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One Step Ahead: The Fed Vows to Increase Rates


This week Janet Yellen was giving testimonies in front of the Congress during her official semi-annual meeting. Amid all else, Ms. Yellen opened the doors for possible forthcoming monetary tightening, the first one of its kind for the past 6 years. She cautiously announced a possible rise in rates “possibly in June, or even later this year”. Important fact, considering that since the beginning of the financial crisis, the Fed has been committed to keeping rates as low as possible, hoping to bootstrap the economy. Now, things seem to have changed.


The American economy finally seems to be getting healthy. Sound GDP growth figures, rallying financial markets, and climbing wages bring hopes that the fenix seems to finally rising from the ashen. And despite the fact that neither inflation, nor growth figures have reached their expected values, the Fed brings its tightening policy plans to the table. The reason is that with monetary policy it is equally important not only to track the events that already took place, but also foresee what might take place. If everything goes according to the Fed’s scenario, then such a preemptive growth of rates could yield its results when the economy really gets running. A gradual increase of rates would, ideally, not only allow to mitigate possible inflation, but also be less shocking for the economy, without causing an abrupt change later on (when the economy is recovering, at one point or another contracting economic policy is needed, otherwise inflation might be inevitable). In such a way the Feds pledges to take one step ahead of inflation, to be two steps in front in the end.

What next?

Some say that the Fed had been irrational unveiling its plans so long before they could actually be implemented. With wage growth well below expectations, and the economy overall well below full employment, it is hardly surprising that the markets in the USA did not seem to be too bothered. Most likely the reason for such indifference is the fact that the rise is, at least for now, too distant and illusory. That said, the echo of this tentative decisions can be heard already now in some other markets that are seriously dependent on the dollar (tumbling currency of Indonesia in the face of a stronger dollar).


To wrap everything up, it is difficult to predict what effect such decision will have on the US economy, or the world’s economy as a whole, since it is still too far out. However, it is already clear that with a stronger dollar and weaker euro, the pressure on the American economy as a huge consumer market will be growing, and the world’s mega-exporters such as China and Germany will not miss their opportunity to use that. Will the US manage to pull the stagnating Europe out of the turmoil? Well, as one very familiar to us person says: wait and see.

Why are Greeks still important?

Interesting times we live in. That said, when an economist says ‘interesting’, it, of course, means that something somewhere is going wrong. Well, it is. While Greek freshly elected government is desperately trying to negotiate an extension of the bailout program with Germans, the rest of the 18 countries of the Eurozone confront the consequences in a form of deflation, and hopeless attempts to abate it via monetary-expansion measures.

The outlook does not seem to be too optimistic, and some experts even forecast a possible Grexit (if Greece leaves the Eurozone), or the country’s default. With the debt-to-GDP ratio of over 175 per cent, it is not hard to see the reason for such disquiet. Even though that scary scenario is still highly unlikely, the question is: what should other European countries do in order to save the day for Greece and the Eurozone?

First of all, a common mistake would be to think that if Greeks owe money, the rest of the countries should simply make them pay, oblivious of the fate of Greece. Let us go back in history for a moment. After World War II the Allied Countries made Germany pay enormous reparations, which set an already war-exhausted economy into an even deeper economic plunge. Although the situation here is different, because Greeks have to pay their debt, not reparations, the outcomes might be very similar: a more profound recession, or even economic collapse of Greece. The choice is then very simple: force Greeks to pay back the debt today, and they will not pay it back at all, because their recessed economy will be crashed completely.

That said, the EUR 300 billion worth of debt is only part of the problem. And while EUR 300 billion is a lot, it is not the biggest aftermath of the possible Greek collapse. If things go badly and Greece quits the Eurozone, it might engender a whole chain of events. Greece might be the first sailor to leave the boat, but more may follow. This would inevitably lead to further devaluation of the euro, due to high risks associated with a potential collapse of the Eurozone as a whole. However, this worst-case scenario still seems to be very improbable, so let us take a look at some of the more plausible consequences.

Mercifully, the largest economic shake-up of the modern times has passed, and the people in charge of the world’s economies are trying to restart the entire mechanism. This, however, is a tall order, and the authorities will have to use every trick in their magic box to cope with it. As we all know thanks to Morten, there are two mainstream ways of dealing with crises: using monetary and fiscal instruments. The latter one means acting on advice of Lord J. M. Keynes and executing the so-called fiscal expansion, reducing taxes and increasing government spending. This would mean running budget deficits in the short run that would be offset by budget surplus in the long term. Also, and it is critical,the effectiveness of such a measure would be less dependent on the people’s expectations (an increase in disposable income will always trigger consumption to grow, the same applies to an increase in government spending). The importance of the statement in italics will become obvious when we analyze the other measure of crises-battling.

