Wednesday, 31 July 2013

Time to rethink inflation?

Inflation has been made into a bit of a monster by economists but does inflation deserve its bad name?

Inflation is seemingly innocuous and a bit boring. Prices go up over time without hardly anybody noticing or being able to do anything.  But the experiences of stagflation, when the economy stagnated but inflation was stubbornly high in the 1970s, made inflation public enemy number one for economists.  Even though the global financial crisis has shown that there are far worse gremlins lurking in the economy, worries about inflation are hardwired into the way economists look at the world.  Does inflation still matter or should central banks be keeping their eyes out for something else?

Inflation has been targeted by policy makers since the 1970s when economies in the West were plagued by high inflation and slow economic growth amid the effects of the oil shocks.  Inflation became a central part of a downward economic spiral – rising prices for consumer products due to oil being more costly prompted unions to demand higher pay which pushed up the costs for firms, to which they responded with increasing the prices of their goods. The negative impact of rising prices and wage increases in combination with the higher cost of oil devastated the economy and created a link between economic stagnation and inflation – hence the term “stagflation”.  A turnaround came on the back of the unions losing their power to influence wage negotiations after standoffs with Margaret Thatcher in the UK and Ronald Regan in the US.  But inflation is the boogie man than has given a generation of economists nightmares.

The trauma of stagflation was powerful enough for politicians to give up control of monetary policy to independent banks which was seen as the best means by which to keep the beast of inflation in its cage.  This policy has been successful in that inflation has remained subdued over the past two decades with expectations of low inflation translating into only incremental increases in wages.  This new policy was aided by the development of China as source of cheap labour and an exporter of low cost goods which limited increases in both prices and wages.  Despite achieving what it set out to do, the new policy framework also created new problems.

Central banks have focused on slaying the beast that is inflation but choose to ignore higher prices in other areas such as assets like houses or stocks.  Higher prices for assets have the potential to develop into asset price bubbles which when popped can have a devastating effect as shown by the global financial crisis.  Whether it be because asset price bubbles are not always easy to spot and this would create considerable subjectivity in policy making, central banks have typically shied away from acting to prevent the build-up of asset price bubbles.  Inflation in terms of prices of consumer goods is easier to measure and develop a consensus on the correct policy measures but this may be a case of slaying one dragon only to let a bigger one roam free.

Your Neighbourhood Economist would argue that inflation is not the scourge that it once was.  Relentless increases in wages as in the 1970s are not likely to occur as unions do not have anywhere near the same power as before and also because competition from workers in China and elsewhere means that average wages in Western countries have hardly seen any increases at all.  So the past lessons from stagflation do not seem so pertinent any more.  The global financial crisis occurred at a time of low inflation but following a period of excessive lending by banks spurred on by low interest rates set by central banks.

This does not mean that inflation is something that should be let loose again.  Rising prices eat away at what workers can afford to purchase with their wages and they will be able to buy less with their savings that are stashed away if prices are increasing.  Inflation in one country also increases the costs used to produce goods in that country and makes it less competitive relative to goods made elsewhere.  But to have monetary policy revolve around something that has only a minimal effect on the overall economy is out-of-date and potentially hazardous.  Inflation may also be a route to salvation for Western countries buried under high levels of debt – it is easier to pay back loans if wages and tax revenues are increasing (for more on inflation as a power for good, see What's up with inflation?).  It will take a lot for economists to admit that they have gotten side-tracked by an infatuation with inflation, but the aftermath of a near economic collapse seems as good a time as any to do so.

Monday, 29 July 2013

Good and Bad from Slowdown in China

When something is as inevitable as the growing dominance of China, the only option is to take the bad with the good.

It seems as if everyone is keen to know more about China.  The high level of interest is a result of both benefits and threats that China poses to the lives of us all.  China has an undue influence, be it the prices we pay for petrol or for running shoes, due to its dual role as a dominant consumer and producer in the global economy.  So slower economic growth in China and the reasons behind it will have effects that will ripple through the global economy.  But there will be good along with the bad and here is how it may play out.

