A New Era of Monetary Policy

Over the last few years, monetary policy has changed dramatically. Newspapers are littered with terms such as interest rates, money supply and quantitative easing. If you are new to Economics, and interested by what all this means, this may be a good article for you.

This blog explains the basics behind monetary policy before exploring how it has evolved over recent years. I finish with evaluating “forward guidance”, a new monetary policy introduced by Mark Carney, the governor of the Bank of England (BoE).

What is an interest rate?

An interest rate is simply the cost of money (or the price of borrowing money), where ‘money’ is literally the banknotes in your wallet or the balance in your checking account. There are obviously many interest rates, however, when a central bank sets the interest rate, it is referring to the (risk-free) short-term rate on cash deposits, such as the overnight rate between banks.

The most basic economic concept is that in all markets, the price of a good is the equilibrium between supply and demand. An excess demand over supply will lead to a price rise until demand equals supply again and the opposite is true for an excess supply. The money market is no different. People and firms demand money for transactions and the central bank supplies it. Since the interest rate is the price of money, it sits where money demand is equal to money supply. If money supply outstrips money demand, the interest rate will fall until a new equilibrium is reached. Therefore when a central bank says they are reducing an interest rate, what they are really doing, behind the scenes, is increasing the supply of money. By injecting more money into the system, the price of money (i.e. the interest rate) falls.

Conventional Monetary Policy

Prior to the recession, conventional monetary policy involved the BoE simply setting the interest rate (the base rate) each month. If the bank wanted to reduce the rate (for example down to its current level of 0.5%), it would do so by increasing money supply. The BoE does this by buying safe, short-term assets, usually government bonds, from the market. It pays for these assets with money hence increasing the amount of money in the system (increasing liquidity) and reducing the interest rate, as explained above.

The reason the BoE reduced the interest rate so dramatically was to boost the UK economy. The idea is that a reduction in interest rates would encourage spending over saving. A consumer’s return to saving (and the opportunity cost of holding money) falls. Consumer spending is the largest part of GDP and hence the most important factor in boosting an economy. Lower interest rates also encourage a to firm invest more since the cost of financing that investment has fallen. Furthermore, the demand for the pound falls as interest rates fall, depreciating the currency. This in turn increases demand for imports and decreases demand for exports, improving the trade balance. All these factors contribute towards growth.

With any policy come the unintended consequences, which in this case, is inflation. As aggregate demand increases so does the general price level. In fact, the BoE have an inflation target of 2% and must do the very opposite (increase the interest rate) if inflation is too high.  High inflation can be dangerous for an economy for several reasons.

More importantly, excessive monetary policy can lead to a ‘liquidity trap’. This occurs when increasing the money supply can no longer reduce the interest rate. When an economy’s interest rate is close to zero, a central bank can no longer reduce it. Most economies found themselves in this position during the financial crisis, which made them turn to other unconventional methods of boosting the economy, such as quantitative easing.

Quantitative Easing

Many economies turned to QE when rates could be lowered no more. On a very basic level, this involves the central bank buying longer-term and therefore riskier assets, such as longer-term government bonds (gilts). They do this simply by printing money. Technically, this is not true. Central banks use banks as intermediaries. In effect, banks buy longer-term assets from financial institutions, which they in turn sell to the central bank in return for a higher reserve balance (a bank account that a bank holds with the BoE!)

The whole point of this is to reduce longer-term interest rates (‘further out on the yield curve’) and increase the supply of money further.  Conventional monetary policy focused only on short-term interest rates. Although lower short-term rates can feed through to longer-term rates, this is a more direct way of doing so. 

Since yields on government bonds have fallen, is it cheaper for companies to raise capital - lower longer-term interest rates encourage even more investment. As long-term returns to fixed income products fall, investors turn to the stock market instead for better returns, boosting share prices. Most importantly, the hope is that those firms that have sold their assets, spend the money they receive. As banks increase their reserve balances, the hope is that they also will lend more, leading to cheaper long term borrowing costs for the consumer. In the UK, the asset purchase facility (QE) stands at £375bn.

The problem with QE is that if there is no spare capacity to absorb the increase in spending, the policy can be dangerously inflationary. Printing money can lead to hyperinflation such as in Germany in the 1920s post WW1.

Furthermore banks may not lend out their additional reserves (cash hoarding) and institutions may sit on the extra cash without re-investing. There is no policy to force these institutions to spend the increase in money supply.

