Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.

Not so Great Expectations

Economists are sticking to old ideas about our behaviour but is it time to ask them for some more?

Economics has grown in popularity as people try to make sense of the troubles in the economy.  At the same time, what is taught as economics is being challenged after economics provided little help in predicting the global financial crisis or dealing with its aftermath.  Your Neighbourhood Economist has a particular issue with the common view among economists about how people think about changes in prices and interest rates.  This way of thinking has pushed monetary policy in the wrong direction as economists rely on theory which is increasingly being shown to be detached from reality.

The above position is based on the concept of rational expectations where people’s predictions of the future are built into economics models.  This first came to prominence during the 1970s where persistent inflation was a problem - high inflation had resulted in demands for higher wages which pushed up the costs of businesses and thereby led to businesses charging even higher prices.  The notion of expectations enabled economists to explain the reasons behind rising wages.  Since then, inflation has been tamed through new policies which make price stability the main focus of central banks under the rationale that people will not expect inflation to get out of hand if the central banks are on the case.

Central banks have been successful in handling inflation but other problems such as reigning in financial crises and dealing with the aftermaths of such have proved harder to manage.  Economists have been using the same tools through forward guidance which aims to boost lending by instilling expectations that interest rates will stay low for an extended period of time.  At the same time, measures to restore the economy have been restricted by concerns about the possibility of triggering a surge of inflation if central banks are seen to be less vigilant.  Surveys of people’s perceptions of inflation are now commonplace and followed by inflation-fearing economists almost as anxiously as politicians track polls on their popularity.

Yet times have changed.  Inflation is no longer such a big deal - globalization has resulted in increased competition which keeps down prices and weaker labour unions are unable to impose the industry-wide wages hikes of the past.  The average person on the street is not overly concerned about inflation in comparison to other worries about the economy so our actions are no longer shaped much by changes to prices.  The same is true for deflation - although the faltering economy in Japan is brought out as an example of what can go wrong, it is likely that Japan is an anomaly rather than a model applicable to other countries.  The old ideas on economics have not served us well in getting the global economy up and running again suggesting that economists ought to change their thinking to help deal with the hard times. 

Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.

The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

ECB Rate Cut – what's the point?

The European Central Bank set itself apart with looser monetary policy but how is this likely to make any difference to the economy?

Central banks have been busy recently, whether it be talk of forward guidance from the Bank of England or the tapering of bond purchases by the Federal Reserve.  The exception had been the European Central Bank (ECB) which had been going through a quiet period after monetary policy helped to put paid to the Eurozone crisis in 2012.  Worries about deflation jolted the ECB back into action following data showing that inflation was down to 0.7% in October.  The ECB decided to respond last week by cutting its benchmark interest rate from 0.5% to 0.25%.  But, with interest rates already low, will a further reduction make much of a difference to the economy?

A cut to interest rates is something of an anomaly as the ECB is the only major central bank which has not already lowered interest rates as much as possible.  The recent trimming of its key interest rate follows cuts in July 2012 and May 2013 with the ECB using this drip-feeding of interest rate changes to respond to new data on the economy in Europe.  The focus of policy has shifted from saving the Eurozone from collapse, which was achieved by the ECB taking a stand pledging to do “whatever it takes” to save the euro. Instead, the ECB is looking to boost growth with the hope of staving off deflation.

Lower prices may sound like a blessing to consumers but this fall has the effect of making debt tougher to pay back as selling the same amount of goods generates less money for firms which also means that the government misses out on tax revenues.  Not exactly what a heavily indebted Europe needs at the moment.  This is the reason why central banks will typically adjust policy to achieve inflation of around 2% - better to have a small amount of inflation than succumb to deflation.  Inflation has been decreasing elsewhere as well such as in the UK (see previous blog) due to weak growth combined with a fall in global commodity prices (see Inflation – then and now for more on how inflation works).

The interest rate cut in itself will actually have little effect with households and businesses in Europe not keen on borrowing while the economy is so weak.  Rather it is a signal of intent – the ECB will continue to loosen monetary policy while some central banks elsewhere (the US and, to a lesser extent, the UK) are approaching the beginning of the end of their loose monetary policy.  The key mechanism by which this will be fed through into the economy is likely to be the exchange rate but more on this later…

The ups and downs of UK inflation

Inflation has become delinked from the UK economy but at least it seems to be heading in the right direction

Something seems off.  Inflation figures for the United Kingdom released this week show that inflation dropped to 2.2% during the 12 months up to October.  Inflation had previously been high despite the sluggish UK economy but inflation is now on the way down just as the economy is picking up again according to data released at the end of October showing the fastest rate of economic growth in more than three years.  Any links between inflation and the health of the economy take on extra meaning due to the level of prices being the primary concern of central banks.  So how is the Bank of England likely to react to such mixed data?

