Wednesday, May 7, 2008
Deep Recession Fears Forced Fed to Cut Rates
The following is an article I have found in My Paper, Thursday, April 10, 2008, Page A15 under the "My Money" section. I feel that this is extremely relevant especially to the recently covered topic in Economics on Interest Rates and Monetary Policy, and it involves a number of macro-economic concepts taught in Year 2. Also, I'm glad to find the concepts directly applicable to a real life example.
In this article, the Federal Reserve (central bank in the US) policymakers are adopting an expansionary monetary policy due to worries about a deep recession in the economy. This recession, from my understanding of the article, is caused mainly by a fall in the AD curve, thus slowing economic growth in terms of Real GDP. The solution adopted was to cut its most important interest rate by three quarters of a percentage point to 2.25 percent and to pump more liquidity into the global financial system.
In this post, I will try to apply as many economic concepts as possible to the issues (especially liquidity ones) mentioned in the article as well as to give my own views.
Important points are underlined.
Background Information - Sub-prime Mortgage Crisis
Before going into that, the sub-prime mortgage crisis (underlined in blue) is mentioned as well and it is related to the fall in house rates and a credit slump (credit crunch) that was mentioned. This was due to adjustable rate mortgages made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. Also, loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later.
From the article, "further restriction of credit availability and ongoing weakness in the housing market."
This problem accelerated in late 2006 and triggered the global financial crisis due to a drop in the prices of houses in 206-207 in many parts of ths US, thus making refinancing more difficult. This declination of the value of mortgage assets led to the unwillingness of the borrowers to make payments and incurred huge losses, thus causing lenders to reduce lending activity and leading to the credit crunch or to make loans at higher interest rates. In turn, fewer or more expensive loans decrease investment by businesses and consumer spending and it puts a downward pressure on the economy.
Expansionary Monetary Policy
As mentioned above, this policy has been adopted in that the interest rate has been cut. Also, from the last three paragraphs, we can see that the government is regulating (increasing) the credit demand and supply through Open Market Operations as well. This is made possible by "making as much as US$200 billion worth of Treasuries available". This simply implies that the government is lending Treasury securities by purchasing government securities. This can also serve to increase the liquidity ratio for banks and to increase their credit creating ability, thus increasing the money supply in the economy.
Although increasing the Money Supply can increase consumption directly as well through the direct mechanism, the policy was targeted mainly at increasing investments (indirectly) made by the firms by encouraging more lending and borrowing and hence more funds for worthy borrowers (investment firms). This serves to decrease the downward pressure on the economic growth by stimulating AD.
Setbacks - Inflation
However, as mentioned in the article, the two 'dissents' favoured a smaller cut in interest rates for fear of inflation. This is refering to demand pull inflation, i.e. if the huge cut in the interest rate lead to an excessive rise in AD curve much more than the AS curve in general. Here the article addresses the second problem that the US economy is facing and that the policymakers should take this into account as well, i.e. "soaring energy prices and high food costs."
The writer also mentions about inflation expectations and that people 'will act in ways that will make inflation worse.' This refers to the fact that consumers and firms will bring their anticipated consumption forward and that trade unions may start to demand for higher wages, leading to a rise in production costs and a decrease in the AS and an even higher increase in AD (wage-price spiral). These increases prices without really increasing Real GDP/ Income.
I feel that the pressure on inflation could be lessen if supply side policies were used as well. For example, competition could be encouraged, thus firms would need to cut production costs. This would serve to shift the LRAS to the right and to upkeep the shift in AD curve and hence to reduce the potential inflation.
Also, temporary price controls could be used (though risky) to reduce expectations, once the inflation rate is stabilised, they can be removed.
However, we can also see that there is an interplay of the expansionary monetary policy and supply-side policy in that encouraging investments wil not oly boost AD in the short run to counter recession, but also increases the productive capacity of the economy, causing LRAS to shift to the right.
Towards the end, it is also mentioned in the article that economists expect the Fed to lower interest rates in view of the faltering employment market and hence another problem in the US economy is identified. This (stimulating AD) will thus serve to reduce cyclical unemployment, which is caused by a lack of AD.
I find that by reading articles which we've actually found on our own, instead of only reading the examples in the notes and case studies in tutorials, we can further convince ourselves (and others) that what we learn in Economics, especially on macro, is indeed useful and applicable. The article above mentions about the recession, the central bank, monetary policy and the steps used in it to regulate money supply, and also inflation. Such concepts would be boring if we only learn it in theory without applying it to real life scenarios.
Furthermore, there is a sense of achievement when I find that I can understand what most parts of the article is addressing. For example, terms like 'Treasury securities' and 'restriction of credit availability' would have sounded totally unfamilar to me if I have not taken Economics. Also, I wouldn't have realised what the writer is talking about when mentioning that 'people will act in ways to make inflation worst' and that 'the Fed said it would make as much as US$200 billion worth of Treasuries available.' I must again say that I am glad to find an article in which the concepts we learn in a recent topic is directly applicable to a real economy. This serves as a means to consolidate my learning as well.
