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.

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.

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

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).

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.

Question – Interest rates

In response to an inquiry from a reader, Your Neighbourhood Economist explains how low interest rates should have but didn’t affect the economy (with a surprising culprit)

Your Neighbourhood Economist was pleasantly surprised to have a proverbial knock at the door (a photo of which was posted on the blog recently along with an email address for questions) with the following inquiry on interest rates…

I read your blog entry on BOE interest rate hike and needed an opinion. I'm not a finance student but am trying to understanding why something so unusual is happening with the BOE interest rate. You have explained why there is a need to hold the rate low at the moment, seeing there isn't enough inflation yet (as posted in UK Interest Rates – putting off the inevitable). But could you explain to me in layman's terms how this has affected our economy and what other solutions could have been used?

Interest rates are a hot topic at the moment with changes afoot at the Bank of England.  Sometime over the next six to twelve months, the UK central bank is likely to raise its benchmark interest rate off its record low of 0.5% where it has been for more than 5 years.  Low interest rates are the most common way that central banks will try to raise economic growth.  The theory behind this is that cheaper loans will push businesses and households into borrowing money and this extra spending will boost the economy. 

Good in theory but not in practice

In practice, things have not worked out so well.  Businesses have held off taking out loans due to uncertainty over the future direction of the economy.  Companies need to be assured of a decent return from any investment which will typically only make money over the span of several years.  Worries about the future earning potential of any new operations have outweighed the lower costs of borrowing money to invest.   As a result, business lending in the UK has fallen for seven consecutive years with companies preferring to hoard cash instead. 

The main benefactor of low interest rates has been the property market.  House prices in London held up despite the global financial crisis and added to the myth that property values never fall.  So once the worst of the crisis was over, low mortgage rates prompted many to scramble to buy property.  The buoyant housing market has boosted the economy a bit by making people who own property feel richer and spend more.  But more mortgages only pushes up house prices rather than making the economy more productive as investment by businesses would have done.

So the actual effect from low interest rates has been less than hoped.  This resulted in central banks also using quantitative easing – creating new money to buy bonds and other financial assets.  The aim of quantitative easing is increase the amount of money in the economy and help out the banking sector.   Quantitative easing too has been somewhat of a disappointment with few places for the extra cash to be put to good use.  The banking sector typically acts as one of the main means to move cash around the economy but banks have had to focus on their own survival.  The surplus of cash has created its own problems such as distortions in the financial markets which may cause trouble in the future.

Other solutions…?

With businesses not spending and mortgages not adding much to the economy, the obvious solution would be for government to make up the shortfall.  A fiscal stimulus is the typical response to a slowdown in the economy with the extra spending by government making up for weak demand from consumers and businesses.  Yet, government finances in the UK and elsewhere were already stretched before the crisis and deteriorated further with higher welfare payments and falling tax revenues following the crisis.

The Eurozone crisis from 2010 resulted in investors shunning any countries with high levels of government debt.  This prompted the UK government to launch its austerity program with the hope convincing investors that it would sort out its finances.  The plan worked in that the interest rates on UK government debt remained low (also with help from quantitative easing) unlike some countries in Europe such as Ireland and Spain.  However, cuts to government spending hurt the economy and prolong the slump in the economy while also ironically making even more cutbacks necessary.

Still struggling

Getting ourselves out of trouble following the global financial crisis was always going to be tough going.  Recessions stemming from banking crises are typically longer than normal recessions as it takes time to work down the excessive levels of debt and fix the banks.  Less expected was how the economic recovery has been further hampered by ineffective and lacklustre policies. 

Fiscal policy has been working in reverse and the UK government should do more to boost the economy considering that investors are no longer so worried about government debt.  The Bank of England could have done more with monetary policy considering that it can print as much money as it likes but it held back due to misplaced concerns about inflation.  Your Neighbourhood Economist would have liked to have seen more spending by the government and quantitative easing going straight into the economy.

Perhaps the biggest factor holding back the recovery is that economists are slow learners.  Policies such as quantitative easing are new and have helped but more could have been done if economists had not been so caught up with their own ideas.  It is of some consolidation that lessons from the Great Depression (such as the bank bailouts) have been applied to ensure that a similar type of crises has resulted in less fallout.  We can only hope that this crisis is bad enough to ensure better policy in the future.  

