WHOLESALE BANKING & MARKETS

MONETARY AND FISCAL POLICY

David Page Senior Economist

INTRODUCTION • The monetary transmission mechanism –

In ‘usual’ times interest rate changes influence total demand via a number of channels

–

The financial crisis has damaged this transmission mechanism

• What is Quantitative Easing and how does it work –

Quantitative easing is about creating money, but this should not be synonymous with hyperinflation

–

The creation of money is central to a healthy and upbeat economy

–

‘Portfolio adjustment’ engaged as most important channel of QE

• Fiscal Stimulus vs Fiscal Squeeze – an open debate –

The arguments for fiscal stimulus go back to the last great downturn – the Great Depression

–

Financial markets are the prime advocates of fiscal squeeze

–

IMF analysis questions the validity of austerity for growth, learning the consequences ..

THE MONETARY TRANSMISSION MECHANISM

• The monetary transmission mechanism –

Bank rate policy and the impact on market rates

–

Changes in markets rates, asset prices, exchange rates and sentiment are key drivers of demand

• The breakdown of the monetary transmission mechanism and the financial crisis –

The financial crisis has changed the relationship between policy and market rates, through disrupted inter bank lending and the higher costs of unsecured lending

The monetary transmission mechanism- policy rate to market rates

• The Bank of England sets the policy rate, Bank Rate, the rate at which the central bank remunerates commercial banks reserves at the central bank.

• Prior to the financial crisis, commercial banks earned Bank Rate on reserves if they kept within a range of their estimated monthly averages. • Otherwise commercial banks need to enter operations with the BoE (at detrimental rates) or transact with others in money markets. The Bank supplies money (open market operations) to ensure that the average banking sector reserve demand is fulfilled. Market arbitrage ensured market rates remained anchored around Bank Rate from one policy decision to the next.

• Beyond one month, market rates are determined by expectations of future policy rates and increasingly a price for market liquidity, term and credit risk. These shape interest rates for one month to fifty years.

The monetary transmission mechanism- the primary channels

Changes in market rates affect behaviour in the wider economy. Consider a Bank Rate cut. Under normal circumstances this will be associated with a lowering of market rates

• People have more money to spend, lower market rates reduce floating mortgage rates and over time influence new fixed rate deals. Corporates with floating rate debt also benefit. Both pay less interest on their borrowings and have more to spend in other areas. • Intertemporal allocation, people are incentivised to spend more now and save less. The rate of interest is the key return on deferred consumption (saving) it is the opportunity cost of spending today. A reduction in that cost will see more spending today, but with less saving, this reduces the outlook for future spending and has implications for investment over time. • Credit creation and money supply. In normal circumstances money supply is assumed to meet demand. A fall in interest rates encourages borrowing, reducing the cost of borrowing relative to investment project yields. Market interest rates regulate the demand for money, which in turn regulates the supply.

The monetary transmission mechanism- secondary channels Changes in official rates have other impacts

• Asset prices, lower rates reduce discount rates and should see asset prices rise (albeit that lower interest rates also carry information about expectations). Increases in asset prices increase wealth, which in turn can influence spending decisions. • Sentiment, the ‘stimulus’ provided by a central bank can bolster sentiment exogenously, resulting in a positive impact over and above that suggested by underlying fundamentals. This relationship can be subject to any manner of exogenous changes. • Exchange rate, the interaction of market rates and exchange rates means that lower interest rates tend to see exchange rates fall. This should both increase volume demand for exports, while at the same time increasing the price of imports, leading to some substitution and some imported inflation.

The monetary transmission mechanism- the full impact ANNUAL GLOBAL GROWTH RATE

Source: Bank of England

The monetary transmission mechanism- the current breakdown (i) The marginal cost of funding for UK commercial banks

%

5yr CDS premia (maj UK lenders) 8

LIBOR spread Marginal Funding Rate Bank Rate

6

4

2

0 Jan-02

Source: BoE, Bloomberg, LB WBM

Apr-03

Jul-04

Oct-05

Jan-07

The monetary transmission mechanism- the current breakdown (ii) The marginal cost of funding for UK commercial banks – interbank lending difficulties after Lehmans

