Session 12. The New Normal. Deflation and Zero Lower Bound. Deflation and Interest Rates The Zero Lower Bound trap The Great Depression The Great Recession
Deflation and the Zero Lower Bound Trap Deflation is defined as a decline in the aggregate price level. Hence deflation is simply negative inflation. Deflation can be seen as a natural adjustment to weak economic conditions (this is how equilibrium can be restored). In a scenario where nominal interest rates get to zero and because nominal interest rates cannot become negative, additional deflation will make real interest rates increase and reduce growth rates. Traditional monetary policy (lowering interest rates) cannot help and the economy enters a trap of decreased demand, lower GDP growth and even more deflation that further increases real interest rates.
Deflation and the Zero Lower Bound Trap In a deep recession the low level of spending relative to income (the excess of saving relative to investment) might require a negative (real) interest rate. (real) Interest Rate Investment Saving
Deflation and Default Inflation (positive or negative) can produce a redistribution of wealth across borrowers and lenders. Negative inflation (deflation) raises the real value of debt so it redistributes wealth from borrowers to savers. Higher (real) debt will deter consumption and it can also lead to default (as borrowers are hurt) Default can spread over to the financial system as the number of bad loans increases (and possibly banks face the same real increase in their value of their debt).
Financial Crisis: Liquidity, Flight to Quality and Banking Crises In times of uncertainty there is an increase in the demand for liquid assets (currency, government debt). Banks operate in a fractional-reserve system (their liquidity or reserves do not cover all deposits). Their business is to transform short-term liabilities (deposits) into long-term assets (loans, mortgages). An increase in the demand for liquidity can lead a healthy financial institution to become illiquid. Only the central bank can provide the necessary liquidity. An illiquid bank can lead to a bank run: in particular in the absence of insurance on bank deposits, customers will withdraw their deposits as they worry about insolvency. A bank run increases the demand for liquidity and can lead to a collapse of of the banking system.
Banking Crisis: The Unstable Balance Sheet of Banks Commercial Bank Balance Sheet Assets Deposits at Central Bank & Cash Securities (Short & Long Term) Loans to Customers (Short & Long Term) Liabilities Deposits of Customers (Short Term) Loans from Central Bank (Short Term) Debt (Short and Long Term) Equity
Banking Crisis: Balance Sheet of Lehman Brothers February 29, 2008 (Billions of USD) Assets Liabilities Cash 24.13 Accounts payable 96.15 Receivables 52.40 ST debt 428.56 Long Term Investments 695.34 Other current liabilities 28.83 Other LT assets 10.05 Long term debt 207.67 Equity 20.72 Total 781.92 Total 781.92
The Great Depression: Background The Gold Standard. The gold standard was adopted in most countries around the world in the years between 1870 and 1900. This adoption ended a long period of bi-metallic standard in which both gold and silver were used to back the money in circulation. During WWI several countries suspended the gold standard but later it was resumed again (e.g. Britain resumed the gold standard in 1925). The Gold Standard imposes constraints on the way central banks can run their monetary policy and provide liquidity in times when needed. The Great Depression was a world-wide phenomenon every industrialized country underwent some decline in economic activity. For many of these countries the Great Depression led to a sharp increase in unemployment, decline in output and in the abandonment of the Gold Standard (1933 in the US). Usually we consider the years 1929-1933 as the period that we call The Great Depression.