(Please add any further questions on this topic using the comments section at the bottom of the page or email any inquiries on different issues related to the economy to Your.Neighbourhood.Economist@gmail.com)

Global Economy - Half-time Report

It is game on in Brazil but many are hoping for less thrills in the financial markets in the second half of 2014

Just like in a football match, the half-way point (of 2014) is a good time to assess progress so far and look ahead to the second half.  The first six months have been relatively boring but in a good way, after participants and spectators of financial markets have been riding by the seat of their pants over the past few years.  The game plan so far has been an emphasis on defence with central banks in Europe and Japan providing more support for their economies while tapering by the Federal Reserve has been at a measured pace.  Investors are betting on a quiet second half to 2014 but this will depend on whether the markets can hold their nerve when confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number of fronts.  There are reasons for optimism in terms of the economic recovery such as swiftly falling unemployment in many countries.  Share markets are buoyant suggesting that investors are willing to take on risk.  Interest rates on government debt have dramatically fallen for most countries in Europe whose debt has previously been shunned by investors.  The focus of policy makers is no longer on dealing with the potential for crisis but instead on bolstering the economy recovery.

The only problem with this is that much of the progress has been built on loose monetary policy which is due to come to an end.  Investors will have to manoeuvre around the winding up of quantitative easing and higher interest rates.  This will be like a football team losing one player in defence – not the end of the world but it opens up the potential for calamity.  One consequence is that it is unclear how the second half of 2014 will play out.

May 2013 proves us with one example of what is likely to happen sometime soon .  In this month last year, financial markets went into spasms as the Federal Reserve signalled that it would cut back on its monthly bond purchases that constituted its quantitative easing program.  A repeat of what has since been labelled “taper tantrum” seems likely but with higher interest rates as the trigger (maybe prompting headlines of “rates rampage”).  Another popular phrase has been “fragile five” after countries who suffered at the hands of financial market who can turn nervy at any time.

When will things kick off?

The game plan from policy makers adopted so far this year is likely to stay in place considering the relative calm in the financial markets.  The aim will be to not let in any goals (especially any own goals) rather than pushing to score gains in economic growth.  As a result, it is tough to see any big changes in the economy itself.  Dramatic improvements in the economy are not likely with governments continuing to mend their finances.  Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as the economy shows sign of getting a second wind. 

Whether the benign economic conditions continue into the next six months depends on the fickle nature of investors.  Like an erratic football striker who often gets stroppy, investors need to get their way in order to be kept happy.  Central banks will likely take a cautious approach so investors don’t retreat to the side-lines.  This is likely to result in the first hike in interest rates by the Bank of England, which is ahead of its peers in this regard, being pushed back to at least next year.  Further reasons for delay include other policy options being available to the UK central bank and a likely negative effect on the pound from any rise in interest rates.  Others such as the European Central Bank and the Bank of Japan likely have even more to offer in terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding goals and nail-biting action.  In contrast, many will be hoping that the financial markets in the second half of 2014 will be as exciting as a nil-all draw. But just like a game going into extra time and penalty, some excitement is inevitable as monetary policy tightens and it is something that the financial markets will have to cope with this year or next.

Interest Rate Hike – Easy on the Brakes

The Bank of England threatens to be too heavy on the brakes with higher interest rates and the economic recovery may stall as a result

Tinkering with complex machinery is tricky as changing one thing may have unintended consequences elsewhere.  This also applies to the economy.  The prospect of having to raise interest rates at a time when the economic recovery is still fragile is daunting enough.  Yet, there is a number of moving parts of an economy linked with interest rates which could throw an extra spanner in the works – one concern is that higher interest rates will push up the currency and hurt exporting firms.  This may push central banks to use other monetary policy tools to bide their time.

Complicated piece of machinery

What we refer to as the economy is the accumulation of an incredibly intricate multitude of monetary transactions in which we all are a small part.  In comparison, monetary policy is rather basic relying mainly on the lever of interest rates with extra bells and whistles, such as quantitative easing, added only when needed.  Monetary policy has been exceptionally loose but has still struggled to get the economy moving again.  These expansive polices cannot stay in place for ever and there are growing calls for interest rates to be raised off record lows. 

