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.”

UK Output. What's Going On?

The Office for National Statistics (ONS) raised eyebrows amongst analysts on Monday when it reported a drop in its production index of 0.7 per cent, between the months of April and May. Contributing largely to the fall was a plunge in factory output from April, which represented the largest contraction since January 2013 and the first decline in six months according to a spokesperson from the ONS. The output of 10 manufacturing categories out of a total of 13 declined in May compared to the previous month, informed the statistics office. The biggest contributors to the disappointing output figures were basic metals, which decreased 2.3 percent, and pharmaceuticals, which also slid 3.6 percent during that period. 

The latest ONS production figures took a lot of economists by surprise. Indeed, the median forecast of 25 economists was for a gain of 0.4 per cent, according to a recent Bloomberg news survey. So, May’s slump in UK manufacturing was a bit of a damp squib for the markets. After all, UK domestic consumption remained buoyant during the first quarter of 2014, spurred on by the Bank of England’s expansionary monetary policy, which facilitated cheap and readily available credit. The upshot of a loose monetary policy was a boom for manufacturers, who reported the biggest rise in domestic sales since the survey started in 1989 in the first quarter of 2014. Contributing to this figure were British consumers who splashed out on new cars, at their fastest rate in nine years. A whopping 1.29 million new vehicles were sold in Britain during the first half of the year, which represented a 10.6 per cent increase in sales from the same period last year, according to the Society of Motor Manufacturers and Traders (SMMT). Ford Fiesta, Vauxhall Corsa and Ford Focus were top on the buyers’ list. “Britain's car industry has smashed records going back to 1959 with the longest-ever period of sales growth of new cars,” said Mike Hawes, SMMT chief executive. Car manufacturing in Britain also increased during the first half of the year as foreign owned companies invested in production lines at their UK factory plants. Apparently, this trend is expected to continue with manufacturing output for cars predicted to return to levels not seen since the 1970s where a record 1.92 million vehicles were built in Britain during 1972, according to SMMT. Last year the total was 1.51m cars, which represented a six-year high. 

However, while domestic consumption provided strong tailwind for UK manufacturing, in the first half of 2014, UK exports remain lackluster during the same period. 

The lingering recession in many parts of the Euro zone didn’t help boost UK manufacturing sales. UK exports to the EU fell by £11.5 billion in the month of April 2014, which is a decrease of £2.1 billion (15.8 per cent) compared to last month. It is also a decrease of £0.6 billion (4.9 per cent) compared to April 2013. Certainly, bitter austerity is biting hard in the southern countries of Europe and public health cuts were most probably contributing to falls in UK pharmaceuticals exports to the region. Additionally, Britain’s exports outside the EU declined, the trade deficit rose to £8.92 billion in April, 2014 compared to £8.29 billion in March, representing a decline of 1.5 percent in manufacturing exports, according to a recent Bloomberg article.

Furthermore, the strengthening pound against the euro and dollar could also be a contributing factor providing headwinds for UK manufacturers, which was reflected in May’s dismal manufacturing figures. The appreciating pound is making UK manufacturing exports more expensive and thereby less competitive abroad. Furthermore, the Bank of England’s perceived hasty move to tighten monetary policy could also be strengthening the pound even further, providing more anxiety to UK manufacturing. Underscoring this view Samuel Tombs, an economist at Capital Economics in London said, “The data suggest that the stronger pound might be starting to slow the recovery in the manufacturing sector.” However, on an upbeat note he added that, “Despite today’s disappointing figures, we continue to think that the economic recovery will receive decent support from the industrial sector.”

Michael Saunders, UK economist at Citi also played down May’s disappointing output figures. "We do not regard these data as a sign that the economy's rapid expansion is losing momentum," he said and cited a series of positive industry data to back his support. Manufacturing output has increased 2.3 percent from a year earlier and was up 0.6 percent in the three months through May from the previous quarter. 

However, while the ONS cautions into reading too much into one set of monthly figures, there are some strong headwinds for UK manufacturing in the months that lie ahead. External factors such as a slowing global economy could put a further dampener on UK manufacturing exports. Moreover, the benign climate of low interest may be coming to an end. BOE Governor Mark Carney has said that the time to normalize rates is now “edging closer.” The market is betting that rates, which have been kept at a historic five year low, will rise 25 basis points by February. But higher interest rates would be a double blow for UK manufactures as it would make financing investments in plant and machinery more costly. It would also cause an appreciation in sterling, making UK manufactured exports less competitive abroad. Moreover, the geopolitical situation in Iraq and the Ukraine is resulting in higher energy costs, which is a huge input cost for manufacturing. So rising energy costs could also be a headwind for UK manufacturers. Furthermore, there is the UK future relationship with the EU to consider. As Europe moves closer towards a federal Europe and the UK continues to isolate itself from it, this may deter future inward investment into UK plants and machinery. Large scale foreign investors may be put off making future investments in their UK production plants due to a fear that the UK could decide to exit from the European Union. So there’s a number of compelling reasons to be bearish about future UK production figures and it could also be factor for investors deciding to take risk off the table.