%

5yr CDS premia (maj UK lenders) 8

LIBOR spread Marginal Funding Rate Bank Rate

6

4

2

0 Jan-02

Source: BoE, Bloomberg, LB WBM

Apr-03

Jul-04

Oct-05

Jan-07

Apr-08

The monetary transmission mechanism- the current breakdown (iii) The marginal cost of funding for UK commercial banks – rising cost of unsecured lending %

5yr CDS premia (maj UK lenders) 8

LIBOR spread Marginal Funding Rate Bank Rate

6

4

2

0 Jan-02

Apr-03

Source: BoE, Bloomberg, LB WBM

Jul-04

Oct-05

Jan-07

Apr-08

Jul-09

Oct-10

Jan-12

The monetary transmission mechanism- the current breakdown The stimulative effects of the current historic low policy rate are being curtailed by the following factors.

• Disruption of transmission of current official rates to market rates, affected by the rising cost of unsecured lending, preventing historically low rates of official interest reaching the wider economy via mortgage rates or corporate borrowing rates.

• Sentiment, ongoing concerns about the UK outlook has seen a worsening in sentiment

• Exchange rate, safe-haven flows – linked with wholesale diversification of large international reserves moving away from US dollar and euro holdings) and more specific euro-flight flows have left sterling higher than would have otehrwise been the case.

WHAT IS QUANTITATIVE EASING AND HOW DOES IT WORK? • Some popular misconceptions about quantitative easing – the printing press, the Weimar Republic and hyperinflation

• Healthy economies create money all the time

• How QE can influence the economy – the transmission mechanism of QE

• The portfolio rebalancing theory

• Does it work? - the estimated impact

QUANTITATIVE EASING IS THE PROCESS OF CREATING MONEY IN A DIGITAL AGE MONEY CREATION CREDITS COMMERCIAL BANKS’ RESERVE HOLDINGS AT THE CENTRAL BANK, BUT IT IS ANALOGOUS TO PRINTING NOTES

Source: LB WBM

CREATING MONEY HAS NEGATIVE CONNOTATIONS IN EUROPE IMAGES OF GERMANY DURING THE WEIMAR REPUBLIC’S HYPERINFLATION

Source: LB WBM

MONEY CREATION IS PART OF NORMAL AND HEALTHY ECONOMIC GROWTH UK M4 MONEY SUPPLY AND NOMINAL GDP GROWTH % yoy 25 GDP M4 money supply 20

15

10

5

0

-5 Q2 1983

Q1 1987

Source: NATIONAL STATITSICS, BANK OF ENGLAND

Q4 1990

Q3 1994

Q2 1998

Q1 2002

Q4 2005

HOW QE WORKS – THE MONETARY TRANSMISSION OF QE

Source: BANK OF ENGLAND

The monetary transmission mechanism- the full impact ANNUAL GLOBAL GROWTH RATE

Source: Bank of England

HOW QE WORKS – THE MONETARY TRANSMISSION OF QE

Source: BANK OF ENGLAND

HOW QE WORKS – THE MONETARY TRANSMISSION OF QE The Bank of England now argues that the primary channel of QE is the ‘portfolio rebalancing’ effect • Portfolio rebalancing occurs where the Bank of England increases the cash holdings of real money investors (pension funds, life assurance companies) by buying government bonds. These pension funds and others thus find themselves holding too much cash and adjust their portfolios accordingly buying other assets (other government bonds, corporate bonds, equities). This increases the price of these other assets (lowering the yield). This both reduces the funding costs of companies and households and should result in positive wealth effects, both of which should have positive impacts on spending. Other channels

• Sentiment, central bank action in itself can be hoped to have some positive impact on the economy • Exchange rate, announcements of QE have been associated with a softening of the currency, although carrying out QE has often resulted in subsequent currency appreciation • Bank lending, some gilt sales will come directly from commercial banks, but more importantly, pension fund will have bank accounts, which will be boosted by asset sales increasing banks’ money holdings. In turn, this could lead to increases in lending activity. However, separate constraints and deleveraging is separately restraining some lending activity and has led the BoE to expect this to have only a modest impact.

QUANTITATIVE EASING – DOES IT WORK ? BROAD MONEY SUPPLY MEASURES – MONEY GETTING TO THE RIGHT PLACES ?