Interest rates normally affect the economy through the costs involved with taking out a loan.  But this is not the only route of influence.  One example is how higher interest rates will attract in money due to a higher pay-out for savings and this extra cash coming into the economy will push up the value of the currency.  A strengthening currency will adversely affect firms exporting to other countries as prices for their goods typically must rise and this risks putting them at a disadvantage relative to competitors. 

The potential for this is larger when one country moves to tighten its monetary ahead of its peers.  Such is the predicament facing the UK as the Bank of England contemplates the possibility of raising interest rates sometime in the next six to twelve months.  The mere expectation of this has propelled the pound higher relative to other currencies and may put further upward pressure on the pound if interest rates are predicted to rise faster than elsewhere. 

This problem comes about due to the freedom of money to chase around the globe after the best return.  Financial firms have made of most of moving cash around using strategies such as the carry trade – borrowing in a currency with a low interest rate and changing the money into a currency where the interest rates is higher.  This is just one way of how excess liquidity in global markets can work to distort exchange rates relative to the actual physical economy.

Warning lights flashing

Normally higher interest rates are used to slow an overheating economy and a stronger currency would help with this.  Yet, the upcoming hikes to interest rates have the goal of returning monetary policy to normality – a state where interest rates and the rate of growth in the economy are roughly equal.  An accompanying rise in exchange rates therefore acts as a further obstacle to economic recovery which is not intended or desirable. 

The weak recovery means that the UK economy is not quite ready for the double whammy of higher interest rates and a stronger pound.  The effects of both may be benign considering the lower rates of borrowing among businesses and sluggish demand for exports from markets such as Europe.  But there is still the potential for a rise in interest rates to put the economy in reverse at a time when the economy is gearing up for recovery. 

The main issue behind calls for tighter monetary policy is a buoyant housing market.  Yet, the Bank of England has a new range of tools to deal with this such as caps on mortgage lending.  So there is room to wait for other countries, most significantly the US, to catch up in terms of interest rates.  With the threat of waiting too long to act mitigated by housing market measures, it is the downside of braking too soon that the Bank of England should watch out for.

Monetary Policy – Surgery Needed

Current monetary policy is still primitive and will remain so without making use of new measures such as macroprudential policies

Monetary policy has come a long way but it is still in its initial stages of development.  Serious shortcomings mean that the tools of monetary policy are still rudimentary just as those of medicine were crude in the past.  In the same way that leeches would be prescribed for every ailment in medieval times, central banks have tended to rely solely on interest rates to manage the economy.  The tendency to “reach for the leeches” is still with us even though the global financial crisis has highlighted the flaws inherent in this approach and a range of new techniques for managing the economy have been made available.

Learning some hard lessons

Doctors often did more harm than good in antiquity due to a lack of understanding of the workings of the human body.  With our knowledge of the economy also deficient in places, economists may be guilty of causing similar damage.  Hubris led economists to believe that booms and busts could be eliminated but their faith was shown to be spectacularly misplaced.  Despite this, economists have been slow to adjust their view of the world even though their remedies are proving both ineffective and costly.

The global financial crisis and its aftermath have taught us a few valuable lessons.  The limitations of using interest rates to moderate the business cycle (both before and after recessions) are now apparent.  Higher interest rates do little to temper lending when both bankers and borrowers want more debt.  It is also becoming clear that different sectors of the economy react to interest rates in different ways.  Consumers have shown themselves willing to take on excessive debt in order to spend or to buy property.  On the other hand, businesses cannot always be enticed to borrow for investment when the economy is weak. 

The limits of monetary policy have been laid bare by the faltering economic recovery.  Low interest rates and cheap cash have spurred on some lending but not the right type to generate sustainable economic growth.  Households have taken on debt to buy property (which mostly just increases prices) rather than businesses or the government borrowing to make the economy more productive.  Surplus funds have also built up prices in the stock market which, while somewhat beneficial in the short term, will create problems down the line.  The abundance of cash in the financial system may also reduce the effectiveness of central banks’ control over interest rates. 

For a better world

Monetary policy needs to continue to develop as economists learn more about the economy and how it reacts to different policies.  Manipulating interest rates is a blunt instrument that is applied across the whole economy.  Interest rates need to be raised eventually but it seems rash to do so in response to distortions in certain sectors.  An early interest rate hike has been proposed as a countermeasure to the booming UK property market.  Yet, this is like chopping off an arm to treat an infected finger.

