Government borrowing and effect on bond yields and interest payments

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Another few graphs to look at the impact of the UK budget deficit on bond yields and interest payments. Government net borrowing for 2012-12 excluding Royal Mail pension fund transfer and Asset Finance Programme (AFP – the proceeds from Q.E) Government borrowing vs debt interest payments The very large deficits have had  little impact on …

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UK economic recovery 2013

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The UK economy has experienced the most prolonged decline in real GDP on record. GDP is still lower than before the start of the great recession in 2008. This unprecedented recession has been prolonged – despite a sharp depreciation in the Pound, and a raft of unconventional monetary policies. However, recent statistics suggest there are some reasons to be more hopeful and the UK economy is starting to recover. Yet, despite the recovery, many analysts still worry that the economy is unbalanced and could be vulnerable to a further economic downturn in Europe and the rest of the world.

Economic recovery

economic-growth-uk-ons-quarter

Source: ONS

The UK recovery since 2009 is best described as ‘patchy’ The important thing is to maintain recovery for a prolonged period and not slip back down into recession. The governor of the Bank of England recently talked about the need for the UK economy to reach ‘escape velocity’ – this means a recovery strong enough for the recovery to be self-maintaining – without the artificial props of quantitative easing e.t.c.

Where is the recovery coming from?

1. Retail spending. Although real incomes remain depressed, retail spending has shown renewed strength. Compared with a year ago (July 2013 compared with July 2012) the quantity bought in the retail industry increased by 3.0% (ONS). Consumer spending accounts for approx 65% of UK GDP and so is the most important component. A rise in consumer spending is good because it shows a renewed confidence about the economy. However, at the same time, it raises concerns. The growth in consumer spending is partly financed by a fall in the savings ratio, it isn’t being met by growth in real incomes. Therefore, there is a danger the UK recovery is falling into the old trap of being unbalanced and relying on consumers dipping deeper into their pockets (and credit cards)

2. Manufacturing. For a long time, manufacturing has been the struggling sector of the UK economy. The weakness of manufacturing is one factor behind the UK’s persistent trade deficit, but recent evidence is more promising. This week, the  PMI survey for the manufacturing sector found the strongest growth in activity for two and a half years, with output and new orders rising at their fastest rate for 19 years. However, although this sounds impressive, it needs to be remembered manufacturing output is still 11% lower than it pre- 2008 peak.

manufacturing-2000-2012

– a long way to recovery.

Construction has also seen growth in the first part of 2013, but, this is from a very weak base, and construction output is still down 0.5% on a year ago. (ONS)

3. Exports to emerging economies. In 2013, we have seen strong export growth to emerging economies. Exports to BRIC countries have performed well. Exports to China have risen nearly sixfold since 2002.

In one sense, these export growth to new markets is encouraging. With Europe stuck in recession, it is good news the UK exporting sector has been able to diversify into emerging markets, which perhaps have greater potential in the long term. However, there have been increasing concerns that the long boom years for China and India may be coming to an end. This would dampen growth in these new export sectors. Also, it is still a small share of GDP for the UK economy.

4. Housing Market. Another staple of the UK economy. A renewed rise in house prices is a mixed blessing. The rise in prices will encourage consumer confidence and improve the balance sheets of banks. It has also encouraged renewed activity in the construction sector. However, house prices are already stretched, with house price to income ratios close to all-time high. Rising house prices as the main source of economic recovery is another sign of an unbalanced economy.

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UK Unemployment Target

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The new Bank of England governor, Mark Carney, has implemented a type of unemployment target.

As part of forward guidance, the Bank of England state that:

Interest rates won’t rise from 0.5% until unemployment falls below at least 7%.

Essentially, the bank are committing to expansionary (loose) monetary policy until there is a stronger economic recovery and unemployment has fallen. The hope is that the commitment to low interest rates will encourage firms to invest and consumers to spend.

However, this unemployment target of 7% has a few caveats.  The unemployment target and forward guidance on interest rates can be ignored if:

  • Inflation is forecast to breach a 2.5% target over a 24 month horizon.
  • If there is a sharp rise in the public’s expectations of inflation
  • If low interests are likely to imperil the stability of the financial system, e.g. low interest rates could fuel an asset bubble.

UK unemployment-past-5-years-percent

Under the Bank of England’s latest targets, it does not expect unemployment to fall below 7% until 2016. According to the ONS, unemployment is currently 7.8%. It would require the creation of nearly 750,000 new jobs for the rate to fall below 7%

Equilibrium Unemployment

The Bank of England also mentioned the term ‘equilibrium unemployment’. They believe the equilibrium unemployment rate is around 6.5%. The equilibrium rate means that if unemployment falls below 6.5% it might start causing inflation (e.g. competition for employers pushes up wages). If unemployment is above the equilibrium rate of 6.5% then there is slack in the economy (demand deficient unemployment) and this will keep inflation low.

