Monday, 15 September 2014

Monetary Policy – who to save?

Central banks have a host of people needing help in the economy but it may be those not yet in trouble that get priority

There are still many people struggling in the economy but the central bank does not know which of the victims to save.  Like a lifeguard having to decide which of a handful of struggling swimmers to save, central banks have some difficult choices.  Unemployment is falling but many people are still stuck in low paying jobs.  Inflation is low but fears are running high that loose monetary policy will inevitably see prices start to rise.  There is also potential for financial markets to go haywire considering all of the loose money around.  Yet, it seems as if central banks will deal with issues that have not yet arisen despite all of the people still in the water.

Monetary policy to the rescue

The global financial crisis has expanded the role of central banks.  No longer is inflation their sole concern as other issues such as unemployment or financial stability take on increasing importance.  Fulfilling one primary objective, keeping prices from rising too much, is much easier than achieving competing goals.  This was not a problem in the past as a weak economy created an overriding emphasis on shoring up the economy.  The improving situation in the UK and the US will push the Federal Reserve and the Bank of England into sorting out their priorities. 

A falling unemployment rate in both countries means that more people are being put to work.  This suggests that the economy might be close to reaching full capacity and inflation might follow as a result.  However, at the same time, wages are not rising which is what would be expected if firms are employing more workers.  Improvements in productivity have also been poor due to low level of business investment.  This is a problem as firms need to be more productive to pay higher wages and bigger pay packets are needed to boost consumer spending.

The uncertainty would suggest caution but there is one more issue worrying central banks – financial instability.  Low interest rates and printing of more cash through quantitative easing has not made much of a mark on the actual economy but has been a considerable boost to financial markets.  The prices of stocks continue to push relentlessly upward in many countries despite the cloudy economic outlook.  The mass of cheap money has also seen a boom in property prices in some countries.  The continuation of existing loose monetary policies can only result in these problems getting larger.

Saving us from the phantom menace

Central banks have to keep all of this in mind when setting policy.  Interest rates in particular should be raised sooner if fears about inflation or financial instability are given precedence.  But a weak economy may not be able to cope with higher interest rates and the job market might suffer.  Changes to interest rates will affect all of us in different ways but there will be both good and bad. 

We are all consumers so few of us would want to see a jump in inflation as we could not buy as much.  Most of us have a little bit stashed away in the bank or in our pension funds so higher interest rates and less volatility in financial markets will be helpful.  But it is the overall health of the economy that will be felt most keenly.  Economists, with an eye on the bigger picture, are worried about the threat from inflation and financial instability with many pushing for the central banks to respond according.

Yet, the concern is that higher interest rates will be used to deal with problems that exist on paper but not in reality.  Central banks will forsake those already in trouble to save people that are not yet drowning.  Some of the worries of economist might on exist in their theories.  Inflation is different now than in the past and has not caused trouble for decades.  There are also other ways of dealing with issues in finance rather than the blunt instrument of interest rates.   Better to deal with what actually is than what might be.

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