The European Central Bank’s plan to reduce discount rate below zero
Question:
Discuss about the Term Structure of Interest Rates.
The above topic is the contemporary issue in economic chosen for this deliberation. The QE has not been able to spark inflation as there are nagging fears that QE individually trigger deflation. This has compelled the European Central Bank (ECB) to seem poised to reduce the discount rate below zero in the coming few days. This will become the 1st of the monetary superpower to venture into such uncultivated waters. While QE was projected to stimulate the economy as well as pool people out of the deflation, the reverse is being achieved.
This has been evidenced when the third round of QE in the United States failed to increase the anticipation of inflations. It has not worked as well as in Japan either. This was noted by the Wall Street journal even during the year 2010. Approximately ten years after the central bank of Japan first experimented with this QE policy, Japan stays mired in the deflation. This is the general decrease in wages as well as prices which has crippled Japan’s economy.
The QE began in Bank of Japan (BOJ) in 2001. It then remained precise that pushing rates of interest down towards zero for the prolonged duration had been unable to get to the economy moving (Bibow 2016). After 5 years of gradually enlarging its bond purchases BOJ dropped the efforts in 2006. This has been illustrated below:
Initially, it seemed that QE had succeeded in the economic stabilization and stopping the price slides. However, the deflation resumed with a vengeance over the previous two years thereby putting the bank of Japan on the critical spot. It is, therefore, rational to examine why QE failed to work in Japan (Chovancová and Hudcovský 2016). It has been asserted by critics that Japanese Central Bank was not aggressive sufficiently in launching as well as enlarging its bond-purchasing scheme-then dropped QE too soon. Other critics have heled that Japan merely waited too long to get back to the QE policy.
Nevertheless, despite Japan having gone “all in” since then on astounding degrees of QE, it is still stalled in the deflation. Other instance is UK that engage in significant QE, but the rates of inflation are declining in UK as well. Also, China partook enormous quantities of QE, nonetheless it is as well as falling into the deflation. In fact, in spite of enormous QE by the United States, China and Japan, there is presently a global risk of deflation. Thus, it is rationale to examine why QE problem has never worked (Lavoie 2017).
Max Keiser, financial commentator, trader as well as inventor of high frequency trading has made his argument for months on the explanation of QE’s failure. In the first step, QE has failed by throwing easy cash at the zombie banks. Also, the huge banks utilize that easy cash in speculation rather than becoming more sturdy as well as lending it out to the Main Street. The speculation as well as absence of lending reduces the real economy (Main Street) vitality. Accordingly, end product is the deflation instead of inflation (Makabe 2017).
The failure of QE to stimulate inflation in the US and Japan
The evidence is support of the above Keiser’s argument is available. For example, the failing to break up big banks has been destructive to America. This is because the size of the Big Banks is literally causing destruction to the rule of law. In other words, the confidence in the system remained very fragile because fraud disclosure in these Big Banks might lead to a run. Simply put, the big bankers remain “too big to jail” since disclosing a share of the enormous fraud would trigger bank runs. The chief inspiration behind the indulgence of administration of serious criminality evidently is the fear of aftermaths of taking threatening actions on the individual bankers (Ito 2004). The banks’ executives only strive to build their banks to be as big as they can so that they can keep expanding. Once a big is big enough, the bank together with its staff remain not just too huge to fail, but further too big to jail.
Again, the size of these banks enables them to rig the market. Adam Smith (father of free market economics) was aware that economy is hurt by monopolies. As shown by the Libor scandal, the size alongside concentration of the hugest banks permits them to commit enormous manipulation in the global hugest markets, and to partake in insider trading on unprecedented scale in history (Lavoie 2017). It has also been shown by former New York Fed economist, Richard Alford, trading floor economist as well as strategist that banks acquire such huge benefit from info asymmetry thereby disrupting the free market.