The monetary measures imply trying to achieve monetary expansion, hence stimulating investments due to lower interest rates (‘cheaper’ money). Apparently, this is what the ECB is now trying to pull off with their profound, EUR 1 trillion quantitative easing program. This, however, does not seem to be working, because investment is probably the hardest component to stimulate. The hallmark of private investments as a component of GDP is the fact that they are very much dependent on economic agents’ expectations about the future. And in the current geopolitical and economic situations, those expectations are far from needed. This explains why, despite zero interest rates in most countries, investment spendings are still stuck. Worse still, this means that the QE may most probably be of no value, if the future outlook does not change.

The last and the most important question is simple: what to do? The obvious answer could be to abandon the QE and use fiscal tools instead. However, such changes would be too extreme and too audacious for the world that still very well remembers the pain of the last crisis. Various political reasons, personal beliefs and uncertainty about the future, even among global leaders, put constraints on fiscal policy as a measure of boosting the economy.

The only way out then is trying to act like John Roosevelt in the 1930’s, when his duty was to reignite the American economy after the largest crisis of all times. Being rather skeptical about fiscal expansion, he also did not give it too many chances. Instead, he did something that the world’s authorities should be trying to do now: persuade people that tomorrow will be better than today. As simple as it sounds, that one thing could set the Europe’s economy on the right track.

And you know what? For that, we might want to keep Greeks on board.

Looking For Some Oil? Get Deflation for Free

It does not take to be a financial or economic expert to know that the Eurozone is gradually but confidently sliding into deflation. According to Eurostat, in December 2014 inflation has crossed the “red mark” of 0 percent, obtaining a negative value for the first time in quite a while. Why?
The prime reason for this is the falling oil price. With prices of oil that have shrunk by more than half, compared to 2013, production now has become a lot cheaper. This, consequently, pulls the final prices of products down as well. A point that becomes even more obvious, when the value of the so-called “core” inflation is considered (the level of prices excluding prices of food, energy, alcohol and tobacco). Whilst the overall level of inflation is around -0.2%, the level of the core inflation is still above zero, even though only marginally: 0.8% (Eurostat).

In the US the story is pretty much the same. Being seriously dependent on the imports of oil, and to a lesser extent on the prices of goods from Europe, the economists from the Fed should really get their heads round the problem. With the oil imports accounting for 7.8 per cent of all the imports, such a severe plummet in prices could not leave the levels of inflation unchanged.

The question is: why deflation is bad at all? At first glance lower prices, given the same income, mean increased purchasing power, which is certainly not a bad thing at all. The only amendment here: if deflation does persist. However, when inflation is below zero for a considerable period of time, the constantly falling prices push people towards consuming less today, because tomorrow prices will be even lower still. This sets consumption down, which in turn damps GDP, and it goes all over again, until the equilibrium is reached at a lower level of output (sounds familiar, right?).

Also, deflation affects lenders and borrowers. If you borrow 100 EUR today, and have to return it in a year, the person who lent it to you will certainly be happy about some level of deflation (because then, 100 EUR in a year would be worth more than they do now). Clearly, though, you would not share the happiness of that person all that much. If you take it to a broader scale, debtors might end up in a serious trouble (yes-yes, Greeks probably do not like deflation very much, but it has to be said that inflation would not solve their problems, either)

At this point, every SSE Riga student can infer that if the prices are too low, why not inject more money in the economy? Apparently, chaps at the ECB must have thought of the same thing. They are now planning to inject 60 bln EUR every month from March 2015 to September 2016 by buying Eurobonds. They do that, but at the same time they still remain very cautious about it. Firstly, it might result in an unfair distribution of money in the society. Secondly, it reveals the biggest issue of low inflation: the liquidity trap.

As we all know thanks to Morten, the liquidity trap is a situation in the economy, when the government tries to increase the monetary supply, pinning hopes that it will decrease the interest rates and boost investments, but due to the fact that the interest rates are low already, the target is not actually met.
Here we need to introduce the notion of the real interest rates. The real interest rates are the nominal rates less inflation (this relationship is often referred to as the Fisher equation, after a famous American economist Irving Fisher). They show the real interest that people can expect on their saving, excluding the impact of inflation. When inflation is low (or indeed negative), the banking system cannot push the real rates low enough to stimulate investments, because the nominal rates cannot go below 0 (otherwise people would have to pay for saving, which is of course ridiculous).

