Is monetary policy still a potent weapon against recession?

Is monetary policy still a potent weapon against recession? WRITING in Slate magazine in 1997, Paul Krugman, an American economist, neatly captured the widespread belief in the omnipotence of the then-chairman of the Federal Reserve. “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” Faith in the Federal Reserve is not what it used to be. Since September the Fed has cut its policy rate by 1.75 percentage points, to 3.5%. It still has plenty of firepower left—rates are some way above the 1% level reached in 2003—but few seem willing to rely on monetary policy alone to save the day. Politicians and pundits alike were making a case for a fiscal stimulus package even before the Fed's surprise rate cut on January 22nd. That Ben Bernanke, the Fed chairman today, has given his blessing to the plan only adds to the impression that central banks have lost their grip. What lies behind this loss of faith? One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fuelled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending. One of the ways that central banks affect the economy is through their influence on the price of assets, like shares or homes. Other things being equal, a reduction in short-term interest rates should bump up asset values, because their stream of future earnings is discounted by a smaller factor. Now that America's housing boom is ending, the worry is that the Fed is less able to stimulate the spending that comes with rising housing wealth. Assets are already dear, it is said; there are no bubbles left to reflate. Falling home prices make for a nation of savers, not shoppers. And firms are not keen to invest when the market value of their assets is shrinking. Falling asset prices hurt the market for credit too, interfering with another policy channel. Monetary policy affects the choice between spending now or spending later and, for the cash-strapped, credit provides the bridge from the present to the future. Interest rates are the cost of using tomorrow's income to pay for today's spending. Lower rates lift spending by more when there is access to borrowing. Firms and homeowners can borrow cheaply with good collateral, but funds are less abundant when asset values are falling. Consumers may in any case have had their fill of borrowing. Household debt in America has vaulted to more than 130% of disposable income from less than 100% in 2000 (see left-hand chart). In Britain the ratio is higher still. And even if credit demand holds up, banks reeling from subprime-related losses are less willing to supply it. Another strain of policy pessimism argues that interest-rate cuts will only fuel inflation, without helping the economy. In fact it seems likely that America's economic slowdown will create enough slack to ease inflationary pressure. That, at any rate, seems to be the judgment of the bond markets. In the months since the Fed's first rate cut in September, ten-year bond yields have dropped steadily, in contrast to the reaction to the rate cuts in early 2001, when bond yields drifted upwards (see right-hand chart). The distant sound of whirring rotors Central banks are not toothless, however. They can still affect spending by altering the returns of existing savers and borrowers. Lower interest rates increase the disposable income of debtors, by cutting their repayments, even as they eat into savers' cashflow. Borrowers are likely to spend more out of each additional dollar, so tilting the scales in their favour by cutting rates should boost demand. In America the household sector's debt has grown faster than its stock of interest-bearing assets, so the cashflow channel is now likely to be more, not less, powerful. The effect is probably stronger still in countries such as Britain and Spain, where most mortgage rates are closely tied to policy rates or fixed for only short periods. Although the asset-price and credit channels are more constricted than in the past, monetary policy can still work through them. Interest-rate cuts are unlikely to lift house prices, but they may at least arrest the size and pace of price falls. The firms and households that are less burdened by debt will be able to take advantage of lower interest rates, even as others are struggling to reduce their borrowing. If the Fed still has some clout, why the clamour for fiscal stimulus? In an election year, politics is one obvious factor, but economic arguments can also be brought to bear. One attraction is that it eases the over-reliance on monetary policy. Alan Blinder, a Princeton professor and former Fed governor, also argues* that fiscal remedies can boost demand more quickly than interest-rate cuts. Tax breaks work well if they bring spending forward, say by targeting help on the poor, who are more likely to spend than save—though this may be hard to arrange in practice. The drawback is that it leaves decisions to politicians, who risk taking too long to agree on the right policies in a slump and are unwilling to raise taxes in a boom. Although monetary policy is normally best placed to help stabilise the economy, there are some circumstances where fiscal policy can help—during long or deep recessions, when demand suddenly slumps, or when interest rates fall to zero. In the latter case, writes Mr Blinder, “a combined monetary-fiscal effort—deficit spending or tax cuts financed by printing money—may be needed”. This is Milton Friedman's “helicopter drop” of money. Only then will the Fed really start to feel impotent.

