Are central bankers beginning to see sense?

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Since the onset of the financial crisis central bank policies of near-zero interest rates and dollops of quantitative easing have penalised savers and favoured those in debt. It is galling to many of us that central bankers cannot see how misguided and harmful their policies are proving to their economies as a whole. Despite a complete lack of evidence that low interest rates and monetary stimulus are having any positive effect, they persist, as if somehow they will miraculously succeed next time.

Recently, however, a few dissenting voices have emerged among the central banking community. In the United States, Dallas Federal Reserve Bank president Richard Fisher is one. “I firmly believe that the Federal Reserve has already pressed the limits of monetary policy… U.S. banks and businesses are awash in liquidity. Adding more is not the answer to our problems.”

James Bullard, president of the Federal Reserve Bank of St. Louis, is another. “We’ve constantly felt that there would be light at the end of the tunnel and there’d be an opportunity to normalise but it’s not really happening so far.”

Without low interest rates, savers would be saving the American economy

In an intriguing research report William F. Ford, once the president of the Federal Reserve Bank of Atlanta, has pointed out that cutting the income of savers has had a profound adverse effect on the economy. “The prolonged and abnormally low interest-rate structure… has made life particularly difficult for retirees and others who depend on conservative interest-sensitive investments. But the negative effects do not stop there. They spill over into the overall performance of the economy… By lowering interest rates to historically unprecedented levels, the Fed’s policy deprives savers of interest income they normally would have earned on the interest-sensitive assets they hold. Thus, there is an income channel that no one is talking about, and its negative impact can be powerful.”

“Low interest rates are costing the US economy an annual $371 billion in spending, 3.5 million jobs, and 2.53% of GDP.”

His team have calculated that, even on conservative estimates, low interest rates are costing the US economy an annual $371 billion in spending, 3.5 million jobs, and 2.53% of GDP. As he points out, “This is a sizable effect, given that during this time GDP grew by only 2.33 percent and the economy added only 870,000 jobs. With the additional jobs that might have been created by higher interest income levels, the unemployment rate could fall to 6.8 percent. And output could grow more than twice as fast as it has. The resulting GDP growth rate of 4.86 percent would then be closer to the average second-year growth rate of the past nine recoveries, and the U.S. economy would be well on its way to a vigorous recovery, rather than struggling as it is now.”

Canadian economist William White is one of the few who anticipated the financial crisis, warning about it back in 2003. He has just published a paper entitled “Ultra Easy Money Policy and the Law of Unintended Consquences”. Although he believes central bank actions have bought time, he does not think they will create strong, sustainable growth. Pointing out that the fall in interest income hurts savers more than lower rates help borrowers, he is concerned that central bankers are now worsening our economic problems, not helping. Their actions will “create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets… encourage governments to refrain from confronting sovereign debt problems in a timely way, and redistribute income and wealth in a highly regressive fashion.”

Low interest rates do not discourage saving

White does not feel that monetary stimulus is as effective in stimulating demand as is commonly believed and explains why, contrary to the Bank of England’s view, record low interest rates do not necessarily discourage saving or persuade people to spend more and businesses to invest more heavily. “To the extent that such measures are unprecedented, indeed smacking of desperation, they could actually depress confidence and the will to spend.” He understands the plight of many savers, too: “Suppose that savers have a predetermined goal for the minimum amount of savings they wish to accumulate over time. This would correspond to someone wishing to purchase an annuity of a certain size upon retirement, at a desired age. Evidently, a lower interest rate always implies a slower rate of accumulation. But, if in fact the accumulation rate becomes so low that it threatens the minimum accumulation goal, the only recourse (other than postponing retirement) will be to save more in the first place.”

Perhaps the most surprising comments – given their source – have come from Spencer Dale, the Bank of England’s chief economist and a member of the MPC. His recent speech “The Limits of Monetary Policy” was hardly a complete volte face. He still believes that we are in a “period of deficient demand” and that monetary policy should therefore encourage us to “borrow more and save less”. But there is much within it that does make surprisingly good sense.

“Economists and central bankers don’t understand how the economy functions”

He displays a degree of humility utterly lacking in his “Nothing to do with me, guv” boss Sir Mervyn King. “Surely one lesson we have learnt from the financial crisis – perhaps the most important lesson – is that economists and policymakers know far less about the economy and its behaviour than many might have liked to believe”. Dale points out that “we don’t fully understand the structure of the economy or the behaviour of households and companies within it. Not even close.” In that case, he wonders, “Is there a danger that we might do more harm than good?”

“If the handbrake on your car is stuck, putting your foot further and further down on the accelerator won’t get you very far before the car starts to overheat.”

If economists don’t understand the economy, you might expect him to conclude that the central bank should interfere less but he does not quite go that far. He recognises, however, that more QE might do harm, particularly if the diagnosis of what is wrong with the economy is incorrect, as he feels it might be. “In this case, further demand stimulus may run up against supply capacity relatively quickly and so largely result in higher inflation. If the handbrake on your car is stuck, putting your foot further and further down on the accelerator won’t get you very far before the car starts to overheat… The Pavlovian-like response of some commentators to call for more monetary stimulus each time they observe weak growth is not sensible.”

He recognises that inflation and the erosion of household incomes could be having a recessionary effect while low rates and QE might be persuading investors and institutions to seek out riskier ways of getting a yield on their money. “The prolonged period of low interest rates and enhanced support may delay some of the rebalancing and restructuring that our economy needs to undertake. Underlying balance sheet problems can be masked, tempering the incentives to address them. Inefficient firms may remain in business for longer and so slow the reallocation of capital and labour to more productive uses. Low interest rates and the associated forbearance might even explain part of the puzzling weakness in productivity.”

