Central Banks – juggling interest rates and inflation

Low inflation is dampening the effects of low interest rates and central banks are happy to let this happen

As guardians of the economic recovery and a bulwark against inflation, central banks have a tough juggling act to maintain.  This is made even more difficult as priorities shift from getting the economy moving again to keeping an eye out for inflation.  The consequences of this can be seen in central banks’ tolerance towards low inflation with low interest rates proving less helpful as prices remain depressed.  Central banks are letting this happen due to inflation being one ball that central banks dare not come close to dropping.

Too many balls in the air

Central banks have a lot of balls in the air to watch with their remit including managing the price level as well as ensuring stability in the financial markets (and maintaining employment levels in the US).  The number of balls has increased as monetary policy has become the main way to bolster the economy with governments in many countries refusing to use fiscal policy.  But it is inflation that typically remains the main focus of central banks. 

The aversion to inflation was put to one side amid the turmoil of the global financial crisis.  Efforts to prop up the money supply through quantitative easing would have normally also lifted prices but this did not stop central banks taking bold action.  As the threat of crisis has receded, so have measures by some central banks to help out with the economy.  This shift has been made more pronounced due to low inflation as depressed prices strip away some of the positive effects of low interest. 

Juggling priorities  

The rate at which prices are rising affects decisions made by companies on whether to borrow money.  Higher inflation makes low interest rates more attractive to businesses as any products purchased today will be worth more in the future making it easier to pay off debts.  The opposite is also true and flat prices will prompt some business putting off plans to borrow and invest.  The harm done by low inflation is even more pervasive if it is a reflection of a weak economy which seems likely. 

By not doing more to keep prices ticking upwards, central banks are consenting with some of the potential effects of low interest rates being taken away.  It is like a hike in interest rates without interest rates actually having to rise.  It is a sign of how much central banks worry about prices rising too fast that this is happening despite the economic recovery still lacking momentum and inflation close to zero.

Don’t douse the economic recovery

The various roles of the central bank can make it seem as if they are required to juggle fire and water at the same time.  Much has been left to central banks in the aftermath of the global financial crisis which has often resulted in monetary policy being pushed too far.  Central banks were never meant to take such an active role in managing the economy.  A return to their less controversial role of keeping a lid on inflation will come as a welcome relief.  It is, after all, their record on inflation that central banks will often be judged. 

However, it is still too soon to move against the potential threat of a jump in prices.  There is still scope to leave interest rates at their current low levels with other measures such as macroprudential policies available for sectors, such as the residential property market, where lending is getting out of hand.  There is a point in every juggler’s routine where everything seems set to come crashing down – let’s hope that this does not happen due to a premature hike in interest rates.

Interest Rates – low but not low enough

Interest rates may not be low enough to get us on the road to recovery but falling prices should help

Something strange is afoot in the economy.  With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true.  This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment.  Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.  

Not so free market

The self-healing ability of any economy is one of the central tenants of economic theory.  Prices adjust as a means for the economy adapting to any changes.  For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas.  A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers.  Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.

Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment.  Lower interest rates are used to make borrowing cheaper and savings less worthwhile.  This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings).  Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.

Still waiting

The continued wait for a robust recovery suggests that something remains amiss.  The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy.  Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings.  The high levels of household debt that still persist are another reason for consumers to hold back from spending.

The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse).  A further loosening of monetary policy is not on the books for most central banks.  Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement.  Quantitative easing also seems to have run its course while increasing creating negative side effects. 

Where to next?

The inability of interest rates to adjust is hampering a return to economic growth.  With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium.  That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy.  The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer.  Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.

This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off.  There are ways to push this along of which easiest way would be for governments to temporarily increase spending.  Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates.  Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers.  This more radical option would provide a short-term boost to spending.  Sometimes we all need a little bit extra to get us back on track and the economy is no different.

Property Market – nowhere to call home

House prices are distorted by demand from investors and governments are making the situation worse

Houses have become so much more than homes and many of us are missing out as a result.  More than just a place to live, houses have become the investment option of choice during turbulent times.  The popularity of investment properties means that buyers looking for a home are being crowded out of the market.  Rather than correcting this distortion, government policies typically make things worse and leave the dream of their own home beyond the hopes of many.

