Monetary Policy – Page 99 – Digital Finance Analytics (DFA) Blog

How does monetary policy affect the distribution of income and wealth?

The BankUndergound posted an interesting analysis of the impact of on households of their loose monetary policy. Here is an extract, follow the link for the entire paper.

Although existing differences in income and wealth means that the impact in cash terms varied substantially between households, in a recent staff working paper we find that monetary policy had very little impact on relative measures of inequality. Compared to what would have otherwise happened, younger households are estimated to have benefited most from higher income in cash terms, while older households gained more from higher wealth.

Households tend to report that looser monetary policy has made them worse offIn contrast to our findings, the balance of households in the 2017H1 NMG Survey – a biannual survey of households commissioned by the Bank of England – felt that they had been made worse off by lower interest rates since 2008. Those negative responses were concentrated among older households (Chart 7). When asked about the channels through which they had been affected, most focused on the effects on their interest payments and receipts – where older households have tended to lose out – rather than on their wealth.

Conclusion

There has been growing interest in the effects of monetary policy on the distribution of income and wealth. We find that the gains from monetary easing were distributed roughly in line with initial income and wealth holdings. Because the percentage changes in income and wealth were similar across all distributions there was no large impact on inequality. If anything, those at the bottom end of the wealth distribution gained slightly more in percentage terms. Furthermore, most households are estimated to have been made better off than they otherwise would have been if policy had been left unchanged.

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

NZ Reserve Bank to consider employment alongside price stability mandate

The New Zealand Government’s New Policy Targets Agreement requires monetary policy to be conducted so that it contributes to supporting maximum levels of sustainable employment within the economy.

The new focus on employment outcomes is an outcome of Phase 1 of the Review of the Reserve Bank Act 1989, which the Coalition Government announced in November 2017.

“The Reserve Bank Act is nearly 30 years old. While the single focus on price stability has generally served New Zealand well, there have been significant changes to the New Zealand economy and to monetary policy practices since it was enacted,” Grant Robertson said.

“The importance of monetary policy as a tool to support the real, productive, economy has been evolving and will be recognised in New Zealand law by adding employment outcomes alongside price stability as a dual mandate for the Reserve Bank, as seen in countries like the United States, Australia and Norway.

“Work on legislation to codify a dual mandate is underway. In the meantime, the new PTA will ensure the conduct of monetary policy in maintaining price stability will also contribute to employment outcomes.”

A Bill will be introduced to Parliament in the coming months to implement Cabinet’s decisions on recommendations from Phase 1 of the Review. As well as legislating for the dual mandate, this will include the creation of a committee for monetary policy decisions.

“Currently, the Governor of the Reserve Bank has sole authority for monetary policy decisions under the Act. While clear institutional accountability was important for establishing the credibility of the inflation-targeting system when the Act was introduced, there has been greater recognition in recent decades of the benefits of committee decision-making structures,” Grant Robertson said.

“In practice, the Reserve Bank’s decision-making practices for monetary policy have adapted to reflect this, with an internal Governing Committee collectively making decisions on monetary policy. However, the Act has not been updated accordingly.”

The Government has agreed a range of five to seven voting members for a Monetary Policy Committee (MPC) for decision-making. The majority of members will be Reserve Bank internal staff, and a minority will be external members. The Reserve Bank Governor will be the chair.

“It is my intention that the first committee of seven members would have four internal, and three external members. Treasury will also have a non-voting observer on the MPC to provide information on fiscal policy,” Grant Robertson said.

The MPC is expected to begin operation in 2019 following passage of amending legislation. There will be a full Select Committee process for the legislation.

Reserve Bank Governor-Designate, Adrian Orr, said that the PTA recognises the importance of monetary policy to the wellbeing of all New Zealanders.

“The PTA appropriately retains the Reserve Bank’s focus on a price stability objective. The Bank’s annual consumer price inflation target remains at 1 to 3 percent, with the ongoing focus on the mid-point of 2 percent.