The evidence of market manipulation has also been shown by Joseph Stiglitz, Nobel Prize winning economist that giants including Goldman are utilizing their sixe to manipulate it. For example, Goldman has raised the question of size (too big to fail) as the chief problem. Goldman have substantial share of trades in certain markets which is significant because it allows Goldman to trade on both their propriety desks alongside on customers’ behalf. Accordingly, Goldman draws a substantial share of each trade, and hence sufficient information (van den End and de Haan 2014).
It is thus apparent from the above case that bailing the big banks out to the tune of huge trillions have dragged the economy to its foot from where it is inescapable. Only when the big banks are broken up, will the people escape this undesirable situation. Therefore, the inability to break the big banks up remains a dooming to the depression. There is a threat of another huger financial crisis unless derivatives are reined in. It is, however, unfortunate that the big banks are hindering the taming of derivatives.
History has demonstrated why the QE1 to QE3 failed to generate inflation for the dollars produced were globally absorbed. Moreover, QE has falsely assumed that printed the money shall remain in the national economy yet printed dollars end up overseas. The expansion of money supply of the dollars has been unable to generate any inflation since the ancient theories have unsuccessfully considered the global nature of the global economy along with its currency demand of the present Financial Capital of the globe. The United States is unable to print sufficient money to meet the demands of the world.
Why QE failed to work in Japan
A former Federal Reserve economist Ed Yardeni who held positions at the Board of Governors of Fed’s and Treasury Department has noted that it is known that there is never transmission mechanism though which the real economy is stimulated by QE. The overarching question here is the reason the globe is unable to appear to shake off such “lowflation” malaise despite unprecedented QE scale by the United States, Japan, and Britain along with its individual way Switzerland. It has been suggested by Minneapolis Fed Chief (Narayana Kocherlakota) that as earlier as 2011, QE and zero could have perversely be the trigger of deflation rather than the cure which everyone imagined (Murphy and Hines 2010).
Economist have attempted to showcase that QE is deflationary by considering a number of situations: a central bank which is deploying the QE is nearly absolutely at 0 lower bound. QE shall solely assist get the economy off the 0 lower bound in case it is paired with a commitment to the higher upcoming inflation. In case the central bank is deploying QE over a prolonged time duration, that implies it has never paired QE with a commitment to the higher upcoming inflation. Extended QE efficiently signifies the unwillingness by the central bank to commit to upper inflation. QE thus supports the anticipation that economic activity shall run beneath prospective while demand shocks shall never be fully offset. QE shall be linked to a general disinflationary pattern.
The diagram below gives a virtual explication of the five-year breakeven beginning 2012 September, when the Federal commenced QE3, the initial asset-buy plan with no end period:
Based on what is done by the central bank, QE can either be inflationary or deflationary. QE could be deflationary in the long run since the excess capacity remains deflationary and the mechanisms to speak to QE is to close it down. In fact, it is anticipated that China that has partook enormous QE for now to exert the deflationary pressure on the international economy. The unproductive venture is by nature eventually deflationary. This indicates the point worth remembering when venturing in paper assets facilitated by QE liquidity and never underpinned by the sustainable growth of economy. The diagram can help illustrate why this is so:
The above diagram illustrates a graph of an interest rate increase from zero- to five percent (blue dash) and the probable equilibrium values for inflation (red) where k=1 and p=1. As is evident, it is perfectly probable, in spite of price-stickiness of the novel-Keynesian Phillips curve, to view the super-neutral outcome, inflation increases instantly. It shows an interesting situation of how easy is to achieve positive inflation out of rate of interest increase in the above simple novel-Keynesian model with stickiness of price.
The world remains different. This implies that lessons learnt in the previous do not essentially apply to the interest on the plentiful excess reserves globe to which people are heading to. The means that prescribe the negative reaction of inflation to rate of interest rises are a lot more tenuous than one could have imagined. Provided such a downward drift in the inflation, it remains a notion which is worth playing with.
