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.

Low Oil Prices – Feeding the Addiction

Cheaper oil will bring about much cheer but it will help keep key oil producers happy in years to come

Oil is like a drug that the world economy cannot do without and we are in the midst of a turf war over who will call the shots.  A few dealers have had a stranglehold over the market for oil and have been able to set prices as they please.  The arrival of new kids on the block (with the rise of fracking in the US) has triggered a fight for control of the oil market.  The result has been a plunge in oil prices which is a blessing for the global economy but is part of a bigger strategy to keep us all addicted to oil for years to come.

Not a buyers’ market

The sharp drop in oil prices will provide a welcome boost to the economic recovery in many countries.  Oil is like a drug in that it is always in demand and buying continued despite high prices in the aftermath of the global financial crisis.  Prices for oil have only recently eased off (playing havoc with inflation) as demand from energy-hungry China has weakened while supply from the US has expanded.  Oil is also plagued by a further similarity to drugs in that the suppliers of oil tend to be some ugly characters such as Russia, Iran, and Venezuela (as well as some nice ones such as Canada and Norway).  But the kingpin of the oil market is Saudi Arabia due to the size of its reserves of oil and its willingness to adjust its output to market conditions.

Saudi Arabia is the top dog of a club called OPEC where some of the major producers of oil banded together to wrestle control of the oil market away from Western energy firms.  OPEC came to prominence in the 1970s when the countries cut oil output as a protest against Israel.  Along with the devastation wrought due to the resulting surge in oil prices, efforts to conserve energy also acted to weaken the need for oil.  Once oil prices returned to normal, OPEC has looked to set its output so as to make the most money while also suppressing incentives to cut back on oil consumption. 

Sticking to the optimal level of output was always going to be tricky when cheating would bring in extra cash.  This meant that not all members of OPEC stuck to their quotas set to manage the supply of oil and it was left to Saudi Arabia to shoulder the burden of larger cuts to production when required.  Saudi Arabia could pull this off due to its revenues from oil being more than enough to fund its government spending.  In contrast, governments in countries such as Venezuela and Iran spend big to support their anti-Western antics which tend to max out the cash from their energy sectors.

Trying to stay on top

The arrangements behind this oil cartel have been bust wide open due to the surge in oil output coming out from the US.  New fracking technology has unlocked previously inaccessible oil reserves and turned the US into a big player in the oil market.  Faced with a choice of cutting its output or suffer falling prices, OPEC chose the latter.  The Saudis, in particular, were not willing to take a hit and lose out in terms of market share.  As Saudi oil is typically cheap to get out of the ground, their hope is that a lower price for oil will drive others out of business.  A drop in oil prices will also scare away any investment in oil fields that would boost output in the future.

It pays for Saudi Arabia to take a long term view of the market seeing that it has so much oil still underground.  An abundance of new sources of oil or new technologies that eliminate the need for oil would take a big chunk out of the value of its underground stash.  Saudi Arabia is in a strong enough position to sacrifice short-term gain to lock in future control over the oil market.  Be thankful that the Saudis want oil to be cheap for now and keep us all addicted but don’t expect it to last (much more than a few years).

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).

Commodity Prices – Swings and Roundabouts

Commodity markets had gone off in their own direction but are now back on track to help out with the global economy

The global economy has suffered more downs than ups over the past few years but lower commodity prices will provide some long needed cheer.  Long after the onset of the global financial crisis, prices for everything from copper to vegetable oil continued to rise stoked by demand from places such as China.  Weaken global demand has finally taken affect and relief in on the way for consumers everywhere.  It is likely to provide a bigger boost than just a bit of extra cash.

A guide to the road ahead

Commodity markets often follow their own roadmap.  Demand for different materials can rise and fall depending on changes in technology or consumption patterns.  The rising wealth of China and India has pushed up prices for everything from gold to milk powder.  New fracking technology has lowered the price of oil while corn became more expensive due to its use in producing ethanol in the United States. 

Supply further complicates matters as rising demand for any commodity will prompt companies to increase output but this often takes time.  There is a lag of a year or so for farmers to shift from growing one crop to another and even longer for a new mine or source of oil to be developed.  The changing demand and the delayed response on the supply side means that twists and turns in the commodity markets are often accentuated.