“Price stability offers enduring benefits for New Zealanders’ living standards, especially for those on low and fixed incomes. It guards against the erosion of the value of our money and savings, and the misallocation of investment.”

Mr Orr said that the PTA also recognises the role of monetary policy in contributing to supporting maximum sustainable employment, as will be captured formally in an amendment Bill in coming months.

“This PTA provides a bridge in that direction under the constraints of the current Act. The Reserve Bank’s flexible inflation targeting regime has long included employment and output variability in its deliberations on interest rate decisions. What this PTA does is make it an explicit expectation that the Bank accounts for that consideration transparently. Maximum sustainable employment is determined by a wide range of economic factors beyond monetary policy.”

Mr Orr said that he welcomes the intention to use a monetary policy committee decision-making group, including both Bank staff and a minority of external members.

“Legislating for this committee will give a strong basis for the Bank’s use of a committee decision-making process. Widening the committee to include external members also brings the benefit of diversity and challenge in our thinking, while enhancing the transparency of decision-making and flow of information.”

Phase 2 of the Review is being scoped. It will focus on the Reserve Bank’s financial stability role and broader governance reform. Announcements on the final scope will be made by mid-2018 and subsequent policy work will commence in the second half of 2018.

Unconventional Monetary Policies And Persistently Low Interest Rates

A working paper from the BIS – “Effectiveness of unconventional monetary policies in a low interest rate environment” examines the connection between low interest rates and unconventional monetary policy, and their findings suggest the “neutral” rate is likely to rise much faster than many are currently expecting, with significant potential economic impact. Indeed, Central Banks are “behind the curve” and that the assumed lower “neutral interest rate may in fact be wrong.

A reliance on balance sheet tools can, for example, result in resource misallocations, disruptive risk-taking behaviour and political economy challenges. These costs, among others, would have to be weighed against the benefits when considering the appropriate role for central bank balance sheets in the new normal era as well as in future crisis periods.

They suggest that unconventional monetary policies (UMPs) became less effective in the post-GFC period, but not for the reasons typically given. The explanation is nuanced and emerges from careful assessment of the various links in the monetary transmission mechanism.

Post the GFC, major central banks in advanced economies cut policy rates sharply and, then when the room for manoeuvre closed, resorting to a range of unconventional monetary policies (UMPs) that exploited the financial firepower of central bank balance sheets. The lacklustre recovery that followed has naturally raised questions about the effectiveness of these new tools. This paper uses extensive modelling to investigate the links, and the results are troubling. Not least, they find evidence supporting the hypothesis that the economy did not become less interest-sensitive in the aftermath of the GFC, once changes in the “natural” rate of interest are taken into account. They conclude that UMPs had a declining impact on economies over time. Looking forward, the results suggest that the normalisation of balance sheet policies could be accompanied by an increase in the conventionally estimated “natural” rate, which if not taken into account would increase the risk that central banks will find themselves falling behind the curve.

They conclude:

We find that unconventional monetary policies were effective in providing some stimulus to economies at the perceived lower bound for policy rates. The responsiveness of the economy to private sector interest rates remained remarkably stable in our sample. However, it must also be noted that the overall effectiveness fell for two key reasons. First, the “bang for the buck” of central bank balance sheet stimulus declined over time. Larger and larger programmes were necessary to achieve a given change in sovereign yields. Second, the “natural” rate tended to decline with (unexpected) expansionary unconventional monetary policies. This suggests that monetary policy decisions have influenced the perceived “natural” rate, contrary to what is implied by the conventional wisdom. This correlation may also help to explain why monetary policy appears to have had been less stimulative than expected in the past decade, and may indicate that monetary policy could prove to be more stimulative than expected during the normalisation with no change in the conventional wisdom.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Why Are Interest Rates So Low? – Blame Central Banks

Current statements from central bankers around the world argue that current low real interest rates reflect a change in the “neutral” rate, and is linked to demographic shifts, investment patterns and globalisation. In other words, monetary policy is NOT to blame – they are simply reacting.