% yoy 12 M4 M4 - ex iOFC C&H deposits

9

6

3

0

-3

-6 Sep-09

Source: Bank of England, LB WBM

Mar-10

Sep-10

Mar-11

Sep-11

Mar-12

QUANTITATIVE EASING – DOES IT WORK ? NOMINAL GDP LIFTED – WHAT IS THE COUNTERFACTUAL ? % 9

£bn 350

Total QE purchases (RHS) Nominal GDP (%, yoy, LHS)

250

6

150 3 50 0 -50 -3

-6 Feb-06 Source: Bank of England, National Statistics

-150

-250 May-07

Aug-08

Nov-09

Feb-11

ESTIMATING THE IMPACT OF QE The Bank of England has undertaken a variety of studies to try and establish QE impact versus variety of counterfactual cases. It estimates that

• Each £1bn of QE -> 0.62bps reduction in medium to long-term yields. £200bn reduced gilt yields by over 100bps

• The first £200bn of QE resulted in –

70bp contraction in investment grade corporate bond spreads and 150bp fall in sub-investment grade.

–

1½ - 2½% increase in level of GDP

–

¾ - 2½% increase in level of prices

–

Equivalent to 1.5 – 3% reduction in Bank Rate

• BoE has just completed asset purchases to tune of £325bn, meaning monetary policy could be seen as currently equivalent to a Bank Rate of -2% to -4.25%.

FISCAL STIMULUS VS FISCAL SQUEEZE? • Some popular misconceptions about fiscal stimulus – the thrifty household vs macroeconomic implications

• Macro economic effects and automatic stabilisers

• Classical economics, the Depression and Keynesian Stimulus

• The growth of government and insufficient saving in the good times

• Can fiscal austerity deliver economic growth? Unwinding imbalances and the fiscal multiplier

• UK’s flexible deficit reduction plan

• International comparisons

THE UK ECONOMY IS NOT A THRIFTY HOUSEHOLD BALANCING THE GOVERNMENT BALANCES MORE COMPLICATED THAN HOUSEHOLD BALANCE SHEET

GOVERNMENT’S INVOLVEMENT IN UK ECONOMY GOVERNMENT ACTIVITY AS % OF GDP

% GDP Receipts

50

Spending

45

40

35

30 1955

Source: National Statistics

1969

1983

1997

2011

DEFICIT REDUCTIONS HAVE MACROECONOMIC IMPLICATIONS GDP = C

+

consumption

I

+

G

investment

government spending

+

(X-M) net trade

Changes in government spending are integral part of domestic economic growth • Multiplier effects. Each additional pound of government spending has positive impact on GDP. However, each pound spent, for example on construction, puts an extra pound in the pocket of builders. These in turn spend this additional money, boosting retailers incomes. An additional pound spending can lift total GDP by more than one pound. This is known as the multiplier effect.

• Automatic stabilisers. Government spending and receipts are contra-cyclical : Receipts rise (fall) as the economy accelerates (slows). Elements of spending – notably social security payments – fall (rise) as the economy accelerates (slows). as the economy accelerates net government spending falls, slowing the economy; as the economy slows government spending increases offsetting the slowdown.

• Discretionary stimulus.Government spending specifically targeted to boost growth

KEYNESIAN STIMULUS • Classical economics saw periods of boom and bust in the economy as periods of disequilibria in product or labour markets, but believed the economy is self-regulating. An increase in savings results in a reduction in interest rates, which boosts investment demand. A fall in aggregate demand, which sees rising unemployment, should be offset by a fall in real wages.

• Keynes witnessing the Great Depression, argued that even if nominal wage rigidities and the lower bound of zero rates (or higher assuming a liquidity trap) was not an obstacle to automatic economic rebalancing, excessive saving and the associated accumulation of inventory could be and recessions could be self-reinforcing (multiple equilibria).

• Keynes advocated active fiscal policies – discretionary stimulus – to break this cycle, bolster overall economic activity and stimulate private investment.