Back on the map

Prices in the commodity markets had long been out of kilter with the slump in global demand but this seems to be over.  The price of oil, which has been making news recently, is indicative of this new trend.  Increased output in the US coupled with a tailing off of demand from energy-hungry China has resulted in a sharp turnaround in prices.  High prices for commodities such as oil often do not last as more money gets spend on both finding more oil as well as on increasing energy efficiency to lower money spent on oil.  Both of these factors act to stop the price of oil getting out of hand. 

Market correcting forces move in both directions and also work to prevent excessive falls in prices.  Investments in producing commodities are put on hold if prices drop back and low supply tempers a decline in prices.  Lower prices also mean that interest in using resource more efficiently tends to fade.  This is why commodity prices tend to fluctuate in big swings of boom and bust.  With the world economy have just endured a period of high prices, the commodity market seems to be swinging in the opposite direction.  Considering the big swings in commodity prices, this trend is not likely to be reversed any time soon. 

Heading in the right direction

The benefits of lower commodity prices extend beyond the obvious effects of cheaper prices at the petrol pump, on our gas and power bills, and when stocking up at the supermarket.  Less money will go to places such as Saudi Arabia and Russia, where high oil prices only add to the riches of already wealthy individuals, and consumers across the globe will instead have more money in their pockets.  As such, the global economy will benefit as this extra cash will likely to spent rather than piling up in the bank accounts of rich Saudis or Russians.

A further benefit of lower commodity prices is that cheaper commodities mean lower inflation and lower inflation allows more scope for looser monetary policy.  An uptick in inflation would be one excuse that central banks would use to raise interest rates.  But with inflation likely to be subdued (and deflation becoming more of a concern), interest rates are more likely to stay at their current low levels or hardly rise at all when interest rates are eventually raised.  The absence of inflation could even result in a long-needed rethink of what central banks should be doing in terms of monetary policy.  That may work out to be even be more valuable than a few extra notes in your pocket.

Interest Rates – Looking for the right temperature

The economic climate is changing but that may not necessarily mean that interest rates have to change too

Setting interest rates can be as frustrating as fiddling with the heating as the seasons change.  We can rely on the weather forecast as a guide to the outside conditions but it is harder to get a measure of whether the economy is running hot or cold.  This is particularly tricky at a time when some central banks are switching from policies to warm up the economy to measures for preventing the economy from overheating.  The poor economic outlook suggests that the current monetary policy measures may be here to stay despite calls for higher interest rates.

Neither too hot nor too cold

Interest rates are often raised or lowered to nudge the economy toward what is seen as an appropriate rate of growth.  Once the economy is humming along as it should (with inflation in check), interest rates are ideally set to a level that neither helps nor hinders economic growth.  This is the concept of neutral interest rates which should be higher for fast growing economies and lower for economies with weaker growth.  Not only are there differences between countries but the neutral interest rate for one particular country can change over time.

The neutral interest rates have been slipping downward for many countries as their prospects for growth deteriorate.  Many consumers as well as governments are focusing on paying back debt leaving less money to spend.  Companies are hoarding cash instead of investing which takes away another driver of growth.  With most developed countries suffering from the same problems, exports don’t offer much help either.  Even economic growth in China, which has been one of the few bright spots in the global economy, is likely to slow from a boil to a simmer as focus shifts from investment to consumption.

Turning up the heat

There are signs that the global economy is heating up in places.  The British economy is expected to expand by around 3.0% in 2014 while around 2.0% growth is forecast for the US economy.  Yet, the effects of this are not being felt by consumers due to stagnating wages and cuts to government spending.  Low inflation is a further indication that not all is well even these economic hot spots.  These mixed signals have prompted a cautious approach by the US Federal Reserve and the Bank of England who have kept interest rates at record lows close to zero.

The lingering hangover from the global financial crisis continues to hold back the economic recovery.  Consumers are less willing to take on debt after the disastrous results of the previous borrowing binge.  Any plans of investment are reigned amid worried about the prospects for the economy.  Proactive policies tend to go out the window as politics regresses to squabbling over limited government resources.   The likelihood for these factors to lower the neutral interest rates means that interest rates are unlikely to go up by much at all. 

Don’t touch that knob

Depending on the extent to which the neutral interest rates have fallen, it could even be argued that interest rates should stay close to zero until the medium term prospects improve.  There is no immediate reason for interest rates to be raised considering that the main concern of central banks, inflation, is not a concern.  Even looking forward, inflation is likely to remain subdued when factoring in falling commodity prices and weak wage growth.