The Great Depression (US)
The Great Depression (US)
The Great Depression: Role of the Central Bank Monetary Base (Currency + Reserves) Money Supply (M1) 14000 50000 45000 11000 8000 5000 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36 40000 35000 30000 25000 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36 65 Price level 1000 Real money balances (M1/P) 60 900 55 800 50 45 700 40 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36 600 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36
The Great Depression: Role of the Central Bank Money Multiplier (C/D + 1)/(C/D+ R/D) 8 7 6 5 4 3 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36
The Great Depression: Role of the Central Bank Ratios 22 18 14 Currency-to-deposit ratio (C/D) 10 Reserves-to-deposit ratio (R/D) 6 Jan-28 Jan-29 Jan-30 Jan-31 Jan-32 Jan-33 Jan-34 Jan-35 Jan-36
The Great Recession Monetary Base (C+R) and Money Supply M1 (C+D) 2300 2100 1900 1700 M1 1500 1300 1100 900 Monetary Base 700 500 2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03
The Great Recession Money Multiplier = Money Supply / Monetary Base= = (C/D + 1)/(C/D+ R/D) 2 1.8 1.6 1.4 1.2 1 0.8 2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03
The Great Recession Ratios 1.6 1.4 1.2 Currency-to-deposit ratio (C/D) 1 0.8 0.6 0.4 0.2 Reserves-to-deposit ratio (R/D) 0 2003.01 2003.04 2004.03 2005.02 2006.01 2006.04 2007.03 2008.02 2009.01 2009.04 2010.03
The Great Depression versus the Great Recession The absence of a deposit insurance mechanism combined with the reluctance of the central bank to serve as the lender of last resort was a key reason for the dramatic output collapse during the Great Depression. In the 2008 crisis the central bank acted in a very different manner. It provided as much liquidity as necessary through several Quantitative Easing rounds. While the US and Europe still faced a deep crisis, they managed to avoid a much worse outcome.
When Interest Rates Reach Zero: Quantitative Easing US Federal Reserve Balance Sheet Assets Loans to Commercial Banks Securities Liabilities Currency Deposits of Commercial Banks Commercial Banks Balance sheet Assets Deposits at Central Bank Loans to Customers Securities Liabilities Deposits from Customers Loans from Central Bank
When Interest Rates Reach Zero: Quantitative Easing Balance sheet of a Central Bank Assets 2007 2009 2010 Liabilities 2007 2009 2010 Loans to banks Securities 755 1,846 2,159 Govt. 755 777 1,010 Agency+MBS 0 1,069 1,149 Currency 760 861 915 Reserves 43 1,139 1,078 Balance sheet of commercial banks Assets 2007 2009 2010 Liabilities Securities Loans Reserves 43 1,139 1,078 Deposits Loans from Central Bank All figures from US Federal Reserve. End of the year. Billions of USD.
When Interest Rates Reach Zero: Quantitative Easing
Bailout or Profit-Making Provision of Liquidity?
Reminder of the Cost of Banking Crisis Governments (not central banks) step in during banking crises and bail out banks by providing capital or taking ownership of private banks. Some examples: US Savings and Loans crisis (80s/90s) $124 billion (about 1% of GDP) Sweden early 90 s: spent 4% of GDP with a final cost of 2% Ireland 2008-09: Guarantees of Euro 70 billion (25% of GDP) England 2008-09: Loan/Share Purchases 123.93 Billion Pounds (8.5% GDP) + Guarantees of 332 billion Pounds. Spain 2012: 40-100 Billion (3%-7% of GDP)
The Slow-Acting ECB Unlike the US Federal Reserve, the ECB did not engage in Quantitative Easing. It raised interest rates in 2011 under the assumption that the crisis was over. It then engage in giving loans to commercial loans with three-year maturity but banks quickly returned the loans and sent the balance sheet of the ECB towards normal levels. It only engaged in Quantitative Easing after the Euro area had already fallen into a second recession.
The Slow-Acting ECB ECB Balance Sheet (First Round of Monetary Expansion) Assets Loans to Commercial Banks Securities Liabilities Currency Deposits of Commercial Banks Commercial Banks Balance sheet Assets Deposits at Central Bank Loans to Customers Securities Liabilities Deposits from Customers Loans from Central Bank
The Slow-Acting ECB
Bank of Japan
Deflation in Japan 8 6 4 2 0-2 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016-4 -6-8 Real GDP Growth Inflation
The Exit Strategy How will Central Banks control monetary policy when the economy goes back to normal? It can undo all purchases of securities. But wouldn t this put upward pressure on interest rate? Yes, but that s what monetary policy does during an expansion, it follows with higher interest rates. It can also keep the securities and simply raise interest rates on reserves to control inflation.
The Exit Strategy Central Bank Balance Sheet Assets Loans to Commercial Banks Securities Liabilities Currency Deposits of Commercial Banks Commercial Banks Balance sheet Assets Deposits at Central Bank Loans to Customers Securities Liabilities Deposits from Customers Loans from Central Bank
Session 12: Summary Interest rates adjust to the state of the business cycle. When inflation is low nominal interest rates should be low. If inflation gets close to zero or becomes negative, interest rates reach the zero lower bound and this might become a trap.