Before starting on what might happen, it will be useful to look at the reason behind the slowdown.  The Chinese economy has reached a point of change in its development.  In the past, higher wages would prompt people employed in agriculture in rural China to move into the cities and work in factories.  This trend spurred the size of the economy to expand as these workers were being put to more economically productive uses compared to scratching out a living on small-scale farms. 

The first factories in China made basic goods such as clothing in the same way that the growth in textile factories was behind the Industrial Revolution in England around 200 years ago.  But as the economy has become more sophisticated, Chinese firms have invested massive amounts in new factories to produce more complex goods while the government has spent heavily on infrastructure.  But the driving force of growth came from the seemingly endless supply of cheap labour that would be put to use producing goods of higher and higher value.

But the end of economic growth fuelled by cheap labour and piles of investment seems near.  Rising wages in China are a sign that workers are proving tougher to find (refer to End of the end of the world).  Benefits from further investment are not as easy to come by considering the splurge in spending which lifted investment to around 50% of GDP compared to around 15% in the United States.  So the growth of a domestic consumer market as wages rise in China is seen as key as the next phase of economic development.  But the effects of this will not just be felt in China but across the globe. 

China has been the engine that is driving the meagre growth in the global economy.  Economies in places such as Germany and Australia have been kept perky by supplying machinery and minerals for the hungry Chinese economy.  Without this extra boost from China, the slowdown in the global economy would have been a lot worse even in countries which do not have links with China.  As such, a slowdown in China will be reflected in growth statistics across many other countries.  While the Chinese economy is still expected to expand by around 7% this year, the transformation of the Chinese economy from a manufacturing powerhouse to a consumer mecca is bound to be a bumpy ride and the effects of this on economic growth is still unclear (but there is good reason to be positive – see China brings out the Big Guns for more).

The economic rise of China has changed the shape of the global economy.  Everything from the price of coal to cows has been pushed upwards due to the seemingly insatiable appetite of the Chinese economy.  Much of the commodities have gone into providing the building blocks of the Chinese economy (steel girders and concrete slabs) and the fuel needed to drive the growing economy.  Less investment and slower growth will halt the upward rise in prices in some areas such as steel and other metals.  This will help lower construction costs all over the world and will be a blessing for places like Europe and the United States where investment has been weak. 

The slowdown in China is expected to provide other benefits for Western countries as well.  As shown by Chinese shoppers’ desire for luxury bags and shoes, demand for goods from overseas will increase as consumer demand picks up in China.  Whether it be producers of chocolate bars or fancy cars, there will be ample opportunities for Western firms to target Chinese consumers in the future as there will be strong demand for foreign goods until Chinese companies can build up their own brands.  The flipside of higher wages in China is that goods produced with a “Made in China” label will not be so cheap anymore.  Despite grumblings of firms faced with competition from exports, Chinese goods have been a boon for consumers in the West and have helped meagre pay packets go further.

For all of the good and bad, a slowdown is needed so that the Chinese economy does not implode under the weight of massive debts and reckless investment (for more detail, seeWhy China needs a slowdown).  The way forward will include some rocky patches but the rise of China is inevitable and will throw up challenges both within and beyond its borders.  Trying to fight it would be like trying to push back a rising tide – the only option is to make the most of it.

Tuesday, 23 July 2013

China brings out the big guns

Staying in control of a rampant economy is not easy but the Chinese government shows that it has the necessary firepower.

While investors follow the movements of central banks with one eye, their other eye would most likely be following the fortunes of China.  The rapid rate of expansion in the Chinese economy seen over the past couple of decades may be coming to an end with the era of cheap labour seemingly coming to an end.  But the centralized government in China has so far shown itself apt at managing the Chinese economy through its growing pains (see Why China need a slowdown? for related story).  Despite mounting concerns over economic growth in China, Your Neighbourhood Economist believes that the Chinese government has both the necessary firepower to point the economy in the right direction and the willingness to use it.

