Central Banks – juggling interest rates and inflation

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

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

Too many balls in the air

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

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

Juggling priorities  

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

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

Don’t douse the economic recovery

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

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

Interest Rates – low but not low enough

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

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

Not so free market

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

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

Still waiting

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

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

Where to next?

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

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

Emerging Markets – Caught in the Crossfire

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

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

Danger zone

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

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

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

Collateral damage

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

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

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

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.

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.

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.  

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)

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

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.