“The Bank of England must focus on its inflation target”

Dale is not blind to the dangers of ignoring inflationary pressures. “In the UK, we saw firsthand in the high and variable inflation rates of the 1970s and 80s, the cost of monetary policy taking its eye off the ball.”

He appreciates that unwinding QE, which has seen the Bank buy 40% of conventional gilts, could be tricky and risks unsettling the government bond market and crowding out fundraising for the private sector.

Dale concludes: “There are limits to how much we should ask of monetary policy. We need to remember how little we know about the economy and how it works. Beware confident economists… We need to consider the potential costs as well as benefits of further policy easing. We are in unchartered – and potentially dangerous – waters. Above all, we need to remain firmly focussed on hitting our inflation target.”

Hallelujah.

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5 Comments

1. Frances

   September 25, 2012 at 3:58 pm

   Regretably i cannot see Merve the Swerve and his bunch on the MPC seeing the “light” anytime soon

   Its blindingly obvious to even a 12 yr old kid that denying Savers of 40% of their income by forcing down Interest rates is a hiding to nowhere .
   In just the last 3 years without touching the capitol sum and ensuring i get the highest possible rate of interest my income has been slashed by a total of £12 K

   Multiply that by the millions of Pensioners like me who never had the opportunity to put money in a private pension but instead scrimped and scraped and went without trying to save for some comfort in retirement and you have a huge huge problem and a major reason why theres absolutely no growth in the econimy we dare not do more than buy mere essentials

   But despite pointing this fact out on several occasions to the clowns at the B of E they have persisted in being puppetts of GOs crazy edicts .
   While my children were growing up i had no money and neither do many of todays families

   The only people who have benefited from all this are those with huge mortgages and those who run up debts plus of course all the RICH who can afford the insider advice to own the only stocks and shares /assetts that have increased in value because it sure as hell is not my portfolio of shares nor my house and certainly not my half state pension and nor is it 99% of pension funds

   The only Pension Fund thats increased is the Bank Of Englands

   Theres a Surprise !!!!!!!!!!!!!!!!!!!!!!!!!

   I also know the one person who applied for the recent vacancy on the MPC was rejected because they dare to have different and very realistic views on how to get us out of the mess Mervyn and his bunch have got us into

   I am well aware Gordon Brown and the EU crisis caused the problem in the first place but NOTHING the B of E has done has made a blind bit of difference and instead wrecked millions of lives permanantly because nothing will restore my lost £12K or that of other savers

   meanwhile Merve and his bunch sit pretty on incomes of over £250K a year and Pension pots in the millions

   Recommend (11)
2. Democorruptcy

   September 27, 2012 at 3:03 pm

   No central bankers are NOT beginning to see sense. They are trying desperately to blow up another asset bubble, hoping people are stupid enough to repeat what they have done before and borrow too much money.

   Low interest rates push money into assets which pulls money from the economy. Article here about BTL landlords costing the economy £8bn in disposable income via rents way above inflation.

   http://blogs.lse.ac.uk/politicsandpolicy/2012/09/26/are-high-rents-holding-back-the-recovery/

   It would be far better for the economy to remove tax advantages given to BTL landlords (e.g. mortgage relief) and instead use that money to remove income tax on savings (as Cameron promised “if elected” in 2009 http://www.guardian.co.uk/politics/2009/jan/05/davidcameron-conservatives)

   Recommend (7)
3. John H

   October 2, 2012 at 2:06 pm

   How many others here remember that “promise” to remove income tax from savings? Unsurprisingly, that came to nothing.

   And be careful, talk of abolishing National Insurance and switching this to income tax could well increase the amount of tax on savings as no doubt the government would relish the opportunity to further milk savers.

   One slightly more optimistic note though. An article I read suggested that once the US Presidential Elections are out of the way the Federal Reserve is likely to start increasing its base rate and this in turn could force the BoE to act. Though this would be in the face of Merv the Swerve and his misguided and failed policy of near-zero base rates.

   Is the disastrous era of abnormal base rates drawing to a close? We’ll have to wait and hope.

   Recommend (4)
4. frances

   October 2, 2012 at 5:35 pm

   Not only did David Cameron
   Nick Clegg
   George Osborne

   ALL Make speeches PROMISING to relieve savers of tax on interest they said it was unfair that savers paid tax on interest

   Yet George Osborne in deliberate collusion with Merve the Swerve has RIPPED off all the prudent and the pensioners of millions in interest

   Merve then has the brass necked cheek to claim that QE has not affected savers or pensioners because assett prices have risen
   B of E report on Distributional Effects of QE is the biggest fabrication going and they refuse to provide a single piece of proof for what they say

   Majority of pensioners relying on savings interest do not have assetts and also likely lost what shares they did have in the confiscation of NR and B and B by Gordon Brown

   If you phone the B of E their staff fully admit they know that low interest rates are robbing pensioners and are merely a stop gap proceedure from which we can never recover

   The plain fact is there not one single Politician of any colour in this country who gives a damm about anyone but themselves and the rich they are feather bedding at our expense

   Yet it seems we have Billions to spend in overseas aid which lands in the hands of the likes of Mugabe and our NHS is happy to spend more millions treating health tourists and illegals while those who have paid in all their lives are denied treatment

   Recommend (5)
5. John.

   October 7, 2012 at 10:04 am

   The unfathomable derivatives market monstrosity is the next bail out the banks and their bonus for failure crooks are working on securing public money for.

   http://moneymorning.com/2012/09/17/banks-are-setting-us-up-again-this-time-the-fall-could-be-2-6-trillion-or-more/

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