On monetary policy and financial markets
- Employment generation in the U.S. has been weaker than expected, threatening the fragile post-pandemic recovery.
- The Bank of Japan’s decision to raise interest rates after years of keeping them low has also rattled financial markets, setting off a reversal of equity flows and a collapse in Asian markets.
- These rapid turnarounds have come on the back of attempts by central banks to combat the problems of inflation and repressed economic activity using the tool of interest rates.
Monetary Policy
- The current consensus regarding monetary policy is to assume a trade-off between unemployment and inflation.
- Central banks raise interest rates as inflation rises, reducing investment and hence slowing aggregate demand.
- This leads to a reduction in the demand for labour, reducing the ability of wage-earners to push for higher wages, and ease inflationary pressures.
- Several have criticised the normal conduct of monetary policy, stressing that solving inflation by increasing unemployment represents an unfair burden being placed on workers everywhere, who are already grappling with a cost-of-living crisis.
- Instead, they argue, inflation could be better tamed by forcing companies to reduce their profit margins and by breaking monopolies.
- The release of a jobs report that showed a less-than-expected increase in employment led to fears of a recession, and caused a rapid sell-off of equity stocks.
- This, coupled with concerns regarding the less-than-expected performance of big tech giants, led to a rout in the stock markets.
- What is of note is that the economy wasn’t actually in a recession, the market just expected one to occur.
- The rise in unemployment rates triggered the “Sahm rule” which mandates the automatic disbursal of unemployment checks to households when the increase in unemployment rates breaches a certain threshold.
- The economy may be displaying the potential for recession, but the threat of a future recession was enough to spark fear amongst investors.
- This indicates one of the problems of conducting monetary policy in the presence of a strong financial sector.
The carry trade
- On the other side of the world, Asian markets were rattled by the increase in interest rates by the Japanese Central Bank following long periods of low rates.
- A long period of economic slowdown in Japan has led to central banks keeping interest rates at levels close to 0.
- Low Japanese interest rates have led to what is known as the “carry trade”, where foreign investors take advantage of low rates to borrow from Japan and invest in foreign markets.
- The increase in interest rates caused a disruption in this form of trade, leading to investors selling stocks in other markets to deal with higher borrowing costs.
- This has added to selling pressures in other markets.
- These incidents highlight the potentially destabilising nature of finance.
- The speed with which financial assets can be bought and sold and the ease at which national borders can be traversed, represents burdens upon the normal conduct of monetary policy.
- As Keynes once said, “When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done.”