This equilibrium rate of 6.5% is therefore composed of structural factors / supply side factors (the natural rate of unemployment)

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Forward guidance in monetary policy

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Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.

The aim of forward guidance is to influence long term interest rates and market expectations. For example, the Central Bank might want to boost economic activity by convincing markets that interest rates will stay low for the foreseeable future.

It means that Central Banks are pledging to keep interest rates low, even if inflation starts to creep above its target. It can be seen as an indirect way of placing less emphasis on low inflation and more emphasis on economic recovery.

The Central Bank could say it intends to keep interest rates at 0.5% for a certain time period (until 2015) or
it could say it intends to keep interest rates at 0.5% until certain economic criteria are met (e.g. interest rates will stay at a certain level until unemployment falls below 6%).

What are the benefits of forward guidance?

It helps the Central Bank to influence long term interest rates. The Central bank can only directly control short term rates – Base rates. In normal economic circumstances, a change in base rates usually leads to an equivalent change in commercial bank rates (the long term lending rates which are important in an economy) However, in the credit crunch / great recession there was a divergence between base rates and commercial bank rates. Lower base rates were not passed onto consumers.

base-rates-bank-rates-mortgage-rates

mortgage rates and bank lending rates didn’t fall as much as base rates

If commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates. But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates (e.g. mortgage and lending rates) because they know they will be able to borrow from the Central Bank at 0.5%. The hope is that this will encourage banks to cut rates, and increase overall lending in the economy. This increase in lending should boost investment and economic growth.

Inflation / deflation expectations. Another feature of forward guidance is that it might influence inflation expectations. If the Central Bank states that interest rates will stay at zero until unemployment falls below 6%, markets, firms and consumers may be more liable to expect higher inflation than previously. Some economists argue that, if there is currently a risk of deflation, higher inflation expectations can help boost spending and economic growth. This is particularly beneficial in a liquidity trap.

How credible is forward guidance?

There is nothing to stop the Central Bank ignoring its own pledge. The Bank of England could  pledge to keep interest rates at 0% until 2015, but if circumstances change – they could raise interest rates. Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate. Markets do tend to place a lot of weight on Central Bank pronouncements. 

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Solutions to Financial Crisis

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Readers Question: I have recently read an article stating that “a country has only four options for getting out of a financial crisis: devalue, inflate, default, or deflate”… Would you be so kind to explain what these options comprehend?? Firstly, when people refer to a financial crisis they could refer to different economic problems. Recession …

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Ryanair to charge £160 for check-in luggage

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Ryanair certainly no how to get free publicity, and although they say there’s no such thing as bad publicity. You have to half-admire a company whose strategy seems to be to annoy customers as much as possible.

Recently, the outspoken Ryanair Chief Michael O’Leary stated that the cost of checking in luggage to a Ryanair flight could increase up to £160. Effectively, Ryanair are trying to price out customers bringing check-in luggage.

Ryanair are motivated to increase the cost of  checkin luggage because:

  • To save weight and hence fuel costs (fuel now accounts for 50% of Ryanair’s total costs)
  • To reduce flight turnaround time.
  • To reduce staff costs in dealing with check-in baggage.

From one perspective Ryanair have a real economists perspective. They are simply wanting to charge customers the marginal cost of each aspect of air-travel. The weight of check-in baggage could not justify the extra cost. But, to low cost airlines, the speed of turnover is very important for determining the number of flights that they can squeeze in a day. Reduce the number of check-in baggages, and the turnover time at airports is reduced. If Ryanair price luggage out of their flights, they might be able to fly even more. They could become more akin to trains. Arrive at the airport, and a few minutes later, you could be going back out. This means more frequent flights, lower costs, and lower prices

Do Customers benefit?

Ryanair is that service that people love to hate. We love complaining about Ryanair’s excessive charges. But, at the same time, we like the cheap airflights. In theory, charging customers the marginal cost of aspects of airtravel, should increase allocative efficiency. People may prefer to avoid taking a check-in bag, and get the cheaper flight. If you need to take luggage, you may find yourself looking for another airline (assuming Ryanair haven’t beaten all the competition)

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UK policies for economic recovery

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UK economic-growth-2007-2019

Readers Question: what are the policies that UK are using for the recovery of its economy?

Since 2010, it is has seemed the government doesn’t really have a policy for economic recovery. The burden of recovery has fallen more on the Bank of England and monetary policy. – zero interest rates, quantitative easing, and allowing the depreciation of the Pound.

Fiscal policy has been the opposite of countercyclical since 2010. This means the government has sought to reduce the deficit through cutting government spending or, at least, reducing the growth of spending.  In particular, public sector investment was cut. A few years ago, there was a brief attempt to argue that this deficit reduction strategy would help ‘improve confidence’. But, really the opposite occurred – confidence fell, with householders concerned about job losses.