Max Keiser’s argument on QE’s failure
The fundamental logic remains pretty precise: increasing the nominal rates of interest either increases inflation or upsurges real rate of interest. In case real rate of interest increases, it has to upsurge consumption growth. The projection is solely counterintuitive since for quite an extended time, people have convinced themselves of the reverse. The monetary policy will increasingly be perverse following Fed’s payment of interest on reserves held by banks with it. In case Neo-Fisherites are correct, the all that has been done by Fed’s in attempting to stimulate economy is not only useless but also backward (Goodhart 2013).
Presently, the irresistible majority of empirical research indicates that QE alongside Fed easing generally, incline towards increasing inflation in the short run. However, a question is raised in case this is at the lower inflation cost in the long run. Japan has held rates of interest at zero for several years with economy being in and out of deflation. Enormous QE markedly failed to make the United States hit the projected two percent inflation target. A question begs that what if the mainstream macroeconomics is wrong, and extended durations of low rates of interest trap people in a type of secular stagnation which is completely distinct (Ziemann and Guérard 2017).
QE has only helped in the short term but is hurtful to the economy in the long term. Originally, long-run rates of interest decline much more than witnessed in an economy without QE policy. This implies that succeeding economic recovery is realized sooner (tier 1). Nevertheless, as the economy gets up, long-run rates increase abruptly as domestic bond market subjects fear the central bank must mop up each excess reserves by unloading its long-run bonds holdings (Harari 2013).
Subsequently, demand falls in rate of interest sensitive sectors like automobiles as well as housing resulting in slow of economy and compelling the central bank to ease its policy position. The economy will in turn incline towards recovery again, however, as market players reemphasize on probability of central bank absorbing extra reserves, long-run rates outpour in a recurrent cycle christened the QE “trap” (Belke and Polleit 2010).
In economies without QE, tentatively, the drop in long-run rates become additionally gradual, that lags the beginning of recovery (tier 2). Nevertheless, because it is needless to mop up enormous fund quantities by the central banks, everyone is no more at ease once the recovery begins, and the increase in long-run rates remains far more gradual (Angelo 2017). Once the economy begins to turn around, the recovery pace becomes really swifter since rates of interest remain lower as shown below:
To sum up, QE fails in several other ways like failing to assist the economy. It also assist the rich but extremely hurts the poor. It remains among the leading causes of disparity. The runway disparity cripples economy. Thus QE hurts the economy indirectly by escalating runaway disparity as it is nothing but a Ponzi game.
References
Angelo, D., 2017. Impact of Quantitative Easing on the Term Structure of Interest Rates.
Belke, A. and Polleit, T., 2010. How much fiscal backing must the ECB have? The euro area is not (yet) the Philippines. Économie internationale, (4), pp.5-30.
Bibow, J., 2016. From Antigrowth Bias to Quantitative Easing: The ECB’s Belated Conversion?.
Chovancová, B. and Hudcovský, J., 2016. Quantitative Easing in Europe and its Impact on the Stock Market. Montenegrin Journal of Economics, 12(3), p.155.
Goodhart, C.A., 2013. The potential instruments of monetary policy. Central Bank Review, 13(2), p.1.
Harari, D., 2013. Japan’s economy: from the “lost decade” to Abenomics. House of Commons Library, Standard Note SN06629. London: Oct, 24.
Ito, T., 2004. Inflation Targeting and Japan: why has the Bank of Japan not adopted inflation targeting? (No. w10818). National Bureau of Economic Research.
Lavoie, M., 2017. Rethinking monetary theory in light of Keynes and the crisis. Brazilian Keynesian Review, 2(2), pp.174-188.
Makabe, K., 2017. Buying Time: Environmental Collapse and the Future of Energy. University Press of New England.
Murphy, R. and Hines, C., 2010. Green quantitative easing: Paying for the economy we need.
van den End, J.W. and de Haan, J., 2014. Europe’s banking problem through the lens of secular stagnation.
Ziemann, V. and Guérard, B., 2017. Reaping the benefits of global value chains in Turkey.
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