Moreover, lending has not gotten out of hand except for in isolated sectors such as real estate in certain countries (such as the UK).  Other worries also include low rates of return pushing investors to chase after higher pay-outs by putting money into increasingly riskier investments.   Yet, these issues can be dealt with using targeted policies rather than relying solely on interest rates.  Higher interest rates are seen as helpful in that it will give central banks more capacity to respond in the case of another downturn.  But setting interest rates has less of an effect when the financial markets are awash with cash. 

Like a bickering couple arguing whether the heating is set too high or too low, expect the debate over the right level for interest rates to drag on.  Despite all this, it looks as if interest rates might be best left where they are for now.

Quantitative Easing – Waiting while Europe Sinks

As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse

It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe.  The situation in European grows continues to get worse as economic growth stagnates and deflation sets in.  Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high.  This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place. 

Politics muddies the water

Monetary policy is tough enough in one country, let along for the 18 countries which use the euro.  The European Central Bank has acted boldly when given the chance.  It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone.  This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil.  But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro. 

Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks.  Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement.  Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion.  The problem is the rules and regulations that get in the way of more efficient ways of doing business.  Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.   

Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show.  So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is.  Instead, it has been easier to blame others and wait in the hope that economic growth will return.  This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.

The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others.  Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain.  Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy.  The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.

Waiting until things get worse

The central bank has already responded to the threat of deflation through a policy of negative interest rates.  Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy.  This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans.  Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act. 

Yet, even the Germans will eventually have to see deflation as the greater threat.  But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack.  Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant.  So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.

Interest Rate Hike – not expecting the worst

People tend to fear the worst but higher interest rates may not mean interest rates that are actually that high

Some things that people normally dread as not so bad in reality – such may be the outcome with the upcoming hikes in interest rates.  Interest rates are set to levels which relate to the strength of the underlying economy (as reflected in the level of inflation).  But the pressure to push up interest rates is likely to be limited considering that the long-term prospects for the economy are a bit grim.  On top of this, there is a growing range of policy tools that central banks can use instead of interest rates to manage the economy.  So when higher interest rates do come, like a visit from the in-laws, it may not be as painful as had been expected.

Inflation not so scary

One of the main jobs of central banks is to set interest rates so as to keep inflation low.  This is because inflation in itself is seen as having a negative influence as well as being a sign that an economy might be overheating.  Inflation comes about as firms increase prices typically when their costs are rising or when demand is strong.  Yet, neither is the case at the moment.  Stagnating wages, which is the largest expense for many firms, mean that higher costs are not likely to translate into higher prices. Sluggish consumer spending is prompting some firms to cut prices so as not to lose customers.

This is more than just the result of a sluggish economic recovery as shown by growing concerns about the long-term prospects for the economy.  Investment by businesses continues to remain weak despite record low interest rates.  The expanding operations of companies would help to fuel gains in productivity which further feed into higher wages.  But, with firms not wanting to spend and consumers not likely to get their hands on much extra cash, economic activity is expected to remain subdued.  Austerity measures are a further damper on the economy as governments rush to sort out their finances.

The most glaring reason to not expect any trouble from inflation is prices have barely budged despite everything that has happened over the past decade.  Inflation has remained subdued (mostly 5% or (much) lower) despite a surge in bank lending in the lead up to the crisis or central banks printing billions in new cash in more recent times.  The only time inflation popped up on the radar of policy makers during the depth of economic recession in 2011 due to high commodity prices (more on that later).

This time is different

Not only is inflation expected to remain low but influences over monetary policy are also likely to act to keep interest rates low.  For starters, the potential for a slower pace of economic growth will make it difficult to justify central banks raising interest rates.  Calls for a hike to interest rates at the Bank of England (which is likely to go first among the larger central banks) may be premature considering low inflation and the stuttering economic recovery. 

Monetary policy is also developing so that central banks have more options available to them to deal with inflation and other negative aspects of a buoyant economy.  The most promising of these are macroprudential measures such as caps on mortgage lending and other controls on banks.  These will enable central banks to rein in overheating parts of the economy without having to increase interest rates.

There have also been changes to inflation itself.  As mentioned above, any inflation recently has tended to come from outside sources such as commodity prices rising in global markets in line with growing demand in emerging markets.  Higher interest rates can only have an effect when a rise in prices is due to factors within the economy itself.  So if inflation is due to external causes, central banks will likely hold off increasing interest rates.

