Friday, 24 February 2012

Economists save world (for now)

A slight exaggeration maybe but economists at central banks in different countries have been decisive in dealing with the global financial crisis while politicians have been bickering about different ways of dealing with the problems.

Conventionally, lowering of interest rates is the main tool for central bankers to combat weakness in the economy but a new set of tools was deemed necessary after interest rates of close to zero have proven to be inefficient in combating the current economic downturn. Central banks now rely on quantitative easing which is the purchasing of government or other bonds using money which the central banks can print themselves as a way of increasing the money supply. In theory, an increase in the money supply means that there is more money for consumers to spend which is a boost to the economy but may also cause inflation (which is not a problem at the moment).

While the Federal Reserve and the Bank of England have each carried out a couple of rounds of quantitative easing, perhaps the prize for the most ingenious and effective policies in the face of adversity goes to the European Central Bank (ECB) and its new governor Mario Draghi. Central banks are usually set up independently from the governments in each area but governments can still wield a degree of influence over the operations of the central banks. This has been particularly true in the case of the ECB.

While central banks in the US and UK have purchased bonds issued by their government in order to reduce the interest rates on government debt, the ECB has been prevented from doing this by politicians in Europe. Many countries in Europe lead by the Germans are against the ECB purchasing the government bonds of countries in Europe with high levels of government debt such as Greece, Italy, Spain, or Portugal. The resulting lower interest rates on government debt would help relieve the pressure on these countries but Germany would rather that the higher interest rates spur the indebted countries to changes their ways.

The ECB has come up with a way of prompting purchasing of the government bonds of European countries without actually doing the buying itself. Draghi, the new governor, expanded the lending by the ECB to banks in Europe to allow for borrowing at its main interest rate (currently 1.0%) for up to three years. This meant that banks could borrow funds cheaply off the central bank and make easy money by buying government bonds which offered considerably higher returns. The ECB provided 489 billion euros of loans to banks in December and this had the effect of lowering the interest rates on bonds of European countries which have made earnest efforts to reduce government debt while keeping the pressure on other countries which have not.

Funnelling money through the private banks has proved a clever way of realising the policy of quantitative easing in the case of the ECB which has the choice of many different government bonds to buy. By providing private banks with the funds to purchase government bonds, it has meant that which bonds to buy is left in the hands of investors which allows for rational decision making based on market principles rather than being influenced by politics.

So the ECB was ingenious enough to come up with a way of easing the crisis in Europe despite obtrusive politicians. Not exactly saving the world but helping out under difficult circumstances.

Monday, 13 February 2012

Stocks Up Despite Doom and Gloom

After all the doom and gloom in my last posting, I noticed a strange headline in the newspaper. The negative outlook for 2012 would suggest that stock prices would not be doing so well, but instead, stocks are the highest they have been since the plunge in the markets amid the financial crisis. So while economists typically like to stay clear of talking about stocks, hopefully I can provide some insight into what seems to be a bit of an anomaly.

Stock prices often move in directions that are different to what is actually happening in the economy. One explanation is that investors will purchase stocks not only based on what has occurred in the past but also what is predicted to happen in the future. This means that the stock market is dominated by whether investors are feeling optimistic about the future or are downbeat on the prospects for companies making profits. The forward-looking nature of investors means that stock prices are typically seen as a leading indicator – a measure that points to an upturn or downturn in the economy before this is registered in the actual growth data. This may be the case here but it is unlikely considering, for example, the Federal Reserve in the US is planning to keep interest rates at close to zero as mentioned in the previous posting.

Instead, market sentiment has been buoyed by the outlook for interest rates that was released recently by the Federal Reserve. Weak prospects for growth in the US economy have prompted the central bank to state that it expects to hold interest rates down until late 2104. This implies a negative outlook for the economy but it is taken as being positive for stocks. The reason for this is because low interest rates mean that the return from bonds will typically be low and investors who are looking for a better return will be tempted to invest money in stocks instead. Stocks in the US have already bounced back strongly after a massive sell off when the Dow Jones Industrial Average plunged from around 14,000 in October 2007 to below 7,000 in March 2009. The Dow Jones index has since climbed back up to near 13,000 by the beginning of February 2011 which is the highest since May 2008.

The stance taken by the Federal Reserve is positive for stocks in other ways. Consumers and firms will be more likely to borrow if interest rates are low. Also, the commitment to keep interest rates low further suggests that the central bankers in the US will take less aggressive policies against inflation and this is a positive sign for some companies. Higher inflation means that firms such as electricity and gas providers as well as other companies which sell energy products would have more scope to increase prices and this would help boost profits.

Of course, this is not the only reason for the recent gains in the stock market. Data out last week showed that employment is on the rise with 243,000 jobs created in January in the non-farm sector. But the central bank’s policy does provide a background whereby the attractiveness of stocks is increased compared to other investments which means more money will flow into stocks along with any improvements in the economy.

Not any great investment advice, but hopefully, the world may make a little bit more sense.