Forward Guidance

Mark Carney, the new governor of the BoE, was made famous for forward guidance when he implemented it in Canada. He has now done so in the UK. The idea is simple promise. Carney has promised the UK that he will not increase interest rates until unemployment falls below 7% (currently at 7.8%). This has very similar effects to QE. It flattens the yield curve, or in other words, reduces longer-term interest rates and expectations of future interest rates. Carney said he does not expect the interest rate to rise until at least 2016.

Forward guidance is supposed to provide the markets with reassurance and confidence. It allows firms to invest knowing they will not be hit with higher costs of financing their debt in the medium-term and encourages consumers to buy mortgages with the knowledge rates will stay low for a while yet. In summary, it increases spending and borrowing.

Yet the FTSE tumbled and the opposite happened when forward guidance was announced. The first reason for this was that Carney anchored an interest rate change to another variable – unemployment. Tying a future rate rise to the level of unemployment leads to a lot of uncertainty. Firms and consumers cannot accurately predict when unemployment will fall to 7%. In fact, the markets believe that the BoE is far too pessimistic and are predicting a rate rise much sooner in 2015. It also makes a mockery of the monthly unemployment statistics as firms and net borrowers sit and hope that the jobless remain jobless so that rates do not rise. The more optimistic view of the markets hence meant that the yield curve was not flattened as much as Carney would have liked.

Furthermore, there are too many get-out clauses that make the date of a rate rise far too unpredictable. If medium-term inflation expectations become too high then rates will rise. As we have seen, low interest rates cause inflation. With inflation currently at 2.9%, markets fear that this get-out clause is a possibility. Furthermore, the Financial Policy Committee (FPC) can force a rate rise if they believe the policy causes “potential systematic risks”. In other words, the rate can be raised at any time.

My conclusion on forward guidance therefore is that it is a great idea if it is bold. If you can make a credible commitment to keep rates low for a certain amount of time, like he did in Canada, then forward guidance can have the intended consequences. Albeit very risky, a promise such as “I will not raise the interest rate until 2016,” would certainly have the desired effects if credible. However, by tying it to the unemployment statistics and providing too many get-out clauses, the policy does not do much at all. In fact, all has done is bring forward the markets’ expectation of when rates will rise.

Immigration – Dispelling the Myths & Ignoring the Ignorance

Humans have an innate desire to place blame and find a scapegoat. It therefore does not surprise me that immigration in the UK is a touchy subject when it absolutely should not be. The UK, now more than ever, is in dire need of a large influx of immigration yet David Cameron has succumbed to the irrational public pressure to reduce it. This is a perfect example of politics interfering with sound economics.

The conservative party wants to limit net immigration to 100,000 people per year. It has already tightened the rules and imposed a cap on student visas and set a limit for non-EU skilled immigration. Luckily nothing can be done about EU immigrants who have a right to migrate, but even this, which accounts for a third of net migration, may come under scrutiny following a future EU referendum.

Let’s be clear. Immigration in a globally competitive world is fundamentally good and in the case of the UK, absolutely necessary. UK net immigration needs to increase not decrease. The Office for Budget Responsibility (OBR) has been clear on this. UK demographics are changing and our population is ageing. In order to prevent the UK from going bankrupt, we require a large influx of immigrants to pay off our overwhelming debt burden through taxes and work.

Usually anti-immigration arguments are riddled with myths, ignorance and xenophobia. It is time to dispel the myths of immigration so we can overcome the ignorance.

Dispelling the Myths

“Immigrants cost us money”

Perhaps the most common and factually incorrect argument is that immigrants cost the UK taxpayer money. The anti-immigration clan fall back on the idea that many immigrants sponge off the state and use the UK as a health or benefit tourist destination. This is wholly untrue and to some extent simply racist propaganda.

Of course there are the few that abuse the system just like there are a minority of UK citizens that do so as well. Yet the overwhelming majority of immigrants are of working age and hold jobs. They pay taxes, national insurance and contribute to spending and our GDP. Most are skilled and many hold university degrees or equivalents. Immigrants add to the economy, increase productivity, increase the flow of ideas and innovation, improve trade links and add new specialisations to a rather one-dimensional economy. Most importantly, as the OECD explains, immigrants without a doubt put more into the pot than they take out.

It is for these reasons that the OBR has recently published a report saying that the UK requires an influx of immigrants to sustain public finances and counteract a talent shortage. The UK is an ageing population. The OBR says that a net of 140,000 migrants per year from 2016 would lead to a net debt to GDP ratio of 99% by 2062. With zero net migration, however, it will rise to an obscene 174%. To maintain the UK 2.75% long-term trend growth, we need the same immigration levels as when Britain was opened up to Poland. Sir Alan Budd calculates that due to changing demographics, trend growth will naturally fall to 2% (an almost 30% decrease in the long run growth rate), unless immigration increases.

