With the UK economy already struggling, the atmosphere in the financial sector has just a bit moodier, as Moody’s have downgraded the credit rating of 12 financial firms in the UK, including Lloyds Banking Group, Royal Bank of Scotland and Nationwide. The change in credit rating has emerged because of Moody’s belief that the UK government was less likely to support these firms if they fell into financial trouble. It was, however, emphasized that it did not “reflect a deterioration in the financial strength of the banking system.” The same can not be said for Portugal, who has similarly seen nine of their banks being downgraded due to ‘financial weakness’. George Osborne commented that it was down to the government no longer guaranteeing our largest banks, but he also said:
“I’m confident that British banks are well capitalised, they are liquid, they are not experiencing the kinds of problems that some of the banks in the eurozone are experiencing at the moment.”
Lloyds Banking Group and Royal Bank of Scotland both saw falls in their shares following their downgraded credit rating. Other banks, including Barclays also saw their shares fall, despite not being downgraded. Perhaps another indication of the interdependence we now see across the world. In interviews, George Osborne has continued to say that he believes UK banks are secure and wants them to become more independent to try to protect taxpayer’s money in the event of a crisis. Moody’s explained its decision saying:
“Moody’s believes that the government is likely to continue to provide some level of support to systemically important financial institutions, which continue to incorporate up to three notches of uplift…However, it is more likely now to allow smaller institutions to fail if they become financially troubled. The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”
The above comment reflects Moody’s approach to downgrading UK banks – not all have seen the same credit rating cuts. RBS and Nationwide have gone down 2 notches, whilst Lloyds and Santander have only gone down by 1 notch. Markets across the world will continue to react to this development in the UK financial sector, so it is a story worth keeping up to date with. The following articles consider the Moody environment.
UK banks’ credit rating downgraded The Press Association (7/10/11)
UK financial firms downgraded by Moody’s rating agency BBC News (7/10/11)
Moody’s downgrades nine Portuguese banks Financial Times, Peter Wise (7/10/11)
Bank shares fall on Moody’s downgrade Telegraph, Harry Wilson (7/10/11)
Moody’s cuts credit rating on UK banks RBS and Lloyds Reuters, Sudip Kar-Gupta (7/10/11)
Moody’s downgrade: George Osborne says British banks are sound Guardian, Andrew Sparrow (7/10/11)
Whitehall fears new bail-out for RBS Financial Times, Patrick Jenkins (7/10/11)
Questions
- Do you think that Moody’s have over-reacted? Explain your answer.
- What factors would Moody’s have considered when determining whether to downgrade the credit rating of any given bank and by how much?
- Why did share prices of the affected firms fall following the downgrading? What does this suggest about the public’s confidence in the banks?
- Do you think it is the right move for the government to encourage UK banks to become more independent in a bid to protect taxpayer’s money should a crisis develop?
- How might this downgrading affect the performance of the UK economy for the rest of 2011? Explain your answer.
- What are the differences behind the downgrading of UK banks and Portuguese banks?
As the prospects for the global recovery become more and more gloomy, so the need for a boost to aggregate demand becomes more pressing. But the scope for expansionary fiscal policy is very limited, given governments’ commitments around the world to deficit reduction.
This leaves monetary policy. In the USA, the Federal Reserve has announced a policy known as ‘Operation Twist’. This is a way of altering the funding of national debt, rather than directly altering the monetary base. It involves buying long-term government bonds in the market and selling shorter-dated ones (of less than three years) of exactly the same amount ($400bn). The idea is to drive up the price of long-term bonds and hence drive down their yield and thereby drive down long-term interest rates. The hope is to stimulate investment and longer-term borrowing generally.
Meanwhile in Britain it looks as if the Bank of England is about to turn to another round of quantitative easing (QE2). The first round saw £200bn of asset purchases by the Bank between March 2009 and February 2010. Up to now, it has resisted calls to extend the programme. However, it is now facing increased pressure to change its mind, not only from commentators, but from members of the government too.