A NEW THINKING IS REQUIRED

If emerging economies diverge from America's, monetary policy also needs to break free POLICYMAKERS in Washington and London have been losing sleep over the risks of financial meltdown and recession. In sharp contrast, the biggest worry in Beijing, Moscow and other emerging-market capitals is rising inflation. China's inflation rate has jumped to 8.3% from 2.2% in early 2007; Russia's is running at 13.3% (see left-hand chart). HSBC forecasts that the average inflation rate in emerging economies will rise to 6.6% this year, its highest in ten years. One reason is the surge in food and energy prices. Food accounts for a bigger slice of spending in poor countries than in rich ones, so rising grain and meat prices have a bigger impact on inflation. But this is only part of the story: core inflation rates are also creeping up, and lax monetary policies are to blame. As America stumbles, growth in emerging economies seems to be holding up well. HSBC forecasts average GDP growth of 6.5% this year, more than four times as fast as in developed countries. The problem is that although economies may have decoupled, their monetary policies have not. Whereas the greater resilience of the emerging world is a source of stability for the global economy, the monetary linkages between rich and poor economies complicate matters. Emerging economies were partly to blame for America's housing and credit bubble. As China and Gulf oil exporters purchased American Treasury bonds in order to hold down their currencies, this pushed down bond yields and helped to fuel the housing boom. Low yields also encouraged investors to seek higher returns in riskier assets, such as mortgage-backed securities. That bubble has burst, prompting the Federal Reserve to slash interest rates. Now, those same exchange-rate policies that helped to cause America's financial crisis are leading emerging economies to run overly loose monetary policies. Apart from the Gulf states, few countries still peg their currencies to the dollar, but most try to limit the amount of appreciation. This means that as the Fed cuts rates there is pressure on emerging economies to do the same, to prevent capital inflows pushing up their exchange rates. Saudi Arabia, the United Arab Emirates, Qatar and Bahrain have all followed the Fed's April 30th rate cut. In the face of rising inflation, emerging economies should be lifting interest rates, not cutting them, but their rigid currency policies make this hard. In turn, continued surging demand in emerging economies boosts commodity prices, which reduces Americans' spending power and so encourages the Fed to cut rates further. The more the Fed cuts, the bigger the risk of inflation in emerging markets. The right-hand chart shows just how loose monetary policy is. Joachim Fels and Manoj Pradhan, of Morgan Stanley, have made a stab at estimating neutral interest rates, ie, the short-term rates that would keep GDP growing at its trend pace and inflation on a stable path. The results are startling. In China and Russia, actual real rates are negative, against estimates of neutral real rates of 8% and 5% respectively. In India, real rates are close to zero—still far below the estimated neutral rate of 6%. Only in Brazil are real rates positive and above the neutral rate. Admittedly this ignores other tightening measures that central banks use, such as banks' reserve requirements (both India and China have been steadily increasing them). Nevertheless, it is no coincidence that Brazil has the lowest inflation rate of the four countries. Russia, with the lowest real interest rates, has the highest inflation. Not so easy The usual advice given to overheating emerging economies is that they must let their currencies rise. This would help to curb inflation by reducing import prices, and a flexible exchange rate would create more room for an independent monetary policy. Currency appreciation thus seems the obvious solution. However, Stephen King and Stuart Green, economists at HSBC, argue in a recent report that it raises many awkward questions. How far should currencies rise in order to keep inflation in check? China has allowed the yuan to rise by 18% against the dollar since 2005. Brazil's currency has appreciated by more than 100% since 2003, yet even this has not stopped inflation from picking up. At 4.7%, the rate may be lower than other big developing countries, but it is still up from less than 3% a year ago, partly because of excessive growth in domestic demand. In the past two years real interest rates have fallen sharply (although they are still the highest in the world) and public spending has surged. In April the central bank raised interest rates for the first