Monetary Policy

Source: www.thebusinessinsider.com

The accelerator throttle controls the revolutions per minute (RPM) of an engine similarly to the way the money supply, in any given economy, influences the rate of economic activity. When the engine (economy) under idles, the driver simply pumps the accelerator (money supply) to increase the RPMs (economic activity). Conversely, if the dashboard indicators show the presence of an overheating engine (inflation) the driver (bank governor) can ease off the money supply to cool the economy down.

In essence this is Monetary Policy, which is commonly defined as a government strategy of influencing economic activity by controlling the money supply. The task of controlling the money supply is usually delegated to a Central bank, in the UK it’s the Bank of England, in the US the Federal Reserve (FED) and in the European Union (EU) the European Central Bank (ECB) that is responsible for controlling monetary policy. Central banks can use three tools in their kit to influence the money supply. They are as follows; the buying or selling of national debt; changing interest rates and the changing of credit restrictions.

Monetary policy has been and still is in vogue with policy makers since it is promoted as a viable solution for manipulating economic activity through the money supply rather than taxation. So it is no surprise then that monetary policy is favored by political parties of the centre; centre right, such as the Conservative’s in the UK and Democrats in the US who advocate low tax regimes and less government spending.

In the financial crisis of 2008 in order to prevent a financial implosion and another Great Depression II that would have inevitably ensued, Central Banks around the world pumped the system with liquidity. Quantitative easing (QE), it was believed would bring the system back from the precipice and save us from misery. So central banks entered the bond market and bought historic amounts of sovereign debt, which in turn triggered the desired effect of raising bond prices, or gilts in the UK, which then lowered interest rates. With interest rates kept at record historic low rates of near zero percent, this would stimulate investments, increase demand and lower the unemployment rate, so the theory goes.

Six years on and doomsday predictions of another Great Depression have fortunately failed to materialize, however some may argue that in the peripheral states of the EU they are already experiencing the effects of a Depression with mass unemployment rates of over twenty percent in Greece, Spain, Portugal and Cyprus. Nevertheless, the ECB has decided stick with the policy of monetary expansion to keep the economy ticking over. In June, ECB bank governor Draghi decided to do more of the same by cutting base rates to 0.15 percent from 0.25. Additionally, deposit rates are now entering uncharted waters of negative 0.01 percent; the implications being the ECB will now actually charge its clients for holding funds overnight in a deposit account. But if the previous repeated cuts in EU base rates haven’t improved the situation, it beggars belief to think that these new round of historic base rate cuts are going to have any different effect. So perhaps the rate cut in June, which frankly is soon approaching zero percent from near zero percent, indicating a policy with now little or no leverage is merely nothing more than just a symbolic move from the ECB Governor Draghi. Despite years of expansionary monetary policy the south remains plagued with chronic unemployment, credit is tight since banks are still reluctant to lend, preferring the alternative option of rebuilding their balance sheets from the last financial crisis of 2008. Moreover, there’s even fear of the dreaded deflation gripping the economy, an unwelcomed prospect since lower prices deter business from investing and consumers from spending, which then metamorphoses into a downward economic spiral. Recent economic sentiment in Europe’s powerhouse, Germany isn’t entirely upbeat either. The central bank in Portugal recently reported that it needs to be rescued from bankruptcy. Additionally, there were talks back in February that Greece might need a third bailout. In short, expansionary monetary policy to the full throttle hasn’t really been effective in the Euro zone. 

With respect to the UK economy, while mainstream likes to paint a bright spot. Perhaps things are not so bright in what has been described even by some optimists as a “lumpy recovery.” Looking at the facts industrial production and construction are still down respectively by 10 percent each since the financial crisis of 2008. Moreover, the era of money pumping which ought to have spurred on capital intensive activities like industrial production and manufacturing may have fueled a speculative bubble in the bond market, equities and London property prices.

So maybe pumping money full throttle has actually skewed investor’s perception of risks and encouraged investor risky behavior, thereby creating a bigger bubble and a bigger bang when it eventually pops. Paradoxically, while pumping money supply full throttle might have prevented the economy from stalling, in the short medium term, it could have also caused unintentionally and engine blowout.

The flaws with monetary policy is that while the central bank can manipulate the money supply, the monetary authorities can’t actually control what the business community and investors do when they are presented with a period of cheap money. Who is to know whether investors will use the cheap money to buy gold, bonds and companies to buy their own shares?

It’s much easier to predict what happens with a machine when you increase the flow of fuel and air into its combustion chamber, but when you throw human behavior into the equation then it becomes guess work.

Whether monetary policy is now defunct depends on what will happen in the economy and the markets in the near future. But when the monetary authorities do much of the same thing, a quote from Albert Einstein comes to mind, “Insanity is when you do the same thing over and over again expecting a different result.”