating the stock market in the process. And also lending to stock investors, whose margin debt to buy shares on credit has been hitting record highs. Last week the Dow ended above 16000, another record for the headline index of 30 major companies.
The last record was set in 2007, a few months before the Dow’s previous high watermark.But for all the talk of the Fed’s role there’s an alternative way to understand a record Dow and higher profits: a shift of power from workers to owners. The stock market would actually be much higher if the unemployment was much lower. I think the economy is still really fundamentally weak, and that slack that’s in the economy right now, with all the unemployed people, all the unemployed businesses, would actually bring up the stock market even further.
With near zero interest rates in the US and the promise of them to remain until 2015 those that are living off the interest on savings, mainly the retired, are finding their incomes squeezed. According to The Economist personal interest income has plummeted by 30% which equates to a $432bn annually and more than 4% of disposable income. Former IMF chief economist Raghuram Rajan describes the Fed’s policy as:
“expropriating responsible savers in favour of irresponsible banks”
How should lower interest rates work according to the textbook?
However today it seems that even with these really low interest rates businesses and consumers don’t want to borrow or cannot qualify due to the more stringent requirements required. Furthermore with less consumption in the circular flow you would think that there is less need to fuel anymore investment spending.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Nobel Laureate Joseph Stiglitz came out strongly against the recent QE3 by the US Fed and the ECB’s announcement that it would buy government bonds of indebted eurozone member countries. With this announcement stock prices in the US reached post-recession highs although some worried about future inflation and significant government spending. According to Stiglitz these concerns are unwarranted as there is so much underutilisation and no serious risk of inflation. But the US Fed and the ECB sent three clear messages:
1. Previous actions didn’t work – ie QE1 and 2 2. The US Fed announcement that it will keep rates low until 2015 and buy $40bn worth of mortgage backed securities suggested the recovery is not going to take place soon. 3. The Fed and the ECB are saying that the markets won’t restore full employment soon – fiscal stimulus is needed.
In textbook economics increased liquidity means more lending, mostly to investors thereby shifting the AD curve to the right and thereby increasing demand and employment. But if you consider Spain an increase in liquidity will be cancelled out by an austerity package.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending. Joseph Stiglitz
Here is a great graphic from the BNZ showing how the NZ dollar performed in September. You could say that it strengthened on the back of notably QE3 from the US Fed and the improving global growth sentiment. Furthermore the NZ economy has performed well under trying circumstances.
June quarter GDP accounts revealed the NZ economy finished Q2 1.6% bigger than where it began the year. That is solid economic growth under ordinary circumstances. But given the ongoing challenging and uncertain global economic environment we should not under sell this achievement. It is the strongest six month expansion we have seen in the past five years. Source: BNZ
Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index