In its current state of development, the economy in China is still very much like the Wild West – lots of small firms battling it out in a gun fight to see who comes out on top.  This analogy does not hold so well when taking in consideration the giant state-owned companies which dominate parts of the economy or firms such as Huawei or Baidu who have already grown to the point where they are mostly above the fray. But China is a world away from having a few large firms dominate each industry as would be the case in most Western countries.  As such, competition is fiercer with big rewards awaiting those that can prosper.  The Wild West analogy also reflects the relative state of lawlessness in China where firms don’t have to worry as much about issues such as pollution, labour standards, and respect of intellectual property.

To add to the lawlessness, politics in China can seem at times as it is run by a bunch of gunslingers.  The higher levels of government are choreographed pieces of political theatre but politics at lower levels is more of a grubby battle.  Ambitious officials in regional government in China need to impress in terms of economic growth or social stability and can often become a law unto themselves whether it be taking land from farmers to build factories or getting local banks to splash out on loans to businesses. This incentive to create booming local economies can act against central government diktats even though both levels of government are controlled by the communist party. 

Banks themselves have also managed to avoid the rule of law and operate with a degree of impunity.  The government sets maximum rates for savers and minimum rates for borrowers with a big gap inbetween to help banks generate a profit.  This suits the major banks which are government owned but savers miss out due to meagre returns on any cash stashed away.  But banks keen to attract more deposits have come up with schemes to offer higher pay outs for investors and this extra cash has enabled the banks to lend even more.

The relative autonomy of local politicians and banks in China has fuelled a lending binge that has gone a bit out of control.  The ratio of debt to GDP has reached 200% which is well past the point when people start worrying.  The leaders in China have tried a softer approach such as signalling their disapproval but to little effect.  But the Chinese government has never shied away from stepping on toes and decided to bring out some big guns to put pay to the wayward banks.  At a time of year when all of the scheming by banks had left them short of cash, the central bank in China left banks to sort the cash shortfall out themselves despite typically acting as a source of funds in the past. The lack of money resulted in banks scrambling for cash and interest rates surged upward briefly topping 25% in the middle of June (search for SHIBOR spike for more info).  This created turmoil among Chinese banks, for whom not only were the central bank’s actions a complete surprise but the intentions behind the move were also a mystery. 

Some interpreted the actions of the central bank to be a brutal way of knocking banks into line but it will probably prove to be more fruitful than the policies of the their Western counterparts.  Whereas other central banks have struggled to maintain stability (see Why is the economy still stuck in a rut? for more on the limited influence of monetary policy elsewhere), China’s central bank is not afraid of drastic action to shake things up even if it will result in a bit of temporary chaos.  The spike in interest rates is expected to have put many banks into trouble but will be good for the banking system as a whole if it helps to reign in lending.  Officials in China are conscious of the need to keep the economy growing so that the Communist Party can maintain its grip on power.  It is this focus on the big picture rather than the fickle concerns of voters that will keep the Communists in power in what is destined to soon be the world’s largest capitalist economy.

Thursday, 11 July 2013

Why is the economy still stuck in a rut?

As the last hope for an economic recovery, monetary policy has proven lacklustre at best and here is why things have not turned out as planned.

It has been more than five years since the onset of the global financial crisis but it still seems as if we are stuck cleaning up the mess.  The task of getting the economy back on track has been made even trickier with policy makers being side-tracked by a number of misadventures such as the Eurozone crisis and the fiscal cliff in the US.  Governments everywhere have been shackled by large debts and central banks have been relied on to save the day.  Despite having a better track record in the past, the inability of central banks to use monetary policy to fix the problems created by the unique circumstances of our current dilemma have prolonged the economic stagnation.  Your Neighbourhood Economist looks at why the central banks had to try new things and why even this fresh approach has not improved the outlook for the future.

Monetary policy had always provided a road map back to economic recovery in the past.  The directions were simple – lower interest rates would help get the economy back on the right path. The theory behind this was that making it cheaper for firms or households to borrow would give the economy a boost at a time when other sources of growth were flagging.  Interest rates could be topped up again once the economy had been kick started with inflation used as a gauge on the strength of the economy (i.e. low inflation suggests weak demand with rising inflation seen as a sign of an overheating economy). 