However, an interesting (and complex) working paper Why so low for so long? A long-term view of real interest rates? from the Bank for International Settlement raises serious questions about the assumption which Central Banks are working with. In fact, their analysis suggests that monetary policy is the cause of the low rates, not a reaction to them and this has long range impact. This turns current thinking on its head. Central Bankers policy have driven rates lower!

Global real (inflation-adjusted) interest rates, short and long, have been on a downward trend throughout much of the past 30 years and have remained exceptionally low since the Great Financial Crisis (GFC). This has triggered a debate about the reasons for the decline. Invariably, the presumption is that the evolution of real interest rates reflects changes in underlying saving-investment determinants. These are seen to govern variations in some notional “equilibrium” or natural real rate, defined as the real interest rate that would prevail when actual output equals potential output, towards which market rates gravitate.

Prevailing explanations of the decline in real interest rates since the early 1980s are premised on the notion that real interest rates are driven by variations in desired saving and investment.

But based on data stretching back to 1870 for 19 countries, our systematic analysis casts doubt on this view. The link between real interest rates and saving-investment determinants appears tenuous. While it is possible to find some relationships consistent with the theory in some periods, particularly over the last 30 years, they do not survive over the extended sample. This holds both at the national and global level. By contrast, we find evidence that persistent shifts in real interest rates coincide with changes in monetary regimes. Moreover, external influences on countries’ real interest rates appear to reflect idiosyncratic variations in interest rates of countries that dominate global monetary and financial conditions rather than common movements in global saving and investment. All this points to an underrated role of monetary policy in determining real interest rates over long horizons.

Overall, our results raise questions about the prevailing paradigm of real interest rate determination. The saving-investment framework may not serve as a reliable guide for understanding real interest rate developments. And inflation may not be a sufficiently reliable signal of where real interest rates are relative to some unobserved natural level. Monetary policy, and financial factors more generally, may have an important bearing on persistent movements in real interest rates.

Can Gradual Interest-Rate Tightening Prevent a Bust?

From The Mises Institute.

The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity

Fed policy makers are of the view that if there is the need to tighten the interest rate stance the tightening should be gradual as to not destabilize the economy.

The gradual approach gives individuals plenty of time to adjust to the tighter monetary stance. This adjustment in turn will neutralize the possible harmful effect that such a tighter stance may have on the economy.

But is it possible by means of a gradual monetary policy to undo the damage inflicted to the economy by previous loose monetary policies? According to mainstream economic thinking, it would appear that this is the case.

In his various writings, the champion of the monetarist school of thinking, Milton Friedman, has argued that there is a variable lag between changes in money supply and its effect on real output and prices. Friedman holds that in the short run changes in money supply will be followed by changes in real output. In the long run, according to Friedman, changes in money will only have an effect on prices.

It follows then that changes in money with respect to real economic activity tend to be neutral in the long run and non-neutral in the short run. Thus according to Friedman,

In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.1

According to Friedman, the effect of the change in money supply shows up first in output and hardly at all in prices. It is only after a longer time lag that changes in money start to have an effect on prices. This is the reason, according to Friedman, why in the short run money can grow the economy, while in the long run it has no effect on the real output.

According to Friedman, the main reason for the non-neutrality of money in the short run is the variability in the time lag between money and the economy. Consequently, he believes that if the central bank were to follow a constant money rate of growth rule this would eliminate fluctuations caused by variable changes in the money supply rate of growth. The constant money growth rule could also make money neutral in the short run and the only effect that money would have is on general prices.

Thus according to Friedman,

On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favoured for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.2

In his Nobel lecture, Robert Lucas raised an issue with this. According to Lucas,

If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?3

Consequently, Lucas has suggested that the reason why money does generate a real effect in the short run is not so much due to the variability of monetary time lags but more bound up with whether money changes were anticipated or not. If monetary growth anticipated, then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production.

Moreover, according to Lucas,

Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.4

Both Friedman and Lucas are of the view, although for slightly different reasons, that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth.

The current practice of Fed policy makers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy could lead to stable economic growth. This framework also accepts that a gradual change in monetary policy in the spirit of Friedman’s constant money growth rule could reinforce the transparency.