A more measured approach would be preferable but will take time to realise.  Techniques such as minimally invasive surgery have been developed in medicine over many years and economists should aim for similar progress in monetary policy.  Disparities between policies in theory and practice mean that trial and error will be necessary.  Using a still sickly economy to trial new policy options may seem reckless.  Yet experimentation is the main route to breaking fresh ground even in medicine where there are actual lives at risk.  Forward guidance is an example of a policy which seemed useful in theory but whose application was fraught with issues.

A wider range of policies would help deal with problems now and in the future with greater effectiveness.  These two goals can be achieved by the Bank of England trialling the much-discussed macroprudential policies such as caps on mortgages and other limits on property lending.  Having a greater range of options allows for better tailoring of policy while targeted measures enable greater freedom in setting interest rates to reflect the overall economy.  Just as modern medicine has had to advance beyond leeches, future monetary policy will need to progress past what we currently have and such an evolution will only happen as a result of taking bold actions today.

Central Banks – false illusion of power

The Bank of England shows how little central banks can do with their limited resources

Everyone looks to central banks as the custodians of the economy.  Once upon a time, central banks were regarded as having almost mythical powers to control the forces of the economy.  However, this fairy tale was shattered by the global financial crisis and central banks have since been trying to regain their previous status as economic titans.  Central banks have fought back with extra powers such as quantitative easing which have helped bolster their popularity.  In contrast, the trouble that the Bank of England is having in dealing with the conflicting problems of a fragile recovery and a booming housing market shows central banks at their most impotent.

The myth and the reality

Much of what central banks do relies on creating a belief in their resolve and ability to call on seemingly unlimited resources.  Chronic inflation in the 1970s was reined in by central banks flexing their muscles and inflation has stayed low ever since.  Even in the throes of a crisis, the European Central Bank kept the Eurozone together merely by proclaiming that it was willing to do “whatever it takes” to do so.

With the power to print money, central banks have the godlike ability to create something out of thin air.  It is often only the ideas of economics that keep central banks from unleashing the full force of their powers.  The ability to summon money from the ether is of limited use when most economists are scared of rising inflation following an increase in the supply of money.  Economics has also restricted central banks to operating only in a small arena, which reduces their capacity to act as a power for good.

One example of this is quantitative easing which helped ease the pain over the downturn but came with side effects.  The purchases of bonds through quantitative easing helped to shore up the financial markets but did little to alleviate a chronic shortage of demand in the actual economy.  A slightly different way of using quantitative easing could have had more punch with less mess but also came with the possibility of some inflation. 

Like something from Greek tragedy 

The Bank of England operates in this world of possibilities, but with only limited options.  It has made use of what was available (low interest rates and quantitative easing) but the economic recovery has struggled to gain much traction even after five years.  Yet, the consequences of its policies have shown up as a housing market boom at a time when the Bank of England still has its hands full nursing the economy.

One thing that the Bank of England is missing is a bit of help from the government.  Not only is the government dragging down the economy with its austerity measures, but it is creating problems with policies such as Help to Buy which stoke up the property market just as the central bank is praying for it to cool down.  For all of their potential power, central banks still have to steer clear of politics putting any criticism of government policy out of bounds.  The government with all of its populist tendencies still trumps an institution established to look out for the long term health of the economy. 

Instead, the Bank of England and its governor, Mark Carney, have tried to use the media to communicate their concerns about the property market.  However, this is having little effect as the Bank of England can be ignored since there are few actions it could actually take to back up its words.  Its main weapon would be higher interest rates but the economic recovery is seen as not yet being strong enough.  It would be a shame to see the Bank of England fall from grace battling a wayward government and a run-away property market but it will take a heroic feat to stop that happening.

UK Interest Rates – putting off the inevitable

Higher interest rates are on their way but are still too scary to talk about

An economic recovery is a timid creature that can be scared away merely by saying the wrong thing.  That is the implication behind statements coming out of the Bank of England which has played down the possibility of higher interest rates.  The Bank of England cut interest rates to a record low more than five years ago, but improvements in the UK economy mean that we are nearing a time when interest rates will have to return to “normal” levels.  This may still be a fair way off considering that the Bank of England seems to think that the subject is too frightening to even discuss.