However, even interest rates close to zero have failed to gain traction amid the consequences of the global financial crisis.  There are two main reasons for this which relate to borrowers and lenders.  On the lending side, banks have shrunk their operations due to chronic uncertainty that pervaded both the financial well-being of the banks themselves and any borrower they might lend to – banks were unsure of the potential for losses on their own books, let alone those of other business which they may lend to.  A wave of new regulations also acted to hamstrung banks who reacted by lending less to lower the level of risk on their balance sheets with other options such as selling shares not available (this problem was most pronounced in Europe – see Another reason not to bank on Europe for more). 

Borrowers too weren't in the mood with many companies and households having already taken on too much debt during the years of cheap credit which led up to the crisis.  Uncertainty was another factor as wage earners worried about their jobs while firms were more concerned with their own survival rather than borrowing to expand their operations.  Rather than borrowing, the opposite was more likely to be the case as consumers paid down their credit cards while firms repaid their debt and kept cash for a rainy day.  A lack of willingness on both sides (lenders and borrowers) meant that more debt was out of the question no matter how low interest rates would be set.  This put pay to conventional notions of monetary policy and required a fresh approach.

Quantitative easing was taken on-board as a possible solution.  This involved central banks buying bonds to provide funding for banks and companies wanting a different source of cheap funding.  The bond buying also lowered the returns on these safer assets and pushed investors to put their money into more risky assets such as buying bonds of struggling countries in Europe like Greece or Spain.  The extra money in the global financial system was expected to help grease the wheels of banking which had seized up.  But little of this additional cash has reached the real economy and has been hoarded by banks or companies or has gone to pump up share prices.

The limited extent to which their policies fed through to the economy prompted central banks to throw more and more funds at the problem with the Federal Reserve in the US buying US$85 billion in bonds each month and the Bank of Japan pledging to double the money supply in two years (for more on this gamble, see All bets are ON).  The acceleration of monetary policy has not driven the economy much faster through the slowdown.  However, even just the notion of an eventual retreat by central banks has caused jitters among investors who have benefited most up to now from the real-world consequences of monetary policy (refer to Caution - Windy Road Ahead to see how monetary set the tone of stock markets).

So the outlook for the stagnating economy is not good.  Governments remained mired in their debt with even relative bright spots such as the recovery in the US economy in peril when factoring in likely cuts to government spending in years to come.  Central banks have dug themselves into deep holes by trying to do too much and even the limited effects of monetary policy will be difficult to maintain (for more on why thus might be the case, see The perils of doing too much).  The result being that problems in the economy such as a shortfall in demand and uncertainty over the future continue to drag on consumer and business sentiment.  All it would take to ignite economic growth again is a commonly held belief that the future will be brighter.  But, considering all of the above, it is proving a hard sell.  

Thursday, 4 July 2013

So what’s the rush?

Having vanquished the threat of economic disaster, the Federal Reserve sets its sights on a return to normality.  

It would seem to be anyone’s fantasy to have the power to influence the direction of the global economy and have investors hanging off your every word.  But it is more of a nightmare for Ben Bernanke, the chairman of the Federal Reserve.  Despite concerns over the strength of the economic recovery in the US, the Federal Reserve is already planning to shed its guise of defender of the economy.  But why the rush?

The Federal Reserve has been thrust into the role of hero with monetary policy deemed to have mythical power to heal the ailing economy.  The limited resources at the hands of central banks have required the use of heavy firepower to stave off economic disaster.  But it is a victory that has come at a heavy price with central banks now deeply involved in the management of the global economy which is proving a difficult position to retreat from (for more, see The perils of doing too much).  Statements by Bernanke in the previous weeks which suggested that the day had been saved and further actions could be tapered off prompted investors to run screaming (refer to Monetary Policy in the Real World). 

The haste at which the Federal Reserve is keen to head for the exit despite concerns that the risk of economic meltdown has not been put to rest is mostly due to the perceived consequences of monetary policy.  Economists who run central banks typically have the personality of the bookish and reserved Clark Kent rather than that of a caped superhero.  Rather than believing in their own powers, economists have a faith in the ability of the markets to generate optimal outcomes.  So any actions taken from the top down which are not governed by market forces will generally result in distortions in the natural order of things.  The extent to which the Federal Reserve has had to ride to the rescue – slashing interest rates to close to zero and buying US$85 billion in bonds each month – has created forces that if left unchecked could result in the Federal Reserve being cast as the villain.