But will expansionary monetary policy work, given the gloom engulfing the world economy? Is there a problem of a liquidity trap, whereby extra money will not actually create extra borrowing and spending? Many firms, after all, are not short of cash; they are simply unwilling to invest in a climate of falling sales and falling confidence.
Articles on Operation Twist
Fed takes new tack to avoid U.S. economic slump Reuters, Mark Felsenthal and Pedro da Costa (21/9/11)
How the Fed Can Act When Washington Cannot Associated Press on YouTube (20/9/11)
Analysis: Fed’s twist moves hurts company pension plans Reuters, Aaron Pressman (21/9/11)
What is Operation Twist? Guardian, Phillip Inman (21/9/11)
Operation Twist in the Wind Asia Times, Peter Morici (23/9/11)
Operation Twist won’t kickstart the US economy Guardian, Larry Elliott (21/9/11)
Stock markets tumble after Operation Twist … and doubt Guardian, Julia Kollewe (22/9/11)
‘Twist’ is a sign of the Fed’s resolve Financial Times, Robin Harding (22/9/11)
All twist, no shout, from the Fed Financial Times blogs, Gavyn Davies (21/9/11)
Twisting in the wind? BBC News, Stephanie Flanders (21/9/11)
Restraint or stimulus? Markets and governments swap roles BBC News, Stephanie Flanders (7/9/11)
FOMC Statement: Much Ado, Little Impact Seeking Alpha, Cullen Roche (21/9/11)
Why the Fed’s Operation Twist Will Hurt Banks International Business Times, Hao Li (21/9/11)
The Federal Reserve: Take that, Congress The Economist (21/9/11)
Articles on QE2
Bank of England’s MPC indicates QE2 is a case of if not when The Telegraph, Angela Monaghan (21/9/11)
Bank of England quantitative easing ‘boosted GDP’ BBC News (19/9/11)
Bank of England minutes indicate more quantitative easing on the cards Guardian, Julia Kollewe (21/9/11)
Fed and Bank of England publications
Press Release [on Operation Twist] Board of Governors of the Federal Reserve System (21/9/11) (Also follow links at the bottom of the Press Release for more details.)
Minutes of the Monetary Policy Committee Meeting, 7 and 8 September 2011 Bank of England (21/9/11) (See particularly paragraphs 29 to 32.)
Questions
- Explain what is meant by Operation Twist.
- What determines the extent to which it will stimulate the US economy?
- Why would quantitative easing increase the monetary base while Operation Twist would not? Would they both increase broad money? Explain.
- What is meant by the liquidity trap? Are central banks in such a trap at present?
- To what extent would a further round of quantitative easing in the UK drive up inflation?
- Why are monetary and fiscal policy as much about affecting expectations as ‘pulling the right levers’?
Each month the Monetary Policy Committee of the Bank of England meets to set Bank Rate – the Bank’s repo rate, which has a direct impact on short-term interest rates and an indirect effect on other interest rates, such as mortgage rates and bond yields. Ever since March 2009, Bank Rate has been 0.5%. So each month the MPC has met and decided to do nothing! The latest meeting on 4 and 5 May was no exception.
And it is not just the Bank of England. The Fed in the USA has kept interest rates at between 0 and 0.25% ever since December 2008. The ECB had maintained its main interest rate at 1% for two years from May 2009. Then last month (April) it raised the rate to 1.25%, only to keep it unchanged at that level at its meeting on 5 May.
So is all this ‘doing nothing’ on interest rates (or very little in the case of the ECB) a sign that the economies of the UK, the USA and the eurozone are all ticking along nicely? Are they in the ‘goldilocks’ state of being neither too hot (i.e. too much demand and excessive inflation) or too cold (i.e. too little demand and low growth, or even recession)? Or does the apparent inaction on interest rates mask deep concerns and divisions within the decision-making bodies?
The three central banks’ prime concern may be inflation, but they are also concerned about the rate of economic growth. If inflation is forecast to be above target and growth to be unsustainably high, then central banks will clearly want to raise interest rates. If inflation is forecast to be below target and economic growth is forecast to be low or negative, then central banks will clearly want to reduce interest rates.