time in three years, but this is likely to lure in foreign capital. Should Brazil let its exchange rate rise further—when its current account has already moved back into deficit? The danger of allowing these currencies to float is that they could overshoot as foreign capital floods in, eroding competitiveness and leaving economies vulnerable to a future reversal in capital flows. Another concern is whether it is wise to allow exchange rates to rise sharply when emerging-market exports are being hurt by an American recession. There are no easy solutions. One alternative to a free float is a one-off appreciation. The danger is that this could encourage the expectation of further appreciation, attract even bigger capital inflows and so exacerbate inflation. To work, the revaluation would need to be so big that speculators no longer expected a further rise. But a big increase might not be politically feasible. Another solution is to tighten fiscal policy. This would cool domestic demand without the need for a big rise in interest rates. The snag is that it would boost domestic saving and hence lead to larger current-account surpluses—the opposite of what America requires. The third option, and the one most likely to be pursued, is to do nothing apart from slapping on some temporary price controls, and hope that inflation pressures will soon ease. The risk is that if inflation continues to rise, policymakers will eventually have to slam on the monetary brakes. IF GILBERT AND SULLIVAN were looking for the very model of a modern intellectual, they would surely pick Jeffrey Sachs. He is so “right on” that when Time magazine featured him in its global list of people who influence the world, his profile was written by Bono, a rock singer. His job titles—director of the Earth Institute and special adviser to the United Nations Secretary-General on the Millennium Development Goals—seem almost tailor-made to get up the noses of conservatives. Nor is Mr Sachs lacking in ambition. His previous book was called “The End of Poverty”. Now he has moved on to tackle a wide range of other challenges facing the planet, from climate change through to disease eradication. His goals include stabilisation of the world's population, a move to sustainable energy use and “a new approach to global problem solving”. If the above makes Mr Sachs sound like an impractical dreamer, that would be rather unfair. This densely written book is packed with statistics and carefully worded arguments. Nor is the author a left-wing ideologue. He recognises that the private sector and market-based solutions have a vital role to play. He cites, for example, the success achieved by public-private sector initiatives in tackling acid rain and chlorofluorocarbon emissions. On population control, he makes the good (if counter-intuitive) point that improvements in infant mortality are an important part of the solution. When families know that more of their children will survive into adulthood, they have fewer kids. Reduced fertility in turn leads to improved living standards and, eventually, by cutting the numbers of idle and impoverished young men, reduces the potential for conflict and terrorism. As he remarks, this makes the Bush administration's negative attitude towards family planning even more difficult to understand. Courageously, Mr Sachs does not ignore costs. He reckons the bill for tackling the issues he raises will come to a total of 2.4% of rich-world economic output (about one year's growth). That seems a reasonable price to pay, provided of course that you are not paying it. Indeed, the book's rather jaunty tone plays down some of the hard choices that will need to be made if the world's problems are to be tackled. On climate change, Mr Sachs is very enthusiastic about carbon capture and sequestration, a technology that is unproven on a large scale and will be difficult to adapt to existing power plants. One must also doubt whether all the world's cars could really be converted into gas-electric hybrids by 2026, as he suggests. This brings us to the main problem with the book: it is unremittingly worthy and expects other people to be so too. When the author writes that a post-Kyoto agreement on climate change “should include all actors, not just the rich ones, and not just the rich ones who are willing to reduce emissions”, one wonders how many real people would vote for that. Similarly, he says blithely that “in order to combat poverty and inequality, it is also essential to combat racism and intolerance.” If everyone in the world were as reasonable as Mr Sachs, his solutions would be easy to implement. However, if everyone were that reasonable, there would not be so many problems in the first place.