With all this in mind, it seems that trying to battle deflation with monetary policy measures is not something that is capable of turning the Eurozone to its former prosperity. For a moment it looks like the fiscal policy measures could cope with the job better (anti-austerity measures, etc.)

After all, when most of the European countries have managed to cope with the economic pique of 2008-2009 maybe it is time to go further? This would mean increasing government spending, reducing taxes and trying to defibrillate the suffocating economy in the good old ways.

Why nobody does that? There are many possible explanations. To put it short, the reason most likely stems from political and geopolitical situation. Because when the world is on the brink of maintaining social stability, fighting wars, suffering from terrorists, and battling social inequality, nobody is willing to take their chances.

Will Quantitative Easing Save Europe?

On Thursday, the European Central Bank has published Account of Monetary Policy Meeting. The largest topic that now is being discussed is Quantitative Easing (QE). It assumes purchases of European bonds, mostly governmental. The mechanism works by the indirect influence on the overall interest rate level through lowering the yield of government bonds.


Base money M0 in Euro area (millions of Euro)

We all can understand how quantitative easing works, recollecting our lectures in macroeconomics.The Central Bank buys bonds from banks and increases demand on them, which leads to appreciation in price. The increase in bonds’ price means lowering the interest rate, and this effect should transpose to the whole economy. The difficulty is that the demand for bonds is already very high, because banks see too high risks to invest in the private sector, so for the central bank it is too unprofitable to buy bonds with an almost negative interest rate.


Money suppy-demand equilibrium increases

As we know, the monetary base M0 increases when central banks issue more money to shift the LM curve to the right in the ISLM model. Increasing M in money demand−supply equilibrium condition
L = M/P increases money demand, and the LM curve shifts. Ideally, we assume a movement along the IS curve, which represents all equilibriums in the goods market, to the lower interest rate, which relates to a higher GDP level. Therefore, we can expect the third significant increase in M0, which is represented by the red graph.

As ECB Quantitative Easing package shows, they are planning to buy government bonds for €60 bn a month during the whole program. This significantly exceeded market expectations despite some insiders noted that this amount would be €50bn monthly “because purchasing more assets sooner would “accelerate the impact” of QE.” Moreover, this program will go in addition to previously introduced methods of fighting small amount of new credits and the growing threat of a deflationary downward spiral.
The previous instrument ECB used for lowering borrowing interest rates was TLTRO, Targeted Long−Term Refinancing operations. It was a program of cheap long−term loans at the interest rate of just 0.15% to the largest commercial banks. These loans could be issues to businesses and households for 4 years or even more, if these are successful project, but cannot be given to purchase the real estate to avoid another realty bubble as in 2007. This program has been partly successful. The Governing Council of the European Central Bank notes that “The targeted longer-term refinancing operations (TLTROs) had contributed to a further decline in bank lending rates across the euro area, thereby easing borrowing conditions for firms and households.” However, everyone agrees that the expectations of banks’ desire for more liquidity have been overestimated: “The total estimated take-up over all eight TLTRO operations was significantly lower than envisaged in September 2014.” The first transfer in September 2014 resulted in taking loans of €82.6 bn, and in December €129 bn were allocated. Despite that, the total amount of €212 bn is very far below the initial 400 billions that were expected to be taken by banks in 2014. Many experts agree that the modest cheap loans’ appetite is the main reason of the dramatic change in ECB policy, which include QE of such a scale – ECB has not reached the expectations of lowering interest rates in public sector, and has now decided to operate independently from commercial banks, using the mechanism described previously. This situation cannot be called positive for the economy, because it was expected that the full amount of TLTRO will increase GDP of western European countries approximately by 0.3%.
At the moment the real GDP of 2014 is still being counted, although estimation can already be called as very accurate. ECB is almost sure that the European economy has expanded by 0.8% in 2014, and makes forecasts for the upcoming years. It builds it policy assuming the real GDP growth at 1.0% in 2015 and 1.5% in 2016, which was announced in Account of Monetary Policy Meeting. We should remember that these estimations already include the massive QE and assumption that the appeared difference in interest rates won’t remain solely in MFI (monetary and financial institutions) – the banking sector which we know from macroeconomics lectures as the second column of banking hierarchy, but will transfer its impact to “the society”, which is represented by the third column. If it happens, we are supposed to see the inflation rate above 1.5% in 2016, which is what ECB expects to be the healthiest for European economy by meaning “close to 2%, but not higher”. Frankly, now even the best economists can say how the quantitative easing will be successful in Europe. The forecasts of the public and private sectors are almost equal today, but both of them assume the highest uncertainty for previous years, so today the best decision is to act prudently based on forecasts, in other words – wait and see!