KEYNESIAN STIMULUS AND THE END OF THE DEPRESSION? EXAMPLES OF KEYNESIAN STIMULUS IN THE 1930s

FISCAL STIMULUS QUESTION OF IMBALANCES GOVERNMENT DEFICIT REFLECTS SURPLUSES IN HOUSEHOLD, CORPORATE AND CAPITAL ACCOUNTS % GDP

9

Government Households

Business Overseas

6 3 0 -3 -6 -9 -12 Q1 1987

Source: National Statistics

Q1 1992

Q1 1997

Q1 2002

Q1 2007

Q1 2012

PROBLEM WHEN GOVERNMENT SPENDING IS PRO-CYCLICAL THE UK GOVERNMENT CONTINUED TO RUN A LARGE DEFICIT DESPITE ECONOMIC GROWTH % GDP

% yoy -4 PSNB (LHS)

12

GDP (RHS) -2

8 0 4 2 0 4 -4 1993

Source: National Statistics

1996

1999

2002

2005

2008

2011

PROBLEM WHEN GOVERNMENT SPENDING IS PRO-CYCLICAL DEVELOPED ECONOMY GOVERNMENT DEBT RISING BEFORE CRISIS

%GDP

% GDP

100

UK US 220

Germany France

80

Spain Japan (RHS)

190

60 160

40

130

20

100 2000

Source: IMF

2002

2004

2006

2008

2010

MEASURING THE IMPACT OF FISCAL STIMULUS – THE FISCAL MULTIPLIER • Governments need to provide stimulus, but few are in fiscal position to do so. Financial market nervousness constraining government spending.

“If there was reincarnation … I’d like to come back as the bond market. You can intimidate everybody.” – James Carville, Feb 1993

• IMF study of developed economies fiscal contractions since the 1980s. Measuring the size of economic relative to fiscal contraction.

• On aggregate IMF found a fiscal multiplier of 0.5. A 1% point fiscal tightening would see a 0.5% point reduction of GDP. Against this background gradual fiscal austerity can achieve lower deficits.

• However, if central bank policy rates at or close to zero and/or close trading nations also carrying out austerity, multiplier can rise to 2. More recent research suggests multipliers rise as with spare capacity. • Austerity will result in recession, which will not reduce deficits. This is the painful truth confronting much of the euro area.

UK’s FLEXIBLE DEFICIT REDUCTION PLAN CYCLICALLY-ADJUSTED DEFICIT TARGETS AVOID AUSTERITY INTO RECESSION

%GDP 0.0

-0.5

-1.0

-1.5

M ar-12 M ar-11

-2.0 2011-12

Source: HMT/OBR

2012-13

2013-14

2014-15

2015-16

2016-17

FISCAL POLICY DIFFERENCE – THE GRAND MACRO EXPERIMENT CHANGE IN CYCLICALLY ADJUSTED FISCAL BALANCE % 2

Tighter policy 1

0

-1

US Weighted euro area

-2 Looser policy -3 2007

Source: LB WBM, IMF

2008

2009

2010

2011

2012

2013

2014

FISCAL POLICY DIFFERENCE – VARIATION GREATER WITHIN EURO AREA CHANGE IN CYCLICALLY ADJUSTED FISCAL BALANCE % 8 Germany Spain

France Greece

Italy Ireland

6

4

Tighter policy

2

0

Looser policy -2 2010

Source: IMF, LB WBM

2011

2012

2013

2014

SUMMARY AND CONCLUSIONS • The financial crisis has changed the application of the key tools of macroeconomic policy – monetary and fiscal policy. • Traditional monetary policy works principally through its impact on market rates and subsequent impact on behaviour. The financial crisis and more specifically the Euro area crisis has caused a dislocation in market and policy rates. This helped drive the interest rate to its effective floor of 0.5% • Quantitative easing is a monetary policy tool used when short-term rates are at zero. Its principle aim is to inject cash into the real economy to influence asset prices and exchange rates. In turn these are hoped to influence behaviour. In truth there is little consensus surrounding the true impact of QE. • High levels of government borrowing and financial market nervousness have satisfied European finance ministries of need to seek to reduce their deficits.

• Knowledge gained in the 1930s and Keynesian economics – not to mention constant advice from the IMF – impresses the need for a more gentle approach, breaking the positive feedback – pro-cyclical nature – of retrenchment. The debate over the correct pace of fiscal retrenchment continues. • Over the last five years we have learnt that the economic policy makers tool kit has fundamentally changed. We think that it is highly likely that to successfully navigate through the current crisis (crises?) we will see more new tools employed.