Why are higher interest rates needed?

It may seem funny to talk about fears in the market at a time when UK stocks are near record highs.  However, many of the gains over the last few years have come with the support of central banks.  Low interest rates coupled with quantitative easing have prompted investors to dive into the stock market in search of better returns.  The property market has also benefited with asset prices in general booming despite the weak economy.

The hope has been that the extra wealth generated as a result of rising asset prices would prompt people to spend more.  This plan has worked to a certain extent with consumer spending being one of the main drivers behind the economic recovery in Britain.  Yet it has also created a problem in that a reversal in this new-found wealth will have the opposite effect and send consumers running for cover.  This line of thought suggests that it would be great if interest rates could be kept at the current low levels.  However, an increase is inevitable.

The main concern for any central bank is that cheap borrowing will create excessive demand and push up inflation.  Your Neighbourhood Economist has argued that these worries about inflation tend to be overblown.  A more pressing problem comes from the UK property market.  Housing prices have surged upward, recovering at a rate considerably faster than that of the overall economy.  This suggests that such gains in property prices are likely to be unsustainable and may cause trouble in the future.  This situation is made worse by the UK government being unwilling to offer much help in stimulating the economy.

What is so scary?

The central bank is caught at a junction where the long-term costs of low interest rates are becoming more obvious relative to the short-term benefits.  Acting too soon could damage a still fragile recovery while problems such as the booming property market could get out of hand if interest rates stay low for too long.  There will be a point where the Bank of England decides that worries about a premature interest rate hike outweigh that of the potential long-term costs but we haven’t reached that stage yet.

The caution shown by Carney in his recent statements suggests that the UK has yet to approach a point where higher interest rates can even be discussed as a possibility.  This partly reflects the possible outcomes facing the Bank of England.  A stalled economic recovery that results from a hike in interest rates would be one of the most dreaded outcomes for a central bank.  On the other hand, the effects of problems such as a housing bubble or excessive debt are only felt years later.

Low inflation adds to the reasons why the Bank of England might take a more cautious approach.  Inflation is not likely to cause trouble anytime soon given weak gains in wages and a strong pound.  A further factor to consider is that the Bank of England will feel the need to forewarn both borrowers and investors that higher interest rates are on their way.  All this points to a hike to interest rates being a bogeyman for some time to come.

UK government needs to play its part to lift the economy

The government and the Bank of England should be working in tandem but one is taking a free ride

A good partnership is crucial in many aspects of life.  Take the UK economy for example - it is vital that the government and the central bank work in harmony if they are to provide support for the stumbling recovery.  Both seem to share a common view of the task in hand, painting a gloomy picture of the economy.  Yet, to borrow an analogy from the recent Winter Olympics, the combination is more like an ice skating duo that not only can’t stay in synch but where one is sabotaging the efforts of the other.

Working from same play sheet

The starting point of the government and the Bank of England is the same.  Economic data coming out of the UK shows that the country is performing better than most – GDP was up by 1.9% in 2013 with unemployment down to 7.2% in the three months through December.  Yet, if an economic upswing is on its way, neither the government nor the central bank wants anyone to know.  “Neither balanced nor sustainable” is how Mark Carney, the head of the Bank of England, described the UK economic recovery.  The Chancellor, George Osborne, claims that the “recovery is not yet secure”.  A more pessimistic outlook on the UK economy is actually closer to reality.  GDP in the UK is still lower than before the onset of the global financial crisis.

Despite some signs the economy is picking itself up, a fully-fledged return to form is still some way off.  Key drivers of growth are still frozen with UK businesses neither investing nor finding much business in overseas markets.  The economy also scores poorly in terms of long-term prospects with low levels of investment translating into few gains in productivity as well as stagnating wages.

Are you pulling my leg?

The UK central bank is the more diligent of the pair.  It has been working hard to convince people that interest rates will not be rising anytime soon.  The hope is that businesses and households can be convinced to borrow if they feel secure that interest rates will remain at their current low levels.  Mark Carney has tried to use forward guidance to this end but the policy fell flat (as outlined in a previous post).  Downbeat comments on the state of the UK economy are another avenue for soothing concerns over interest rate hikes.