If unexpected monetary policies can cause real economic growth, what is wrong with this? Why not constantly surprise people and cause more real wealth?

Money, Expectations and Economic Growth

What is required for economic growth is a growing pool of real savings, which funds various individuals that are engaged in the build-up of capital goods. An increase in money, however, has nothing to do, as such, with this. On the contrary this increase only leads to consumption that is not supported by production of real wealth. Consequently, this leads to a weakening in the real pool of savings, which in turn undermines real economic growth. All that printing money can achieve is a redirection of real savings from wealth generating activities towards non-productive wealth consuming activities. So obviously, there cannot be any economic growth because of this redirection.

Now if unanticipated monetary growth undermines real economic growth via the dilution of the pool of real savings why is it then that one observes that rising money is associated with a rise in economic indicators like real GDP?

We suggest that all that we observe in reality is an increase in monetary spending — this is what GDP depicts. The more money that is printed, the higher GDP will be. So-called real GDP is merely nominal GDP deflated by a meaningless price index. Hence, so-called observed economic growth is just the reflection of monetary expansion and has nothing to do with real economic growth. Incidentally, real economic growth cannot be measured as such — it is not possible to establish a meaningful total by adding potatoes and tomatoes.

While unanticipated monetary growth cannot grow the economy, it definitely produces a real effect by undermining the pool of real savings and thereby weakening the real economy.

Likewise anticipated money growth cannot be harmless to the real economy. Even if the money rate of growth is fully anticipated there is always someone who gets it first. Consequently, also anticipated money growth rate will set in motion an exchange of nothing for something.

For instance, consider the individual who fully expects the future course of monetary policy. This individual now decides to borrow $1000 from a bank. The bank obliges and lends him the $1000, which the bank has created out of “thin air”. Now, since this money is unbacked by any previous production of real wealth it will set in motion an exchange of nothing for something, or a redirection of real savings from wealth generators towards the borrower of the newly created $1000. This redirection and hence real negative effect on the pool of savings cannot be prevented by an individuals’ correct expectation of monetary policies.

Even if the money is pumped in such a way that everybody gets it instantaneously, changes in the demand for money will vary. After all, every individual is different from other individuals. There will always be somebody who will spend the newly received money before somebody else. This of course will lead to the redirection of real wealth to the first spender from the last spender.

We can thus conclude that regardless of expectations, loose monetary policy will always undermine the foundations of the real economy while tight monetary policy will work to arrest this process. Hence monetary policy can never be neutral.

Can a Gradual Tightening Prevent an Economic Bust?

Since monetary growth, whether expected or unexpected, gives rise to the redirection of real savings it means that any monetary tightening slows down this redirection. Various economic activities, which sprang-up on the back of strong monetary pumping, because of a tighter monetary stance get now less real funding. This in turn means that these activities are given less support and run the risk of being liquidated. It is the liquidation of these activities what an economic bust is all about.

Obviously, then, the tighter monetary stance by the Fed must put pressure on various false activities, or various artificial forms of life. Hence, the tighter the Fed gets the slower the pace of redirection of real savings will be, which in turn means that more liquidation of various false activities will take place. In the words of Ludwig von Mises,

The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.5

Consequently, the view that the Fed can lift interest rates without any disruption doesn’t hold water. Obviously if the pool of real savings is still expanding then this may mitigate the severity of the bust. However, given the reckless monetary policies of the US central bank it is quite likely that the US economy may already has a stagnant or perhaps a declining pool of real savings. This in turn runs the risk of the US economy falling into a severe economic slump.

We can thus conclude that the popular view that gradual transparent monetary policies will allow the Fed to tighten its stance without any disruptions is based on erroneous ideas. There is no such thing as a “shock-free” monetary policy any more than a monetary expansion can ever be truly neutral to the market.

Regardless of policy transparency once a tighter monetary stance is introduced, it sets in motion an economic bust. The severity of the bust is conditioned by the length and magnitude of the previous loose monetary stance and the state of the pool of real savings.