Hope for the best

So, there is likely to be no rush to increase interest rates, and when the inevitable does happen, interest rates are not actually going to rise by that much.  This is welcome news for places where buoyant property prices have push new home owners to take on large mortgages relative to their income.  Higher interest rates still have the potential to stall an economic recovery that is still fragile.  But if central banks wait for the right timing, the eventual interest rate hikes may be like going to the dentist expecting to have some teeth pulled but instead just getting a clean and a lollipop.  

Economists crash but don’t burn

Economists have been caught up in their own tale of hubris but have come out barely unscathed

Sometimes life plays out like fiction and such has been the case with economists.  The advocates of economics had been riding high at the beginning of the century as everything seemed to be running smoothly.  Economists look on a renewed sense of swagger stemming from the (mistaken) belief that fluctuations in the economy had been mastered.  But as often happens in a tale of hubris, the world comes crashing down just at the point where the hero starts to get carried away.  Such has been the tragedy for economists but it is the rest of us that have paid the price.    

Set for a fall

Like the rest of us, economists are liable to go too far when things go their way.  This is made worse by the way in which economics can be seen as more like a religion than a science as it is difficult to prove that economic ideas are wrong.  This means that faith can mean more than fact.  But when faith and fact align is when the problems really begin.  Such was the case for a couple of decades after economists increasingly took charge of central banks since the 1980s. 

Central banks took on the mission of combating the scourge of inflation and their success with this began to build up confidence in their capabilities.  Their theories led economists to believe that low and stable inflation was the key to economic wealth and well-being.  But this meant that problems were allowed to fester elsewhere in the economy due to this narrow focus on consumer prices.  The dot com bubble just over ten years ago should have been a wakeup call.  Prices for tech stock had gotten out of hand but central banks preferred to stand back with the plan of letting the boom and bust run its course and then mop up afterwards.  The mild recession that followed reaffirmed the notion that central banks could fix any problems.   

No so clever after all

Economists made the most of their time in the sun.  Thinking that they had all of the answers, economists started applying their ideas to other topics.  Economists also increasingly plugged their ideas to the public fuelled by the claim that economics could explain almost everything (see the photo above).  Thinking that they knew it all, economists weren’t afraid to let other know about it.  As is typical for a Greek tragedy, it is precisely at this point (where the hero thinks that the world has been conquered) that everything comes crashing down. 

The turning point in this tale of woe came with the global financial crisis.  Economists were not just unfortunate victims of unforeseen circumstance but were the architects of their own downfall.  Their conviction in their own ideas prompted economists at central banks to overlook growing distortions in the economy.  Interest rates were kept too low for too long which allowed for the levels of debt to get out of hand.  The dogma of the almighty central bank also led to complacency at banks that chased after profits without worrying about risks in the economy.

Skipping over the lesson of the tale

It does not take the wisdom of hindsight to see that catastrophe was just around the corner.  But it does help with realizing that the success that central banks achieved may have been more due to luck than clever management.  The surge in exports from China was always going to keep prices down whatever central banks did.  Inflation may not even be a major concern any more considering that prices did not jump despite the surge in lending heading into the global financial crisis or with central banks printing loads of cash as part of quantitative easing.

The saga proved to be something similar to the tale of Icarus.  Emboldened economists also flew too close to the sun but it was their ideas that went into eventually went into meltdown.  But the main difference is that, while economists have fallen from grace, it was others who got badly burnt.  This would be easier to take if economists were busying themselves coming up with better ideas to allow for less turbulence in the economy.  But economists are slow learners and policy is still guided by the same old ideas.  Change may happen and hopefully it does before we all crash and burn again.  

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.

Inflation – More friend than foe

Inflation plays the role of the bad guy in economic theory but this may change now that we are faced with a greater threat to the economy

Inflation has been cast as a villain by economists but it could be a source of salvation.  Rising prices are often seen as one of the main evils in an economy – they push up the cost of living and eat into savings.  This may be the case in a normal economy but may not hold true considering that things are far from normal.  Instead, it might be that the high levels of debt weighing down the economy prove to be a greater menace.  In an ironic twist of fate, it is inflation that may prove to be our best weapon in our fight against high levels of debt.

I’ll be back (as the good guy)

Villains can turn into heroes with a twist in the storyline.  Just think of Arnold Schwarzenegger’s character in the second Terminator movie.  The havoc wrought by inflation in the past is almost on the same scale of a cyborg from the future but it has left economists with an innate fear of its return.  Inflation has been tamed and no longer poses the same danger to the economy having been the focus of monetary policy for decades.