George Osborne seems to be skating off in a different direction.  His remarks on the economy are part of a routine designed to push his austerity program promoted as painful but necessary due to the high levels of government debt.  Austerity did seem to have its merits amid the Eurozone crisis when investors with cold feet were pulling their money out from indebted countries.  Worries about debt levels have eased but the UK government is still sticking with its harsh spending cuts.

Doing more harm than good

The austerity measures are proving harmful in two ways.  Firstly, there is a shortfall in demand in the UK economy which is exacerbated by lower government spending.  The ideal response to weak demand is a fiscal stimulus with the actual benefit to the economy larger than the actual increase in government spending.  Yet, despite the negative effects, the UK government has chosen to do the opposite due to an ideological dislike of large government.

The other negative is that the Bank of England has been left solely in charge of generating an economic recovery.  It is bad enough that the duet has turned into a solo performance but the austerity measures act as a further handicap.  The one-man act has proven tough even for someone with the stellar reputation of Mark Carney but this situation also creates its own problems.

Loose monetary policy has been a factor behind increased asset prices showing up in the property valuations and the stock market.  This has helped to push up consumer spending as households with property or stocks feel wealthier.  Yet only a small portion of the population are benefitting.  Monetary policy by itself is not the route to a balanced or sustainable recovery (as argued in a previous blog).  A change in direction by the government is needed to give more balance or the economic ice may prove thin indeed.

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

UK economy is growing but not yet in recovery

Some good news at last for the UK economy but don’t expect the tough times to be over

The outlook for the UK economy is finally beginning to brighten following a harsh recession and weak recovery.  The Office for Budget Responsibility raised its forecasts for the UK economy with growth of 1.4% expected in 2013 up from a previous estimate of 0.6% in March while 2014 is expected to see growth of 2.4% instead of a prior March forecast of 1.8%.  While the government was keen to publicise this as good news, much of the improvement is due to factors that are likely to be temporary.  Government measures along with monetary policy are behind the perkier economy but the effects will not last and a proper recovery may still be some time away.

The unexpected boost to the economy has come through higher spending by households.  Many UK consumers are feeling better off with UK shares near record highs and the UK property market going through a period of resurgence.  Stock markets in many developed countries have been providing stellar returns as extra cash being printed by central banks flows into shares.  House prices have benefited through a range of government schemes aimed at increasing the availability of mortgages.  This has translated into more consumer spending through a mechanism known as the wealth effect which is the notion that people will spend more if the financial assets which they own are worth more.  The UK government has tried to tap into this effect on spending using schemes such as Help to Buy to lift house prices as a means to boost the economy due to few other options (such as higher government spending) being available. 

The wealth effect relies on growing levels of financial wealth which can be lifted by different measures but which ultimately rely on the health of the economy.  As such, temporary boosts are possible but asset prices (and wealth) can only be pushed up so far and may involve potential negative effects for the economy.  Higher prices for financial assets now come at the cost of price gains in the future  (such as a weaker property market in the future) with a reduced wealth effect.  This may be a necessary price to pay with few other avenues for generating growth but the tactic of pushing up property prices has also been used by the UK government to provide cover for its program of austerity measures. 

With public debt reaching around 75% of GDP in 2012, the government has given priority to cutting back its spending but this is controversial coming at a time when the overall economy is weak.  The government claims that the cuts are necessary as investors would not buy UK government bonds (resulting in the government having to pay higher interest rates) were government debt to get even more out of hand.  Concerns about debt levels have eased considerably since reaching near frantic proportions during the Eurozone crisis, but the government remains unrepentantly committed to slashing spending levels.  Cuts to government spending are going to continue for years to come with the stated goal of reaching a budget surplus by 2018 despite calls for a change in policy.

Other areas of the UK economy also have little to offer in terms of growth.  Exports from the UK have failed to pick up despite a weaker pound and the value of the currency has begun to rise again which does not bode well for UK exporters.  Investment is also weak with lending to businesses in decline.  It is proving tough to come up with an engine to drive growth in the UK – a recovery is long overdue but we may still have to wait.