1. Milton Friedman The Counter-Revolution in Monetary Theory. Occasional Paper 33, Institute of Economic Affairs for the Wincott Foundation. London: Tonbridge, 1970.

2. Milton Friedman The Counter-Revolution in Monetary Theory

3. Robert E. Lucas, Jr Nobel Lecture:Monetary Neutrality, Journal of Political Economy, 1996, vol. 104,no. 4

4. Ibid.

5. Ludwig von Mises, The “Austrian” Theory of the Trade Cycle. The Ludwig von Mises Institute 1983.

Does past inflation predict the future?

Interesting Analytical Note from the Reserve Bank New Zealand. They have recently changed their modelling of inflation, preferring to use past data rather than a two year prediction because despite low unemployment, inflation has remained lower than would be expected on the old method. This suggests monetary policy needs to be more stimulatory than expected .

Forecasts of non-tradables inflation have been produced using Phillips curves, where capacity pressure and inflation expectations have been the key drivers. The Bank had previously used the survey of 2-year ahead inflation expectations in its Phillips curve. However, from 2014 non-tradables inflation was weaker than the survey and estimates of capacity pressure suggested. Bank research indicated the weakness in non-tradables inflation may have been linked to low past inflation and its impact on pricing behaviour.

This note evaluates whether measures of past inflation could have been used to produce forecasts of inflation that would have been more accurate than using surveys of inflation expectations. It does this by comparing forecasts for annual non-tradables inflation one year ahead. Forecasts are produced using Phillips curves that incorporate measures of past inflation or surveys of inflation expectations, and other information available at the time of each Monetary Policy Statement (MPS). This empirical test aims to determine the approach that captures pricing behaviour best, highlighting which may be best for forecasting going forward.

The results show that forecasts constructed using measures of past inflation have been more accurate than using survey measures of inflation expectations, including the 2-year ahead survey measure previously used by the Bank. In addition, forecasts constructed using measures of past inflation would have been significantly more accurate than the Bank’s MPS forecasts since 2009, and only slightly worse than these forecasts before the global financial crisis (GFC). The consistency of forecasts using past-inflation measures reduces the concern that this approach is only accurate when inflation is low, and suggests it may be a reasonable approach to forecasting non-tradables inflation generally.

From late 2015, the Bank has assumed that past inflation has affected domestic price-setting behaviour more than previously. As a result, monetary policy has needed to be more stimulatory than would otherwise be the case. This price-setting behaviour is assumed to persist, and is consistent with subdued non-tradables inflation and low nominal wage inflation in 2017.

Figure 6 shows the average 1-year ahead forecast of non-tradables inflation for the measures of past inflation and surveys of inflation expectations. The range of forecasts produced by the models is currently large relative to history, perhaps reflecting differences between the surveys of inflation expectations and measures of past inflation. The two most accurate measures (shown by the red lines) suggest non-tradables inflation will be between 2.5 and 3 percent in 2018 – similar to the forecast in the August 2017 MPS and only a little higher than the latest outturn of 2.4 percent in the June quarter 2017.

Conclusion

Non-tradable inflation has been surprisingly weak since 2014. Phillips curves with the survey of 2-year ahead inflation expectations suggest non-tradables inflation should have risen by more than we have seen, given the level of the unemployment rate and the Bank’s estimates of the output gap. This note shows that using measures of past CPI inflation instead of surveyed inflation expectations would have produced more accurate forecasts of non-tradables inflation, although not all of the weakness in non-tradables inflation would have been predicted.

The Bank has adjusted its forecasting models to better capture the role of past inflation, moving away from using the survey of 2-year ahead inflation expectations to underpin its forecasts

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

Will Wages Rise Any Time Soon?

On of the drivers of mortgage stress, which continues to rise, is flat and falling income growth. This phenomenon is hitting other economies too, such as the UK.