No home sweet home

The property market is never far from any topic of conversation.  Since everybody needs a place to live, it affects us all.  The substantial price tag that comes with buying a house would be enough to weigh on anyone’s mind.  But property purchases take on even greater significance as real estate also counts as a form of saving for the future.  The money tied up in property is the biggest investment that many of us make.  This means that the ups and downs of the housing market shape the financial well-being of many families. 

The predominance of property investment is further accentuated as buy-to-lets become increasingly popular as a means of putting ones wealth to work.  The abstract nature of shares and bonds along with the shenanigans in the financial markets makes property seem like the safe-as-houses option.  Yet this extra source of demand for real estate inflates house prices beyond their value as a mere place to live.  Investment in real estate brings benefits, such as providing rental accommodation and improvements to neglected properties, but the costs also mount as investment in property increases.

With a relatively fixed amount of housing in large cities, one person’s buy-to-let gets in the way of a house becoming a permanent home.  Along with the benefits to home owners, neighbourhoods also have a greater sense of community with stable residents.  The higher house prices due to property investment results in home ownership being coupled with a larger amount of mortgage debt.  This makes the property ladder more tenuous for debt-laden buyers who could easily be caught out by any economic hardship.

Need to make room for more

Governments, which could work to limit these negative consequences, tend to only exacerbate the problem.  Policies targeting the real estate market differ across countries – tax breaks for mortgage debt, low levels of capital gains tax, easier access to loans.  But the common thread is that it is all too tempting for governments to please better off voters by bolstering the property market.  The predominance of monetary policy as the main tool for managing the economy makes this even worse by stoking up borrowing (and the property market) when the economy is weak. 

While pushing up demand, governments do too little to boost supply.  It is more housing that is often cited by politicians as the solution to buoyant property prices but government regulations and zoning rules are not reflective of the growing need for new houses.  Houses take too long to build while elections are never far off even though more building would make for good economic policy at a time when the economy is still suffering from a shortfall in demand.

Financial markets are awash with other places to invest.  Our animal spirits should be limited to parts of the economy where the ups and downs can be absorbed without wider consequences for the rest of us.  Housing is too important to get caught up in such investment games.

Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

China – Playing Catch Up

Many expect the Chinese economy to misbehave but it is more likely that China will grow out itself out of trouble

China is growing up in front of our eyes and there is an expectation that, like any adolescent, it will get into trouble before fulfilling its promise.  Naysayers predict that China’s growth spurt has left it with a number of issues that must be worked through before it can get any bigger.  Yet, China has a good head on its shoulders in the form of the Communist Party which will do all it can to keep the economy buoyant.  While the years of stellar growth are likely over, it need not mean that the Chinese economy will be held back.

Big trouble in (not so) little China?

The spectacular rate of growth achieved by China over the past decade could never continue forever.  Quite the opposite, the rapid expansion would have been harmful if it had been maintained and a slower pace of growth is actually a preferable outcome.  This is because much of the economic growth had been fuelled by investment – construction of new factories to sell cheap goods overseas along with the expansion of megacities in China to accommodate an influx of workers from the countryside. Normally, investment accounts for around 10% to 15% of GDP in most developed countries but reached 50% of GDP in China. 

This building frenzy could not continue especially when it is becoming more difficult to make money and some investments would be wasted on pointless projects.  It is the examples of this, empty apartment blocks and overly lavish public spending, that pessimists point to as evidence that China has gone too far.  With large amounts of bad debt expected to result from these poor investments, the financial sector is expected to take a big hit and drag the whole economy down with it.  The argument is basically that China has gotten too big for its boots and will need to shrink.

Growing up is never easy

Your Neighbourhood Economist would instead argue that China has a similar problem to what he had when he was growing up.  His mother would buy Your Neighbourhood Economist clothes that were too big for him in the knowledge that he would grow into them.  It is ungainly to be sporting oversized gear and this seems to be similar to the phase China is going through.  This is partly because China had been expanding so quickly that any investment needs to be put up in a hurry.  There is also the added complication of spending getting out of hand as regional politicians try to impress their bosses in the Communist Party.