British banks gone AWOL

The banking sector is in dereliction of its traditional duties in the economy and quick fixes will not be enough to make amends

After nearly collapsing and bringing the economy down with them, UK banks are further adding to their bad name by holding back the economic recovery.  Banks are either too weak or too caught up in making easy money to fulfil their traditional role in the economy.  The situation is made worse because monetary policy works through the financial sector and banks are crucial links through which money is fed into the actual economy.  Instead, bank lending to UK businesses has been falling, thereby dampening the impact of lower interest rates and pushing the Bank of England to pump more and more money into the economy (which is not healthy).  Why have banks seemingly abandoned their posts?

Banks have traditionally acted as intermediaries between those with money to spare and those in need of financing.  There is a surplus of funds at the moment due to quantitative easing by the central banks which is aimed at getting more households and companies to borrow.  But this money is not getting to businesses - partly because the weak economy has hit demand for loans but also because of the reluctance of banks to lend.  A large amount of debt, which could go bad due to the weak economy, is making banks cautious while new banking regulations are restricting banks’ capacity to take on fresh loans.  Small businesses have been hit hardest as there are few other options for getting cash.  As a result, there has been a large knock-on effect on the economy as small businesses are a significant source of jobs and innovation.

Other parts of the finance sector have failed to pick up the slack.  Investment banks (which are different to retail banks who carry out the functions above) have long had only weak links with the actual economy and continue to generate profits through their ability to make money from money while also attracting some of the best and brightest who could offer more in other sectors (see previous blog).  Firms such as Wonga, which offer lending services now shunned by retail banks, are being hounded for their trouble.  The only bright spot has been mortgage lending but that has been targeted by government initiatives along with monetary policy to the extent that the Bank of England has had to apply the brakes due to concerns about a housing bubble.

The failure of banking to facilitate the circulation of funds around the economy has resulted in surplus cash flowing into financial assets such as property or the stock market rather than being put to productive use in the actual economy.  The Bank of England has tried a scheme of providing banks with funds for lending but more needs to be done to clean up banks and change their behaviour.  One of the reasons why Japan took so long to recover from a financial crisis more than two decades ago was that it allowed problems in its banking sector to stagnate.  Let’s hope that it doesn’t take that long to learn the same lesson.

UK Property Market – Prudence over Politics

Why we should be happy that the Bank of England is putting the brakes on the government’s efforts to boost the property market.

It is the job of politicians to get elected, but it does not follow that governments always do what is in the best interest of voters.  This might be the best explanation behind the actions of the current UK government with regard to the housing market – angling for voters (and an economic recovery) by pumping up property prices with little concern about the long term health of the economy (for more on this, see rebound in UK house prices is not all good news).  Many expressed a sigh of relief when the Bank of England stepped in to put the brakes on a booming real estate market by taking away incentives promoting mortgage lending among banks.  It is something new to see a central bank taking a stance which puts them at odds with the government but it provides a good case for arguing for greater oversight of government policy.

The current understanding of the role of a central bank is as an independent body which watches over the economy with powers to intervene if there is too much or not enough growth.  Central banks are kept separate from politics where policies are aimed at winning over voters within a time frame of a few years.  Some aspects of government where a longer time frame is required such as monetary policy could be influenced in a negative way by political calculations and it is thought that central banks are better positioned to administer monetary policy in order to achieve goals such as warding off inflation.

The global financial crisis highlighted that low inflation in itself is not sufficient for financial stability with aggressive lending by banks combined with excessive gains in asset prices also shown as big threats.  Central banks have been given greater scope to oversee the overall health of the financial sector and this is behind the latest policy actions by the Bank of England.  The UK government was hoping that a buoyant property market would increase spending and create a feel-good factor propelling it back into power in elections scheduled for 2015.  Yet any gains in real estate prices without higher wages would be unsustainable and put home ownership beyond the reach of many, ultimately requiring weaker prices in the future to bring house prices back in line with the economy. 

Governments and central banks had previously been operating in their own separate spheres of influence but the extended remit of central banks may bring them into conflict.  This has the potential to work in a positive way to provide greater oversight for government policies shown to be at fault in the past (for example, high government borrowing in the UK in the run up to the global financial crisis).  Another example of how the European Central Bank did the most to save the euro while the various governments in Europe squabbled.  It is not hard to argue for giving more power to economists (see previous blog) when politicians provide so many reasons for doing so.