But what if inflation is above target and will probably remain so and, at the same time, growth is low and perhaps falling? What should the central bank do then? Should it raise interest rates or lower them? This is the dilemma facing central banks today. With soaring commodity prices (albeit with a temporary fall in early May) and the economic recovery stalling or proceeding painfully slowly, perhaps keeping interest rates where they are is the best option – an ‘active’ decision, but not an easy one!
Articles
Central Banks Leave Rates Unchanged News on News (8/5/11)
European Central Bank set for a bumpy ride City A.M., Guy Johnson (9/5/11)
Euro Tumbles Most Against Dollar Since January on Rate Signal; Yen Climbs Bloomberg, Allison Bennett and Catarina Saraiva (7/5/11)
Rates outlook Financial Times, Elaine Moore (6/5/11)
Interest rates on hold amid fears economy is stalling Independent, Sean Farrell (6/5/11)
The decision to hold back on increasing interest rates may turn out to be wrong Independent, Hamish McRae (6/5/11)
Bank of England: Inflation threat from fuel bills BBC News. Hugh Pym (11/5/11)
Andrew Sentance loses last battle over interest rates Guardian, Heather Stewart (5/5/11)
Interest rates: what the experts say Guardian (5/5/11)
King’s Defense of Record-Low Rates in U.K. Is Bolstered by Economic Data Bloomberg, Svenja O’Donnell (5/5/11)
BoE holds rates: reaction The Telegraph, Joost Beaumont, Abn Amro (5/5/11)
UK interest rates kept on hold at 0.5% BBC News (5/5/11)
Bank of England Signals Rate Increase This Year as Inflation Accelerates Bloomberg, Svenja O’Donnel (11/5/11)
ECB: Clearing the way for an Italian hawk? BBC News blogs: Stephanomics, Stephanie Flanders (5/5/11)
Ben and the Fed’s excellent adventure BBC News blogs: Stephanomics, Stephanie Flanders (27/4/11)
Inflation up. Growth down. Uncertainty everywhere BBC News blogs: Stephanomics, Stephanie Flanders (11/5/11)
Inflation report: analysts expecting a rate rise are wide of the mark Guardian, Larry Elliott (11/5/11)
May’s Inflation Report – three key graphs The Telegraph, Andrew Lilico (11/5/11)
The Errors Of The Inflation Hawks, Part I Business Insider, John Carney (9/5/11)
Errors of Inflation Hawks, Part II CNBC, John Carney (9/5/11)
Data and information
Inflation Report Bank of England
Inflation Report Press Conference Webcast Bank of England (11/5/11)
Monetary Policy ECB
ECB Interest Rates ECB
Monetary Policy Federal Reserve
US interest rates Federal Reserve
Questions
- Why is it exceptionally difficult at the current time for central banks to “get it right” in setting interest rates?
- What are the arguments for (a) raising interest rates; (b) keeping interest rates the same and also embarking on another round of quantitative easing?
- Should central banks respond to rapidly rising commodity prices by raising interest rates?
- Why is inflation in the UK currently around 2 percentage points above the target?
- What is likely to happen to inflation in the coming months and why?
- Explain the following comment by John Carney in the final article above: “To put it differently, the textbook money multiplier doesn’t exist anymore. This means that Fed attempts to juice the economy by raising the quantity of reserves—the basic effect of quantitative easing—are bound to fail.”.
- What has been the recent relationship in the UK between (a) growth in the monetary base and growth in broad money; (b) growth in the monetary base and inflation and economic growth?
Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.
According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:
CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.
It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.
Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)
Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)
Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England
Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)
Questions
- Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
- Explain the difference between the forecasts and the outturn.
- Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
- What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
- What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
- How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.
However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:
“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.
Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”
Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.
BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)
Questions
- Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
- What is the relationship between interest rates and inflation?
- What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
- How has the recent speculation affected fixed rate mortgages?
- What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
- What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
- Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?