Government & Economy

Tutorial 4 – Monetary Policy

Wednesday, 11am – 12 noon

Briefing Note Question 2: Discuss the main causes of the Global Financial Crisis (2007-2009). How should monetary policy respond in the short term to such a crisis? 0706840s Ahmad Sultan

The Housing Bubble crash in USA and Europe had liquidity repercussions felt by financial sectors worldwide and led to the Global Financial Crisis. Monetary policy is at the heart of this discussion and it has centered around the Taylor Rule which calculates the ideal short term nominal interest rate Central Banks should implement. John B. Taylor (2007) argued that an over-accommodating Federal Funds Rate below the Taylor Rule interest rate by almost 300 basis points was responsible for over-borrowing and, subsequently, the Housing Bubble, during which actual housing starts were, at their height, above the Counter Factual Taylor Rule housing starts by approximately 400 thousand unitsi. But as seen in figure 1 Bernanke (2010) posits a PCE calculated Taylor Rule interest rate (dependent on expectations of inflation rather than real time inflation) which shows that the actual Fed. Rate was almost in line with the Taylor Rule rate. Yet the view of a recession caused by low short-term interest rate has historical significance in USA where out of 14 interest rate tightening cycles since 1955, 10 were followed by a recession within 18 monthsii. However the argument that monetary policy was not significant in explaining the Housing Bubble is highlighted in its inability to prevent the housing bubble from forming: President of the Federal Reserve Bank of New York, William C. Dudley explains that a mixture of non short-term interest related factors like subprime lending and CDOs, followed by a surge in economic activity that led to positive feedback loops of demand-driven credit availability and increased systemic risk all led to the housing bubble and Global Financial Recession. In this light, Taylor’s Counterfactual housing starts curve proves weak because it ignores the above factors that would have increased real estate demand despite the Taylor Rule. Furthermore, the strength of the causation between low interest rate and the Housing Bubble has been challenged. Figure 2 shows that many countries had higher change in real house prices between 2002 and 2006 despite being closer to the Taylor Rule nominal interest rate than USA. Low long-term interest rates created by capital inflows in USA, and countries like Spain and Ireland where larger bubbles were formed despite the European Central Bank rates (2% in 2004) being less aggressive than the Fed. Rate (1% in 2004) further weakened the idea that loose monetary policy was a universal premise of the bubbles. So while low central bank rates were certainly followed by a housing bubble, weak regulatory oversight and increased capital inflows help us better understand the causes of the Global Financial Crisis. As an initial response major central banks should and did lower interest rates to a zero low bound level in hope of boosting aggregate demand by an increase in spending and lowering of long-term real interest rates. (Walsh, 2009) Once the overnight rates have reached the floor level, central banks need to find other ways to inject money into the economy via “balance sheet measures” (Fujita et al., 2010), the two most common policies adopted known as Quantitative Easing (QE) in UK and Credit Easing (CE) in the US. The Bank of England (BoE) describes QE as purchasing assets from private institutions and identifies main outcomes of QE as following: supplying more money to institutions; increasing the asset prices; increasing bank lending as banks’ reserves increase; decreasing the price of borrowing; and increasing total wealth. These aims are expected to be achieved via QE and ultimately increase spending and incomes of households while maintaining the 2% inflation target (BoE, 2010). Based on market reactions to news about QE purchases, Joyce et al. (2010) found that gilt yields were about 100 basis points lower than they would otherwise have been as a result of QE, which estimates suggest mainly came through a portfolio rebalancing effect. CE by comparison is a policy adopted by the Federal Reserve, and “focuses on the mix of loans and securities that the Fed holds and on how this composition of assets affects credit conditions for households and businesses.” (Fed, 2009). The Fed believes that it “must focus its policies on reducing those spreads and improving the functioning of private credit markets.” (Fed, 2009). In the UK, the inflation rate is currently 3.7% (ONS, 2011), above the target level of 2% which makes a second round of QE virtually impossible at this point. However the annual growth of money held by households and non-financial companies in the UK increased by 1.1% in December 2009 (FT, 2010). A study by Taylor showed that the Term Auction Facility launched in order to provide lending directly from the Fed, increasing the flow of credit, and aiming at lowering of spreads in the financial markets did not meet the primary goal set by the Fed but did create some gain in all sets. So while the long term implications are unclear, the short-term implementation of QE and CE prove to create much needed immediate economic reactions for advance economies.

Appendix Figure 1 Figure 2

Bibliography Adrian, Tobias & Estrella, Arturo, 2008. "Monetary tightening cycles and the predictability of economic activity," Economics Letters, Elsevier, vol. 99(2), page 263. Bank of England (BoE). Quantitative Easing Explained. By Bank of England. Mar. 2009. Web. <http://www.bankofengland.co.uk/monetarypolicy/pdf/qe-pamphlet.pdf>. Federal Reserve. "FRB: Speech--Bernanke, The Crisis and the Policy Response--January 13, 2009." Board of Governors of the Federal Reserve System. 10 Feb. 2009. Web. 19 Jan. 2011. <http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm>. John B. Taylor, 2007. "Housing and monetary policy," Proceedings, Federal Reserve Bank of Kansas City, pages 463-476. Joyce, Michael. “The financial market impact of quantitative easing”. Bank of England working paper. August 2010. Accessed online at: www.bankofengland.co.uk/publications/workingpapers/wp393.pdf Office for National Statistics (ONS). "National Statistics Online - Inflation." Home: UK National Statistics Publication Hub. Web. 03 Feb. 2011. <http://www.statistics.gov.uk/cci/nugget.asp?id=19>. Taylor, John. “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”. Stanford University. November 2008. Accessed online at: http://www.stanford.edu/~johntayl/FCPR.pdf Walsh, Carl. “Using monetary policy to stabilize economic activity.” University of California, Santa Cruz. August 20, 2009. Accessed online at: http://www.kc.frb.org/publicat/sympos/2009/papers/Walsh.08.26.09.pdf William C. Dudley, 2010. Asset Bubbles and the Implications for Central Bank Policy, Federal Reserve Bank of New York.

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