So, today’s speech from RBA Governor Philip Lowe is timely – The Labour Market and Monetary Policy. This speech covers trends in employment and wages in Australia, and the impact of these on monetary policy decisions. It describes developments in the labour market in Australia, including the growth of employment in the services sector, and in part-time jobs. The speech then explores the reasons behind subdued wages growth in Australia and other advanced economies, and the challenge this poses for monetary policy. It restates the Bank’s approach to making monetary policy decisions within the framework of a medium-term inflation target, in way that supports sustainable economic growth and serves the public interest.

He makes the point that if some of the long standing links between income growth and monetary policy are not working as they did, more monetary stimulus may encourage investors to borrow to buy assets, which poses a medium-term risk to financial stability.

In comments after the speech, he also made the point that surging asset prices has led to a growth in inequality across Australia.

Whilst unemployment looks reasonable,

… under utilisation is a real issue.

The persistent slow growth in wages is creating a challenge for central banks. It is contributing to an extended period of inflation below target. In years gone by, the more standard challenge was to keep wage growth in check, so as to stop upward pressure on inflation, which could lead to restrictive monetary policy. No advanced economy faces this challenge at present.

It is possible that things could change in the not too distant future, particularly in those countries at, or near, full employment. It may be that the lags are just a bit longer than usual. If so, we could hit a point at which workers, having had only modest pay increases for a run of years, decide that it is time for a catch-up. If such a tipping point were reached, inflation pressures could emerge quite quickly. In this scenario we could see a period of turbulence in financial markets, given that markets are pricing in little risk of future inflation.

This scenario can’t be completely discounted. It would seem, though, to have a fairly low probability in Australia, especially in light of the continuing spare capacity in our labour market. The more likely case here is that wage growth picks up gradually as the demand for labour strengthens.

Globally, an alternative scenario is that the period of slow wage growth turns out to be much more persistent, partly for the reasons that I discussed earlier. In this scenario, wages growth eventually picks up, but it takes quite a while longer. If so, inflation stays low for longer, although there are other factors that could push inflation higher.

This scenario is one in which the Phillips Curve is flatter than it once was. It is one in which inflation is harder to generate. We can’t yet tell though whether the Phillips Curve in Australia has become flatter, given that we have experienced relatively little variation in the unemployment rate over recent times.

The combination of a flatter Phillips Curve and inflation below target raises a challenge for central banks: how hard to press to get inflation up?

For a central bank with a single objective of inflation, the answer is relatively straightforward. Inflation is too low, so you do what you can to get inflation up. If inflation doesn’t increase, you need more monetary stimulus.

This approach does carry risks, though. A flatter Phillips Curve means that the monetary stimulus has relatively little effect on inflation, at least for a while. At the same time, however, the monetary stimulus is likely to push asset prices higher and encourage more borrowing. Faced with low inflation, low unemployment and low interest rates, investors are likely to find it attractive to borrow money to buy assets. This poses a medium-term risk to financial stability.

Is monetary policy less effective when interest rates are persistently low?

Interesting BIS working paper which says that at low interest rates, monetary policy transmission becomes less effective.

Interest rates in the core advanced economies have been persistently low for about eight years now. Short-term nominal rates have on average remained near zero since early 2009 and have been even negative in the euro area and Japan, respectively, since 2014 and 2016. The drop in short-term nominal rates has gone along with a fall in real (inflation-adjusted) rates to persistently negative levels. Long-term rates have also trended down, albeit more gradually, over this period: in nominal terms, they fell from between 3–4% in 2009 to below 1% in 2016.

From a historical perspective, this persistently low level of short- and long-term nominal rates is unprecedented. Since 1870, nominal interest rates in the core advanced economies have never been so low for so long, not even in the wake of the Great Depression of the 1930s (Graph 2, top panels). Elsewhere, too, including in Australia, short- and long-term interest rates have fallen to new troughs, reflecting in part global interest rate spillovers especially at the long end.

The persistently low rates of the recent past have reflected central banks’ unprecedented monetary easing to cushion the fallout of the Great Financial Crisis (GFC), spur economic recovery and push inflation back up towards objectives. However, despite such efforts, the recovery has been lacklustre. In the core economies, for instance, output has not returned to its pre-recession path, evolving along a lower, if anything flatter, trajectory, as growth has disappointed. At the same time, in many countries inflation has remained persistently below target over the past three years or so.