Since 2012, the government has announced a reversal of its previous cuts to public sector investment. The government have announced investment of £28 billion to be spent on improving roads between 2014 to 2020 – including enough cash to resurface 21,000 miles – and that it would support £30 billion in rail investments. It is hoping that increasing public sector investment will create economic growth because:

  1. It is some positive news about trying to boost growth rather than the unrelenting talk of austerity post 2010.
  2. It is hoped that public sector investment (roads / railways) will help improve Britain’s creaking infrastructure and provide a supply side boost to the economy in the long run.

However, the decision to increase public sector investment in the next few years has been offset by the attempts to reduce public sector spending in other departments. Overall the fiscal situation will remain tight, with public spending squeezed on many fronts. The government still place great importance on reducing the size of the budget deficit.

In evaluation, the UK has avoided the much more painful austerity we’ve seen on the continent. The government are not pursuing expansionary fiscal policy, but spending is being maintained – it is not been savagely cut like Portugal or Italy. Whether you would call this a policy for economic recovery or a policy for avoiding a recession is a matter of opinion.

UK economic-growth-2007-2019

Monetary policy

With fiscal policy providing little comfort to the economy, the burden on recovery has fallen on monetary policy and the Bank of England.

The problem is that the Bank of England cut interest rates to 0.5% in March 2009. When this interest rate cut failed to create a strong economic recovery, they could not do any more with this traditional monetary instrument. Therefore, the Bank of England looked towards other ‘unconventional forms’ of monetary policy. In particular, they engaged in Quantitative easing – increasing the money supply to buy government bonds – hoping to lower bond yields and increase the money supply.

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Q.E. for Greece and the Eurozone

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My Q: can you see any reason the ECB can’t do a version of QE for Greece? Not necessarily the US/UK way of buying bank bonds and hoping; there may be other ways? But if they could do it somehow, interest-free, so that the new money gets out into the economy, with the proviso that the money will slowly be paid back, but only after Greece finally reaches some positive economic level? Wouldn’t that be more palatable for Greece than having to *borrow* from the ECB at impossible rates? (It seems that the liquidity trap  will avoid any runaway inflation.)

Countries like Greece, Italy and Spain desperately need some form of monetary easing. Increasing the money supply (through some form of quantitative easing) should help to alleviate some of the problems associated with deflation and falling nominal GDP. (Greece recorded an inflation rate of -0.4% in June 2013) Amongst other things, they need an increase in the money supply to try and target higher nominal GDP. At the moment, several Euro countries are caught in a deflationary trap with falling GDP and simultaneously seeing an increase in their debt to GDP burden.

If a country like Greece was not in the Euro, but had their own currency – then the Greek Central Bank could decide to create money and purchase bonds. They could buy government bonds or corporate bonds; the important thing is that it would increase the money supply, reduce bond yields  and help to reduce deflationary pressures and stem the fall in nominal GDP. (It would also cause a large depreciation in the Greek currency, which is something they needed to restore competitiveness)

However, Greece does not have its own currency, it is in the Euro. Therefore, it is up to the European Central Bank. Many of the reasons to prevent Q.E. have been political and related to the set up of the Euro.

(I should point out my knowledge of ECB rules on Q.E. and printing money is somewhat shaky – partly because it is undergoing a process of constant change, and different people in the EU/ ECB have different views)

Firstly, the ECB used to have something in its charter prohibiting the creation of money. To some extent, Draghi’s put has circumscribed this. The ECB can now buy bonds with a 3 year or less maturity.

However, any extension of this decision to pursue a policy of quantitative easing needs to be approved by European Central Bank body. It relies on political support. Others in the EU may veto a plan for quantitative easing over deeply held fears of:

  1. Increasing money supply causing inflation.
  2. Rewarding fiscal profligacy through printing money and inflating away debts. There is a fear of moral hazard, and that it would encourage other countries to allow debts to rise.

In the case of Greece, Quantitative easing would not be a panacea. Greece is well beyond the situation of having liquidity shortages, it is fundamentally broke. However, quantitative easing to keep bond yields low, would give countries like Italy and Spain more time to deal with fiscal deficits – rather than the deeply counter-productive austerity measures we’ve seen in recent years.

Wouldn’t that be more palatable for Greece than having to *borrow* from the ECB at impossible rates?

It is a big problem that countries like Italy are running primary budget surpluses (but because of relatively high interest rates, it is insufficient to reduce debt to GDP ratios. It is estimated Italy will have to run a primary budget surplus of 5% of GDP to reduce long-term debt burden. But, this size of a primary deficit is highly contractionary. Quantitative easing to reduce bond yields would reduce the necessity of deep austerity measures.

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