Transmission Error

22/06/2012 at 3:20 pm 1 comment

It has been quite a week for followers of central banks. On Wednesday we learned that there had been a nail-biting stand-off at the Bank of England that saw plans for more quantitative easing seen off this month by only five votes to four. A day later, the Americans added to the excitement with the Federal Reserve deciding to boost “Operation Twist” by (a strangely precise-sounding) $267bn. And earlier in the month, of course, we saw good old-fashioned interest rate cuts in Australia and China – and the strongest expectations of an ECB cut since eurozone rates last fell in December.

In some cases this can begin to look like panic. The US has enjoyed near-zero interest rates since the end of 2008; the UK since early 2009. Only in present times could a policy rate of 1% in Europe start to look a bit on the high side. If rate cuts aren’t working, and more innovative monetary mechanisms are disappointing too, then – what can be done? Are we all doomed after all?

Indeed, the evidence that policy is not working has been mounting of late in the eyes of some. Growth in the US labour market seems to have stalled again. The UK has re-entered recession. China’s engines have slowed, some developed and emerging economies are fearful of commodity weakness and of course there is Europe, forever threatening catastrophe and weighing on everybody’s confidence.

All this gives credence to one of the strongest bear arguments of all: that monetary policy is broken. Central banks are powerless to encourage recovery, and all the action this month is just so much “pushing on a string”.

And yet there are plenty of people who complain that low interest rates are having a real economic effect. Cash savers in the US, for example, have long expressed dissatisfaction with Fed policy, and private pensioners and annuitants have similarly suffered from low long term rates here in the UK. Now: from governments to businesses to mortgages to student debt to credit cards, the volume of borrowing in these economies is orders of magnitude bigger than the volume of saving. According to the textbook, therefore, while savers suffer, this should be outweighed by the benefit to borrowers. So where’s the recovery? What’s going wrong?

The answer, to some extent, is that there is trouble with the transmission mechanisms of monetary policy – the systems through which central bank activity feeds through to the economy. Most obviously this means the banking system. While the Bank of England was very successful in lowering mortgage rates, for example, a number of headwinds meant that lending banks were significantly less keen – or less able – to advance mortgages in the first place. The credit crunch demolished the marketplace for mortgage debt; it placed a huge strain on balance sheets; the government increased taxes on banks and bank staff; and regulation has reinforced the near-abolition of self-certified, low deposit and interest-only loans.

In Europe there is a similar tale, with governments desperate to see bank lending improve on the one hand while imposing ever higher capital requirements on the industry on the other (and that not exactly in the nick of time). In the US, the existence of Operation Twist itself reflects the disconnect between short term central bank lending rates and the long term yields to which the country’s fixed-rate mortgage market is mostly connected.

Nonetheless, the monetary machinery is not completely stuck – not at all. American mortgage rates did take some time to come down: the average mortgage, which cost a little over 6% in 2008, had fallen only to 5% a year after the Fed cut to zero, and it wasn’t until this year that they reached their 3.9% low. Still, no matter how long it has taken, that lower rate has meant the prospect of more money in the pockets of US homeowners, and it has helped the battered real estate market continue its slow-paced recovery too.

Similarly, while new mortgage approvals remain at low levels this side of the Atlantic, the cost of existing loans plummeted when the Bank cut rates all those years ago. Again, that’s extra money in homeowners’ pockets.

Rather than pushing on a string, then, central bankers are making a net positive contribution to growth which faces headwinds from elsewhere: in some places inflation, in others unemployment, in others the necessity of reducing the national debt, and almost everywhere the sheer nervousness abounding in the wake of the most severe economic crisis for at least a generation.

The obstacles are not trivial, but neither is the cost of money. It may not be time to jettison the textbook just yet.


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1 Comment

  • 1. A Thousand Cuts « The Blog @ Vigilant Financial  |  06/07/2012 at 4:18 pm

    […] have already looked at the argument that central bankers are “pushing on a string”, and noted that this is one of the more genuinely concerning bear points. But there is more to […]

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