Against this background, there have been questions about the effectiveness of monetary policy in boosting the economy in a low interest rate environment. This paper assesses this issue by taking stock of the existing literature. Specifically, the focus is on whether the positive effect of lower interest rates on aggregate demand diminishes when policy rates are in the proximity of what used to be called the zero lower bound. Moreover, to keep the paper’s scope manageable, we take as given the first link in the transmission mechanism: from the central bank’s instruments, including the policy rate, to other rates.

The review suggests that both conceptually and empirically there is support for the notion that monetary transmission is less effective when interest rates are persistently low. Reduced effectiveness can arise for two main reasons: (i) headwinds that typically blow in the wake of balance sheet recessions, when interest rates are low (eg debt overhang, an impaired banking system, high uncertainty, resource misallocation); and (ii) inherent nonlinearities linked to the level of interest rates (eg impact of low rates on banks’ profits and credit supply, on consumption and saving behaviour – including through possible adverse confidence effects – and on resource misallocation). Our review of the existing empirical literature suggests that the headwinds experienced during the recovery from balance-sheet recessions can significantly reduce monetary policy effectiveness. There is also evidence that lower rates have a diminishing impact on consumption and the supply of credit. Importantly, these results point to an independent role for nominal rates, regardless of the level of real (inflation-adjusted) rates.

The review reveals that the relevant theoretical and empirical literature is much scanter than one would have hoped for, in particular given that periods of persistently low interest rates have become more frequent and longer-lasting. While there are appealing conceptual arguments suggesting that monetary transmission may be impaired when rates are low, many of these have not been formalised by means of rigorous theoretical modelling. And the extant empirical work is limited, both geographically and in scope. For instance, most studies assessing changes in monetary transmission in low rate environments focus on the United States. Similarly, there is hardly any work assessing specific mechanisms. The field is wide open and deserves further exploration, not least given the first-order policy implications.

Fed Minutes From March Meeting – Financial Market Impact

The minutes of the US Federal Open Market Committee March 14–15, 2017 have been released. They provide context for the rate decision. All but
one member agreed to raise the target range for the federal funds rate to ¾ to 1 percent. We also got some impressions on how the FED will manage the billions of dollars in assets it purchased in an attempt to reflate the economy after the financial crisis. This is a big deal, with global consequences for financial markets. Not least, think about how expected future rate rises may interact with reducing asset purchases. Bond prices may be impacted. The US T10 was down a little.

In the U.S. economic projection prepared by the staff for the March FOMC meeting, the near-term forecast for real GDP growth was a little weaker, on net, than in the previous projection. Real GDP was expected to expand at a slower rate in the first quarter than in the fourth quarter, reflecting some data for January that were judged to be transitorily weak, but growth was projected to move back up in the second quarter.

Recent information on housing activity suggested that residential investment increased at a solid pace early in the year. Starts for both new single-family homes and multifamily units strengthened in the fourth quarter and remained near those levels in January. Issuance of building permits for new single-family homes—which tends to be a reliable indicator of the underlying trend in construction—also moved up in the fourth quarter and remained near that level in January. Sales of existing homes rose in January, while new home sales maintained their fourth-quarter pace.

The open market reinvestment operations, are currently supporting the financial markets in the US, and are having global impact on interest rate and bond benchmarks. When the time comes to implement a change to reinvestment policy, participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS.

The staff provided several briefings that summarized issues related to potential changes to the Committee’s policy of reinvesting principal payments from securities held in the System Open Market Account (SOMA). These briefings discussed the macroeconomic implications of alternative strategies the Committee could employ with respect to reinvestments, including making the timing of an end to reinvestments either date dependent or dependent on economic conditions.

