Tuesday, 30 December 2014

Bargain Low Interest Rates to Continue in 2015

Borrowing is likely to stay cheap in 2015 as a drop in inflation puts pay to talk of higher interest rates

Christmas is usually followed by a rush off to the sales but borrowers need not hurry as cut-price loans are likely to remain for most, if not all, of 2015.  Acting like retailers with surplus stock to sell after Christmas, central banks slashed interest rates after the global financial crisis.  Six years later, there are growing calls for this to be reversed in countries such as the US and the UK due to as a strengthening economic recovery backed by more people finding jobs.  Yet, plans for higher interest rates have been way laid with falling inflation suggesting that all is not well with the economy.  With unemployment and inflation likely to fall further in 2015, there seems to be few reasons for any changes to be made to interest rates over the next 12 months.

Shopping around

The Federal Reserve and the Bank of England are in the midst of a dilemma – like a shopper not sure of where to head first to snap up some bargains after Christmas.  Unemployment data suggests that the economic recovery is becoming more entrenched with the proportion of Americans and Brits without jobs now below 6%.  Yet, despite more workers being hired, companies are still holding back from investing to expand output.  Aggregate demand is also suffering due to cuts to government spending resulting in an economic recovery that is still patchy.

If the stuttering economy is giving central banks reason to worry, it is inflation that is the real sticking point getting in the way of higher interest rates.  The extent at which prices are rising (or falling) has been adopted by central banks as a gauge for the health of the economy.  It is thus a point of frustration that inflation is heading downward as other signs, such as lower unemployment, suggest that the economy is picking up.  These mixed signals from the economy mean that Federal Reserve and the Bank of England are caught in two minds in terms of what do to with interest rates.

Best to stay put

Things are not likely to get any easier for central banks considering that the trends in unemployment and inflation are not likely to change any time soon.  With companies not yet willing to spend big on new equipment, it makes sense to employ more workers (who are relatively cheap) to get things done.  Lower commodity prices is the main cause behind falling inflation and a rebound in commodity markets is not likely as shifts in demand and supply of commodities taking years to change.  Neither are consumers in any mood for higher prices considering that wages have not kept up with inflation over the past few years. 

All this suggests that 2015 will be more of the same and interest rates are also unlikely to change.  Some will argue that interest rates need to rise to give central banks leeway to act in case of other threats to the economy.  Others will claim that the economic recovery means that inflation will be just around the corner and central banks need to pre-empt any jumps in prices.  But these are risky strategies considering that a bit of inflation in the future will do less damage to the economy than a premature hike in interest rates. 

A still fragile recovery means that, like any shopper out after Christmas, the economy could also do with a bargain (in the form of low interest rates).

Tuesday, 23 December 2014

Let's not (Christmas) party like it's 2007

The heady days leading to the global financial crisis were never meant to last so there is no point in expecting to turn back the clock

It is the time for great merriment but Christmas office parties across London still leave many wishfully thinking back to the good old days.  Despite much talk of an economic recovery, it can still be tough to find reasons to be cheerful about and less cash being spent by companies on seasonal festivities is another reminder of this.  But we should not be asking Santa for a return to the days of lavish Christmas dos with workmates and big entertainment budgets (if they ever did exist).  The economy of old which allowed such excesses could only bring in a few good years of partying before the good times inevitably turned bad. 

Living the high life on borrowed time

The boom times that were still in swing a decade ago seem a long way off.  It was a time when all seemed good with the economy and nothing much would go wrong.  This spirit seemed best exemplified by the exuberance among economists who (mistakenly) thought that their ideas had conquered the ups and downs of the economy.  The great evil of past decades, inflation, had been kept in check and the recession following the dotcom bust passed without much strife. 

This new stable economic environment seemed to benefit the finance sector most of all.  Banks came up with new ways of making lots of money with bankers themselves reaping much of the rewards.  Even some among the rest of us got to enjoy a sprinkling of the good life with many companies splashing out the odd treat on their workers (especially around Christmas time) even if this generosity was not reflected in wages.

The enthusiasm was infectious and we all wanted our share.  The result was loads of new debt as our spending reflected these new aspirations even if our income was lagging behind.  Even the governments in many countries spent beyond their means and got their finances in a mess.  Since inflation remained subdued despite the elevated spending, interest rates never rose by much enabling the debt levels to soar beyond what was prudent.  And banks were only too happy to lend since new financial products, such as mortgage-backed securities, allowed them to pass on increasingly dubious loans to others.

Not banking on trouble

This was one party that could not go on for ever.  An increase in debt is good for spurring the economy along but this can only go so far until lending becomes more reckless.  The final straw was mortgage lending in the United States where new rules encouraged housing loans to individuals who were never likely to be able to afford repayments (so-called sub-prime mortgages).  The many who lost their jobs (including Your Neighbourhood Economist) and even their homes in the ensuing financial turmoil ended up with little to show from the good years.  Yet, on the other hand, the exorbitant pay packets received by many bank employees left them sitting pretty whatever was to happen.

We should all feel repentant like Christmas drinks where we get carried away and make a fool of ourselves.  One way of stopping ourselves getting into trouble is to rein in the banking sector.  This does not mean the equivalent of alcohol-free Christmas festivities but just stricter rules to make sure that things don’t get out of hand.   The perils of too much debt should have always been obvious but it is inability of the banking sector and the financial markets to suitably regulate lending that is perhaps the biggest lesson that we need to address.

Time to sober up

Any economic growth does not count for much if we have to give back most of the gains after a few good years.  Yet, giving up on this easy way of making ourselves richer also means that we cannot expect the economy to grow like in the past.  It will take hard work and sensible policies rather than financial wizardry to make genuine improvements in our standard of living.  The trade-off being that we can create a world where our jobs and what we make for ourselves is more secure.

The government could have a big role to play in this especially since companies are not investing as much as they used to.  Greater spending on infrastructure and education as well as lower medical costs would be a good start to help increase productivity (and wages) as well as going some way to propping up spending.  The solution sounds simple enough but politics is never easy especially at a time when the easy option is for politicians to offer up false promises.  It is voters most of all that need to be realistic in terms of what is achievable.  No party is worth a hangover on the scale of the global financial crisis.

Thursday, 11 December 2014

Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.