European Central Banks Policy Decisions

The long awaited announcement on monetary policy from the ECB this month was made yesterday. In it Mario Draghi announced a package of measures which are designed to defeat the threat of deflation in the Euro Zone and boost growth.

The measures include a cut in the headline rate of interest or the refinancing rate by reducing it from 0.25% to 0.15%. He also announced that the deposit rate will be reduced by 0.10% from zero to -0.10% and that the banks will be given access to €400bn of funds at a low rate of interest provided the funds are used to lend to small businesses. Finally, they will cease sterilising the new funds put into the market. The package is designed to increase liquidity and reduce the currency thereby increasing inflation and boost the economic expansion.

The cut in the refinancing rate to 0.15% was widely anticipated and is really not expected to make a huge amount of difference to economic growth. However, it will put savers under even more pressure in their hunt for good returns and push them towards more risky investments in order to get those returns particularly as Mario Draghi was not able to give them any encouragement for better returns with his prediction that rates will stay low for an extended period of time. His expectation for inflation, which is currently at 0.5%, is for it to be 0.7% this year followed by 1.1% in 2015 and 1.4% in 2016 and suggests that rates will be low for much of that time. The ECB’s target for inflation is 2.0% or under but such low levels will make it difficult for debts to be repaid and for liquidity to improve. What it will do is give businesses the confidence to seek funding for investment in the knowledge that their business plans will not be hit by the increase in their costs from interest payments. This will tend to reduce the returns they need to obtain in order to justify the investment in the first place.

By reducing the deposit rate that the ECB pays on any excess liquidity that banks leave with the Central Bank to -0.10% they hope to encourage them to take the funds back. They can then seek better returns by lending the money on to consumers and businesses at low interest rates. This may, however, entail the banks reducing their liquidity ratios and breeching the Regulators requirements at a time when they are also being subjected to very high fines from those same Regulators which also reduces their liquidity ratios. There will need to be some support from the Regulators for this policy to work. The amount involved is about €120bn which could have a large impact on liquidity ratios but which will only cost the banks €120m in interest charges. Many analysts doubt whether this announcement will have much effect.

The proposal to make €400bn available in what is to be known as targeted longer term refinancing operations or TLTRO may be more effective in improving liquidity as it gives the banks access to additional funds at a low rate of interest provided they are used for the purpose of supporting businesses. These funds will not be required to be repaid for two years and should give a boost to the economy although it has been likened to the Bank of England’s Funding for lending scheme which it is thought has had little impact on the lending conditions for businesses but which was increased with effect from the beginning of this year. The scheme will be launched in September 2014 with an additional tranche in December 2014. This will be followed by further tranches quarterly from March 2015 to June 2016. The total represents 7% of all outstanding loans to businesses and household excluding mortgages. They will all mature by September 2018 and interest will be paid at the time of maturity and will have been fixed when effected. These are very attractive loans for the banks and should make a difference to liquidity. In addition the withdrawal of sterilisation whereby the Central Bank buys back an equivalent amount of loans will give a further boost to liquidity.

In addition the Central Bank has announced that they are working hard on their preparatory plans to buy back asset-backed securities should that become necessary in the future. This is very close to a full scale quantitative easing programme and would only be considered and activated if inflation stays worryingly low.

Mario Draghi was keen to make the point that the ECB was not yet finished with policy actions that could be taken to combat slow growth and very low inflation. He was also keen to stress that it is necessary for countries to continue to put their own house in order and maintain the packages of reforms that they have all agreed upon during the crisis. He may not be happy to hear about the reforms announced by the Spanish government today to boost their economy and Mr Rajoy’s prospects of re-election next year!

The markets had been anticipating this announcement and there were few surprises in the package. One aim was to reduce the Euro against major currencies and thereby increase inflation and the Euro area’s competitiveness. Since May the Euro has fallen from $1.40 to $1.35 so the travel has been effective, however, the package will also lead to European assets becoming more attractive and could lead to a rising currency again as overseas buyers come in. The rise in the stock market that followed the announcement may be an indication of this trend.

Europe is a major global economic bloc and the relatively flat recovery has contributed to the low rate of global economic growth and the stagnation of equity markets this year. A boost to activity provided by this package could lead to better expectations for growth in profits and earnings which, in turn should justify the current valuations of markets and lead to higher forecast growth rates.