The briefings also considered the advantages and disadvantages of phasing out reinvestments or ending them all at once as well as whether using the same approach would be appropriate for both Treasury securities and agency mortgage-backed securities (MBS). In their discussion, policymakers reaffirmed the approach to balance sheet normalization articulated in the Committee’s Policy Normalization Principles and Plans announced in September 2014. In particular, participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings. Most participants expressed the view that changes in the target range for the federal funds rate should be the primary means for adjusting the stance of monetary policy when the federal funds rate was above its effective lower bound. A number of participants indicated that the Committee should resume asset purchases only if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound. Moreover, it was noted that the Committee’s policy of maintaining reinvestments until normalization of the level of the federal funds rate was well under way had supported the smooth and effective conduct of monetary policy and had helped maintain accommodative financial conditions.

To Solve One Problem, Did The RBA Rate Cut Last Year Just Make Another One Worse?

From Business Insider.

When it’s all said and done, May 3, 2016, may well go down as the day when an attempt to solve a problem ended up creating an even greater one in Australia.

Six days after the release of Australia’s March quarter consumer price inflation (CPI) report — something that revealed headline CPI fell with underlying inflation also tumbling to fresh lows — the Reserve Bank of Australia (RBA) resumed a rate cutting cycle that began in late 2011, lowering the cash rate to a then record low of just 1.75%.

That reduction was followed three months later by another cut taking the cash rate to 1.5%, the level it remains at today.

Though there were other considerations, both were largely done in the name of helping to boost inflation — both near-term and in the future.

While the RBA’s response was not all that unusual — it is, after all, an inflation-targeting central bank — the twin rate cuts appear, in hindsight, may have actually created an even larger problem for the RBA.

Those cuts, along with other factors such as the Turnbull government’s reelection ending in political uncertainty over the tax treatment of housing, put a rocket under property prices in Sydney and Melbourne, already the most expensive in the country.

While there’s debate over just how much they’ve increased given varying readings from individual market providers, in simple terms the answer is a lot, in particular driven by resurgent investor activity in these markets.

It’s created a conundrum for the RBA perhaps even greater than just one year ago.

Bill Evans, chief economist at Westpac, summed up the problem perfectly earlier today.

“Even though income growth and inflation are too low and there remains ample spare capacity in the labour market the (RBA) has no flexibility to cut rates,” said Evans.

“The evidence is clear that the rate cuts the Bank embraced last year in the face of low inflation fuelled house prices and household leverage. The Bank is concerned about possible excesses in the housing market.”

Now, like then, inflation remains stubbornly low and unemployment (and especially underemployment) high, creating conditions that are leading to record-low wage growth which are then feeding back into a lack of inflationary pressures.

It’s easy to understand why some believe that the only inflation the RBA succeeded in creating was in housing prices in just two Australian cities, rather than delivering appropriate policy settings for the remainder of the country.

To be fair to the new RBA governor Philip Lowe, a man who took over that title the month after the RBA last cut rates, he’s well aware of the problem, telling parliamentarians last month that he’d like to see unemployment a bit lower and inflation a bit higher.

His reluctance to use monetary policy to speed up this trend, however, was that further rate cuts “would probably push up house prices a bit more, because most of the borrowing would be borrowing for housing.”

He’s hamstrung, in other words, as Evans suggested earlier today.

Other parts of the economy would no doubt benefit from lower borrowing costs, and potentially a lower Australian dollar, but that can’t be delivered by the RBA because of financial stability risks in Australia’s largest, most expensive and economically most important housing markets.

Though no one knows whether the RBA’s conundrum will self-correct, allowing the bank increased policy flexibility to benefit the broader Australian economy, the question that needs to be asked is whether we should wait to find out the answer.

That answer is undoubtedly no.

What is required is a coordinated response to reduce risks in the Australian housing market that will free up monetary policy to do its one and only job — to bring forward or pull back demand within the economy when necessary.

That task will fall to Australia’s banking regulator, APRA, in consultation with the RBA, along with state and federal politicians.

There’s noises being made that suggest this is already occurring, but the longer house prices in Sydney and Melbourne are allowed to run away unfettered, the greater the likelihood that the RBA will be unable to make a difference for the broader economy if and when its required.

That’s a scenario that no one wants to see tested in reality.