The Federal Reserve has been caught out in the past when led by Alan Greenspan for setting interest rates too low for too long.  The cheap rate of borrowing helped to fuel growth but this proved to be unsustainable when the global financial crisis kicked in, as the amount of debt had become too much to bear.  Low interest rates have not yet had anywhere near the same effect this time round as firms and consumers have been so worried about the future that they have been paying back their loans instead.  The key concerns regarding distortion at the moment is in the prices for stocks and bonds which have benefited from the Federal Reserve’s efforts to keep the economy moving (see Doing more harm than good).  Inflating an asset bubble at this time would be like fighting off one crisis only to plant the seeds of another.  And the Federal Reserve not only has to worry about the reactions of investors but also about the value of its own investments considering the US$3.5 trillion in assets already on its books. 

But it is perhaps the psychology of those running the Federal Reserve that is the overriding reason behind a desire to retreat into the shadows.  The Federal Reserve is not comfortable in the spotlight and prefers to operate in the background as a steady hand on the wheel rather than a dashing hero.  The improving economy in the US provides an escape route while other central banks are still on call ready to fight off economic stagnation.  The decision to move first out of the central banks and put down the big guns of monetary policy is bold but it is also prompted by a fear that further actions will require even more of a superhuman effort to tidy up the resulting potential mess.  

Monday, 1 July 2013

How Monetary Policy plays out in the Real World

The past week or so has shown hints of what is in store as the Federal Reserve hands back the reigns to the US economy.

The theory about the ramifications of the inevitable changes in monetary policy have been spelled out in this blog over the past couple of weeks (Caution - Windy Road Ahead) but market movements at the end of last week show how it will play out in practice.  Heavy selling last week was triggered by the rosy outlook painted by the chairman of the US Federal Reserve, Ben Bernanke, which was more upbeat than had been expected and is likely to signal that the end to bond buying by the Federal Reserve is nearer than many had thought.  It is worth taking a closer look at the reactions of the markets to get an idea of how future actions by central banks may impact on us all.

Bernanke’s statements around a week ago made the case that the economic recovery in the US was sufficient enough for the Federal Reserve to move forward with its plans to reduce its buying of bonds later in the year with a target of stopping completely in the middle of 2014. Pains were taken to get across the notion that the change in tact was not a tightening of monetary policy but just loosening at a slower pace and that any changes in monetary would depend on a continued recovery in the economy. Yet, because the bond buying by the Federal Reserve has become a crucial support holding up the prices of bonds and stocks, its imminent demise has rattled investors who were caught out by the bullish comments by Bernanke.  

The degree of surprise was spelled out in the sharp movements in the investment markets with prices of bonds plunging and the interest rate on 10 year US government debt jumping from around 1.5% to 2.5% (lower bond prices equate to higher interest rates). This will feed through into the real economy as government debt is typically the benchmark for which all other interest rates in the economy are set. The result will be higher interest payments for mortgage holders which will act as a damper on the promising recovery in the housing market in the US. The higher costs for borrowing will also be a point of concern for companies who are thinking of making new investments.

There are further negatives for the US economy from the changes in monetary policy – the ensuing volatility in the stock market will make households worry about their pensions and other investments making them less likely to spend. A slower pace of bond buying will result in a fall in the amount of new currency getting into circulation which will raise the value of the US currency.  A stronger dollar will make life more difficult for exporters, many of whom are already struggling in the global marketplace. 

This all puts the Federal Reserve in an awkward position of its own actions creating a headwind blowing in the opposite direction of where it is trying to get to – an end to its role of propping up the economy. Bernanke is trying to lessen negative effects of its bond buying plans by outlining in advance a clear schedule for its changes in policy. But the Federal Reserve also needs to ease concerns that it will act too fast and has allowed itself flexibility to modify its plans if the economic recovery weakens. The overall effect is the level of certainty which is craved by many investors will remain out of reach, and the twists and turns of monetary policy will be played out in jumpy markets that will keep everyone on their toes.