OUR MACRO OBSESSION

Our central Bank has taken its eye off the essential Ball of growth and is fixated with fighting inflation...and returning impressive macro economic data Headline Inflation Headline consumer price inflation which rose steadily to 18.4 percent in June, eased back to 17.9 percent in September, showing three (3) consecutive months of decline in the third quarter of the year. Price developments within the quarter saw monthly growth rates especially for the non-food category slow down relative to trends observed for the same period in 2007. Food prices also decelerated during the quarter mainly on account of improved food supply situation during the quarter. As a result, the average price increases of food in the third quarter improved relative to trends a year ago. Non-food prices also turned in better than a year earlier. Cumulatively for the year as a whole, inflation, by the end of the third quarter had registered an increase of 5.1 percentage points, moving from 12.8 percent at the beginning of the year to 17.9 percent at the end of September 2008. The increase in the year so far has been driven by both food and non-food prices. Food inflation which stood at 10.5 percent at the end of December 2007 increased to 17.9 percent by the end of September 2008. Non-food prices, on the other hand, also increased from 14.4 percent at the end of December 2007 to 18.5 percent by the end of September 2008. Details of the annual inflation rates within the various sectors of the economy for the periods September 2007 and September 2008 are reported in Table 2. Inflation rate varied across sectors. Some key sectors experienced sharp increases were the food sub-group, alcoholic beverages and tobacco, clothing and footwear, housing, and utilities, imported household goods and equipment, transportation costs, and educational costs. Inflation has turned in better than expected during the third quarter of the year with prospects of continued easing. At the last policy meeting, the Central Bank raised its key policy rate by 1 percentage point in an effort to dampen inflationary pressures and expectations. The response to the rate rise has been elastic with economy wide rates moving by more than a percentage point. Credit conditions tightened and crude oil prices have since retreated significantly and crude oil is trading at around US$60 per barrel (in the early weeks of November). The significant drop has occurred in the midst of the financial turmoil in the world economy with concerns about the depth and duration of recession in the global economy. At the July 2008 MPC meeting, the expectation was that crude oil prices would continue to rise and stabilize at around US$150 per barrel for 2008. That assumption combined with initial conditions at the time, including spiralling food and energy prices and a relatively faster pace in the depreciation of the

A martyr for the cause

The Man who may say defined the art of Central Banking admits "he didnt understand the financial Markets"! People say the former Federal Reserve chair is just trying to save his own skin – I think he's trying to save ours First they came for the short-sellers, and I did not speak up because I wasn't a short-seller. Then they came for the bankers, and I did not speak up because I wasn't a banker. Then they came for Alan Greenspan, and he rolled over, said sorry and provided some much needed confidence in a crisis-laden market. Yesterday, Greenspan told the House oversight committee that he took some of the responsibility for the current turmoil by admitting his prior lack of elucidation on the subject of regulation. Today, the press has mostly been deciding not only whether he was right or wrong but whether he actually admitted he was right or wrong. The thing with the economy is that because it involves money, it is seen as a science – a thing to be right or wrong about. Yet the variables in the economy – indicators such as consumer confidence or unemployment – are just extrapolations of theories that give a general idea of the state of the economy, not a definitive answer to its problems. Obviously much of the press attention has been devoted to the dichotomy of blaming Greenspan for the current turmoil, having previously worshipped him as the god of all things shiny and bling. Yet very little has been devoted to why he has made this confession – why a retired official, two years out of office, would return to take some of the current deadweight on his shoulders. It is interesting to look at Greenspan's reputation. He is almost universally seen as the man who led the way through the stock market crash of 1987 and the dot.com boom/bust crisis of 2000. However, according to the New York Times, he says he refuses to accept blame for the crisis. Is it not strange for a man so universally revered for the biggest period of growth in capitalism's history to suddenly step up and take responsibility? At 82 years old, with an almost religious following, would you take responsibility for an international financial crisis the likes of which we haven't seen for 80 years? I hope so. At this stage in the meltdown, people like Greenspan know better than anyone else the options available to US, European and UK banks and treasuries. The options are limited. They can ban short-sellers, but to what end? It quickly became clear that the short-selling ban was merely an attempt to prove that something was being done. So what else is there to do? The injection of billions of dollars into banks might allow some further liquidity to allow business to continue but it does little to allay panic. Greenspan has martyred himself for the cause. He has presented himself to congress as a part of the problem. By suggesting he has made mistakes he is allowing for the recognition that his absence from the Federal Reserve might precipitate some positive changes to the economic system. Greenspan's most important role at the Federal Reserve was to inspire confidence through bad times: a job that he continues, unpaid, today. Many people say he's just trying to save his own skin; I think he's trying to save ours. Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004