Yet, China, like a much younger version of Your Neighbourhood Economist, still has a lot of growing to do.  Some of the ill-fitting parts of the Chinese economy may be put to better use as its citizen will continue to migrate toward the cities in search of work.  China has also learnt lessons from its investment binge with the central government shifting emphasis from economic growth to other benefits of greater wealth such as a cleaner environment and a more efficient bureaucracy.  Local officials are being brought into line through a crackdown on corruption and concentration of power within the Communist Party.

Along with changes to policy, the Chinese government also has the resources to deal with any past mistakes.  With both domestic savings and government reserves at high levels, there is plenty of money around if needed.  And, with an eye firmly fixed on keeping the economy growing, the Communist Party would not be as timid compared to Western governments in terms of stepping in and shoring up the banking sector if needed.  China is also moving away from investment as the driver of its economic growth and consumption is expected to pick up the slack (albeit with growth at a slower pace).

Growing while you watch

Your Neighbourhood Economist has seen the change in China with his own eyes.  In a visit 15 years ago, the Pudong area across the river in Shanghai seemed like a ghost town but one that had been freshly built with a scattering of skyscrapers.  Now, Pudong is anything but quiet and the pace at which new buildings continue to go up is testament to China’s growth.  It also shows that it you build it (in China at least), they will (still) come.

Monetary Policy – where has the magic gone?

The European Central Bank tries to cast another spell to save the Eurozone but its magic has been stolen

Monetary policy is like magic – you have to use tricks to get people into believing what you want them to believe.  Both magicians and central banks apply various devices to convince their audience that they can pull off amazing feats.  A bit of showmanship can be crucial in creating an aura of the fantastical when your powers are actually rather limited.  Central banks have pulled this off in the past but quantitative easing by the European Central Bank is more likely to show that it does not have any rabbits left to pull out of the hat.

Trying to work magic

Your Neighbourhood Economist likes to look back fondly to an era when central banks had the financial market enthralled with their mastery of all things economic.  This admiration was won the hard way in the 1980s by bringing double-digit inflation back to more manageable levels and ushering in an era where the booms and busts seemed to have past.  But central banks have been taken down a notch by their inability to revive the economy after the global financial crisis. 

Slashing of interest rates has not worked as high levels of debt meant that no one wanted to borrow. Upping the ante, central banks tried pumping money into the financial system through quantitative easing.  The effect on the actual economy due to quantitative easing also looks to be limited at a time when there is already a lot of spare cash in the financial system.  Financial markets were buoyed by quantitative easing but a side effect has been the potential for heightened volatility in the financial markets. 

With few other options seen as viable, quantitative easing has gone from an unconventional measure to the mainstay policy for central banks despite questions over its usefulness.  The European Central Bank has been slow to try its hand at quantitative easing even though the Eurozone economy was struggling more than most.  This was because Germany (who had initially done well despite its neighbours being in crisis) was firmly against the central bank in Europe printing cash to buy government bonds.  It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself) that the European Central Bank to override this opposition.  

No more magic left

The European Central Bank has been put at a disadvantage considering that the other big central banks have already tried to work their magic through quantitative easing.  Investors are becoming harder to impress having already seen central banks pull off similar tricks.  To maintain the wow factor, quantitative easing has needed to get bigger and bigger.  The central bank in Japan pledged to double the money supply within two years but had to offer up even more cash when its initial plans proved to be lacking. 

The European Central Bank cannot compete on scale as it has to perform magic with one hand behind its back due to the political constraints within the Eurozone.  Any extra boost using the element of surprise was also dented by the protracted process as the European Central Bank and Germany squabbled publicly over quantitative easing in the months before the policy was launched. 

The fractious politics in Europe has sapped power from the central bank who had previously been the main shining light in saving the Eurozone.  Political squabbles have highlighted the limited power at the disposal of the European Central Bank.  It is like a magician who is being sabotaged by their own assistant – it will take more than magic to escape this spell.