Inflation typically moves in line with the economy – increasing during boom times and falling when times are bad.  But as mentioned above, this relationship does not always hold as economic growth in places other than Western countries, such as China and other emerging markets, can affect prices for global commodities, a situation which was not always the case (for more on this, see Inflation – Then and Now). The strength of the Chinese economy explains how inflation in the UK could briefly exceed 5% near the end of 2011 while the economy was struggling.

Although the main goal for the Bank of England is to maintain price stability which involves keeping inflation close to around 2%, the high inflation in 2011 was not seen as a problem on the basis that the factors behind the higher inflation were judged to be temporary (and this turned out to be correct).  More persistent inflation typically comes with more sustained periods of economic growth as increased wealth pushes up demand and results in rising prices.

Accordingly, it may be a good omen that lower inflation has come at a time when the fortunes of the economy are beginning to brighten.  It will give the Bank of England more leeway to keep interest rates lower for longer.  However, it is not clear whether inflation will continue to fall – energy suppliers are planning to hike energy prices while the government will be keen to limit higher fuel bills.  Energy costs will also be dampened by China no longer experiencing the rampant economic growth of the past decade.   At least inflation will be one less thing that the Bank of England will need to worry about with the tricky prospect of interest rate rises on the horizon.

Wonga - Do we need to be saved?

Politicians are questioning our ability to make the right choices but that is not the real problem.

Criticism of Wonga recently reached a new nadir with the rather ridiculous claim by Ed Miliband, the Labour Party leader, that children have been “targeted” throughTV ads.  There does seem to be something unethical about a firm which charges almost 6,000% interest on loans.  However, this hasn’t prevented Wonga from prospering.  With wages stagnating for many people, there is strong demand for extra cash at times of need even if it does come with a big chunk of interest payment.  Yet, many in the media have been critical of a culture of borrowing with Wonga as the new pied piper (see my previous blog on Wonga).  Are Wonga’s loans useful in times of trouble or a snare for the unwary?

One of the key elements of a capitalist economy is that firms will sell any product where profits can be made.  This drive for profits pushes companies to innovate and create things that we didn’t even know we wanted.  The short-term loans from Wonga are one such product allowing quick access to cash that was not previously available.  Their popularity suggests that many find such loans useful, but it also prompts concerns that people are not making the smartest financial decisions.  Politicians among others target the source of supply (the firms offering the loans) rather than the source of the problem which is too complicated to deal with.

This paternalistic way of thinking is the basis for government action on a range of our “bad habits” from smoking (where policies have worked out for the best) to alcohol and fast food (which have been controversial).  Government policies such as these which try to modify the behaviour of adults sometimes seem like a replacement for a decent education system.  The world is growing in complexity and we are faced with an increasing range of choices at the same time as education is becoming increasingly focused on test results.  This leaves teachers with little time to teach important life skills such as a healthy diet or financial literacy.  Politicians could do us all a favour by asking the bigger questions rather than jumping on the latest bandwagon – if only there was a way to improve the behaviour of politicians.

Wonga – the new bad boy of finance?

Wonga has been grabbing headlines for the wrong reasons but who is really to blame?

It is not a good time for finance firms of any guise to be making too much money at the moment.  So the British short-term lender Wonga attracted the wrong type of attention when it announced record profits of 65 million pounds for 2012.  Everybody from Ed Miliband, the Labour Party leader, to the Archbishop of Canterbury have lined up to vilify Wonga for making money out of people who have fallen on hard times.  Wonga, who offer loans of small amounts for a period of up to 30 days, have hit back with a slick new promo video telling the stories of some of its customers.  Is Wonga as bad as they say or is the recent controversy just a bit of name calling to grab some headlines?

Among the numerous criticisms, perhaps the most commonly heard are to do with the eye-wateringly high interest rates which work out at 5,853 percent (as stated clearly on the website).  Yet the short periods of borrowing mean that interest payments are typically small compared to the amounts involved - a typical loan of 200 pounds for 15 days incurs fees and interest of just over 36 pounds.  But 200 pounds would explode out to over 10,000 pounds over 12 months so any mishaps which delay repayment have the potential to spiral out of control and result in massive debts.

So why would people risk this in the first place?  A bit of extra cash when we are short might save us even more money than the cost of the loan when caught in a spot of trouble or might stop us from missing out on a big night out with friends just before payday.  The choice to borrow or not to borrow is one that each of us is free to make (with full disclosure of charges from Wonga).  What the long line of Wonga critics are instead condemning is the fact that so many people are choosing to take out loans through firms such as Wonga.

Wonga is a symptom of and not a cause of a society that spends at will and may not always have money left at the end of the month in case of emergencies.   Life was not always so free and easy - access to any extra cash used to be limited to only those on good terms with their bank managers.  But new ways of getting cash, such as credit cards and short-term loans, have provided money to the masses.  We should be thankful to have it if we need it but better management of our finances might mean that we would be thankful not to need it.