State pensions, social care and healthcare will rise from 14% of GDP to almost a fifth in the near future.  Immigrants can pay for this. Hard-working, productive, tax-paying immigrants, usually in jobs that they are far too qualified to be in can fill the gap. If the Tories continue with their plans, a lack of immigration will completely counteract years of austerity and put the UK public finances back in the same dire position.

Of course, a larger population of immigrants leads to larger NHS and welfare costs. The point is not to focus on only the costs when the benefits so obviously outweigh them. Immigration pays for itself and so much more. Many argue that immigrants from the EU, who are free to move, abuse our health and benefits system. But this is also simply not true for the majority. EU immigrants are, on average, younger and more likely to be in work than a native. Ironically, Spain suffers from elderly Brits spending their later years on its beaches.

 A lot of the skepticism towards immigration is simple scapegoating. Something that I hope will one day be eradicated by globalistion and subsequent acceptance of other races. Immigration does not cause recessions. Recessions are caused by bubbles, greed, stupidity, risk taking and poor judgments.  In fact, immigrants can smooth the costs of a recession for those countries that are lucky enough to attract workers to their labour supply.

“Immigrants take our jobs”

A very right wing argument and once again simply not true. To be fairly crude, lets separate migrants into skilled and unskilled workers. You may be surprised to know that 40% of all UK migrants actually hold a university qualification, which is much better than for the rest of the EU. A large majority hold at least a vocational qualification or similar. Skilled workers are highly demanded around the world for obvious reasons and any country would be extremely jealous of the UK’s influx of such a precious commodity. Skilled workers can only add to the economy whether it is through better products, new skills, a new comparative advantage or greater competitiveness of the UK. Either way, a more productive workforce can only increase the standard of living in an economy.

In the UK, construction workers are in fact in very short supply. With rising demand for property, especially with the government’s new Help to Buy scheme, the UK needs more construction workers to fill the supply gap. Without immigration, rising demand may be met with higher prices rather than a larger supply.

As for unskilled workers, most end up in roles that pay near minimum wage. These are jobs that locals are unwilling to take. It is not the case that unskilled workers are pushing down wages and replacing UK natives. Locals are simply not willing to work at the going wage rate. If this is the case, then I see no reason why UK companies should hire equally or less skilled natives for more money than they are worth. If an unskilled worker refuses to work at the competitive wage then the UK needs unskilled immigrants to fill the gap.

“Abuse our educational system”

This one is less frequent but completely illogical. Education is one of the UK’s greatest exports and I strongly believe that it is a grave mistake to limit student visas. Foreign student fees are much higher than Home fees. It is thanks to a large inflow of foreign students that universities are allowed to flourish and stay afloat. Even if a foreign student moves on after her education, she has still invested a large amount of money in the UK educational system.

Furthermore, it is often the case that foreign students stay in the UK and go on to become highly skilled workers here. This is a win-win for the UK. We charge these students extortionately high prices and they then go on to pay taxes and add to the UK economy afterwards. In a highly globalised world, the country with the most productive workforce will usually prosper.

“Too many people”

The idea that immigration leads to overpopulation is misleading. Net immigration, after the EU was established, averaged at 214,000 per year up until 2011. It then hit 165,000 in 2012, which is a modest 0.3% of our population. This is a lower level than Italy or Spain. With an ageing population and lower birth rates than previous decades, this inflow will hardly have a substantial effect on overcrowding. Thanks to large outflows as well, the UK population will not grow any faster than the rest of the world.

As for language, I find it amusing that people become agitated that an immigrant’s first language may not be English. English is still the second most widely spoken language (behind Mandarin) and the most used language in the business world. It is not going anywhere. Immigrants moving to the UK must learn the language to prosper (and be granted entry). So what if it is their second language?

Conclusion

My conclusion in simple. Increase net migration and focus on more pertinent issues. If abuse of the welfare system or the NHS is a concern, then improve controls and the efficiency of the system. Prevent the ease of tax avoidance of the wealthy and encourage new specialisations. Continue to promote the UK as an exporter of education. These will all help to improve future public finances.

Politicians know the benefits of immigration but capping it wins votes. If only politicians could ignore the ignorance, the UK economy would be much better off in the long run.