Damian Boh 07S6G
In this article, the Federal Reserve (central bank in the US) policymakers are adopting an expansionary monetary policy due to worries about a deep recession in the economy. This recession, from my understanding of the article, is caused mainly by a fall in the AD curve, thus slowing economic growth in terms of Real GDP. The solution adopted was to cut its most important interest rate by three quarters of a percentage point to 2.25 percent and to pump more liquidity into the global financial system.
In this post, I will try to apply as many economic concepts as possible to the issues (especially liquidity ones) mentioned in the article as well as to give my own views.
Important points are underlined.
Background Information - Sub-prime Mortgage Crisis
Before going into that, the sub-prime mortgage crisis (underlined in blue) is mentioned as well and it is related to the fall in house rates and a credit slump (credit crunch) that was mentioned. This was due to adjustable rate mortgages made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. Also, loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later.
From the article, "further restriction of credit availability and ongoing weakness in the housing market."
This problem accelerated in late 2006 and triggered the global financial crisis due to a drop in the prices of houses in 206-207 in many parts of ths US, thus making refinancing more difficult. This declination of the value of mortgage assets led to the unwillingness of the borrowers to make payments and incurred huge losses, thus causing lenders to reduce lending activity and leading to the credit crunch or to make loans at higher interest rates. In turn, fewer or more expensive loans decrease investment by businesses and consumer spending and it puts a downward pressure on the economy.
Expansionary Monetary Policy
As mentioned above, this policy has been adopted in that the interest rate has been cut. Also, from the last three paragraphs, we can see that the government is regulating (increasing) the credit demand and supply through Open Market Operations as well. This is made possible by "making as much as US$200 billion worth of Treasuries available". This simply implies that the government is lending Treasury securities by purchasing government securities. This can also serve to increase the liquidity ratio for banks and to increase their credit creating ability, thus increasing the money supply in the economy.
Although increasing the Money Supply can increase consumption directly as well through the direct mechanism, the policy was targeted mainly at increasing investments (indirectly) made by the firms by encouraging more lending and borrowing and hence more funds for worthy borrowers (investment firms). This serves to decrease the downward pressure on the economic growth by stimulating AD.
Setbacks - Inflation
However, as mentioned in the article, the two 'dissents' favoured a smaller cut in interest rates for fear of inflation. This is refering to demand pull inflation, i.e. if the huge cut in the interest rate lead to an excessive rise in AD curve much more than the AS curve in general. Here the article addresses the second problem that the US economy is facing and that the policymakers should take this into account as well, i.e. "soaring energy prices and high food costs."
The writer also mentions about inflation expectations and that people 'will act in ways that will make inflation worse.' This refers to the fact that consumers and firms will bring their anticipated consumption forward and that trade unions may start to demand for higher wages, leading to a rise in production costs and a decrease in the AS and an even higher increase in AD (wage-price spiral). These increases prices without really increasing Real GDP/ Income.
I feel that the pressure on inflation could be lessen if supply side policies were used as well. For example, competition could be encouraged, thus firms would need to cut production costs. This would serve to shift the LRAS to the right and to upkeep the shift in AD curve and hence to reduce the potential inflation.
Also, temporary price controls could be used (though risky) to reduce expectations, once the inflation rate is stabilised, they can be removed.
However, we can also see that there is an interplay of the expansionary monetary policy and supply-side policy in that encouraging investments wil not oly boost AD in the short run to counter recession, but also increases the productive capacity of the economy, causing LRAS to shift to the right.
Towards the end, it is also mentioned in the article that economists expect the Fed to lower interest rates in view of the faltering employment market and hence another problem in the US economy is identified. This (stimulating AD) will thus serve to reduce cyclical unemployment, which is caused by a lack of AD.
I find that by reading articles which we've actually found on our own, instead of only reading the examples in the notes and case studies in tutorials, we can further convince ourselves (and others) that what we learn in Economics, especially on macro, is indeed useful and applicable. The article above mentions about the recession, the central bank, monetary policy and the steps used in it to regulate money supply, and also inflation. Such concepts would be boring if we only learn it in theory without applying it to real life scenarios.
Furthermore, there is a sense of achievement when I find that I can understand what most parts of the article is addressing. For example, terms like 'Treasury securities' and 'restriction of credit availability' would have sounded totally unfamilar to me if I have not taken Economics. Also, I wouldn't have realised what the writer is talking about when mentioning that 'people will act in ways to make inflation worst' and that 'the Fed said it would make as much as US$200 billion worth of Treasuries available.' I must again say that I am glad to find an article in which the concepts we learn in a recent topic is directly applicable to a real economy. This serves as a means to consolidate my learning as well.
Damian Boh 07S6G