It was the global financial crisis that led to a new peril.  Interest rates that were kept too low along with creativity in the banking sector set the scene for a surge in the amount of loans.  The problem of excessive debt was made worse by policies designed to bring the economy back to life.  Monetary policy has left interest rates at record lows while also resulting in a flood of liquidity in the financial markets through quantitative easing.  This combined with government policy to revive the housing market has seen a dramatic rise in the volume of mortgages.

As we have seen with government spending, a large burden of debt can result in cutbacks which damage an economy.  If consumers are also saddled with debt, the resulting limits on consumer spending have serious implications for economic growth.  Debt is not only bad for borrowers but the resulting sluggish economy dims the prospects for everyone else as well.

More inflation now to save the future

While not a new technology sent from the future, something as simple as inflation could be one way of alleviating the burden of debt on both consumers and the government.  Inflation helps by increasing the size of the economy relative to any debts.  If wages increased along with inflation, households would also have more money for repayments of their loans and the greater tax revenue will be a boost for the government. 

There are a range of measures (including one preferred by Your Neighbourhood Economist) which could be used to nudge inflation upwards in a controlled manner while also adding momentum to the economic recovery.  Many economists would recoil from the idea of higher inflation almost as fast as they would run from a cyborg.  But this has more to do with economists being stuck in the past than the destructive powers of inflation.

There are some negatives to factor in but the overall effect of increased inflation would be positive.  Inflation will eat into our spending power through higher prices for many of the things that we buy.  However, spending on everyday items takes up a smaller portion of the earnings of borrowers compared to paying off debt.  Even though a policy of allowing more inflation would be biased towards those with debt, everyone would benefit from a more vibrant economy.  As the Terminator movies have taught us, our current actions shape our future and a little more inflation would be a small price to pay to bid hasta la vista to our burden of debts.

Economics – more religion than science?

Economists claim to offer salvation but the tenets of economics need reforming before we can be saved

Economics is sometimes like a religion in that its adherents keep the faith irrespective of evidence to the contrary.  The global financial crisis has tested the conviction of many economists but few seem ready to renounce their previous beliefs.  This might seem strange with a discipline that aims to be more like a science but there are factors which mean economics relies more on faith than on facts.  Considering the positions of power held by economists, we can only hope that the moment of revelation is not too far off. 

In Markets We Trust

Economics claims to offer a path to the Promised Land.  The role of God is assumed by the concept of the invisible hand which prophesies that markets will bring about the most favourable outcomes in terms of output and prices.  One of the most sacred beliefs in economics is that we must defer to the invisible hand as much as possible.  Economists help this along, with central banks keeping down inflation while governments open up their economies to global markets.   This ushered in over two decades of unprecedented economic progress until financial turmoil struck like a plague in 2008. 

Yet, despite the economic Armageddon that followed, economists have remained stubbornly tied to the same creed.  The response to the financial crisis has relied on the traditional tonic of lower interest rates with newer orthodoxy calling for the use of quantitative easing when conventional measures did not work.  Central banks have stuck with these policies despite the resulting growing distortions in the financial markets which would be anathema for economists in normal times. 

Believing in false idols

One element which makes economics more like a religion and less like a science is that it is difficult to prove when someone is wrong.  Scientific theories can be tested by experiments carried out in laboratories or similar places where the conditions can be kept in check.  Economic hypotheses cannot be proven in such controlled environments.  The sheer volume of transactions by consumers and firms means that there may be any number of reasons behind a certain outcome.  The impossibility of isolating specific cause and effect relationships means that truths in economics can only be subjective. 

This means that economists can piously hold onto their previous ideas on how the economy works despite any evidence to the contrary.  Economists tend to become wedded to their ideas as they hone them over many years in long careers in academia.  Any newcomers to economic are also indoctrinated into the existing dogma with little scope for breaking out of the mould.  The current generation of economics students have risen up in arms against being taught theories that have little relevance to economic events.

One of the more old-fashioned ideas that economists cling to is a fear of inflation.  The full range of tools for monetary stimulus has not been available as central banks have been adamant that inflation should not be allowed to get out of control.  This stems from psychological scars in the minds of economists due to damage done by inflation in a bygone era (the 1970s).  Europe has suffered the most under this economic fanaticism and has had to deal with the added difficulties of the Eurozone crisis with few policy options available. 

It is not a coincidence that the global economy and economic theory are both stagnating at the same time – economic deliverance for us all may depend on a second coming of economics in a more practical form.

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.

Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.