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Monetary policy and housing markets: interactions and side effects

By Ernest Gnan, Oesterreichische Nationalbank (OeNB) and the European Money and Finance Forum. 1

Monetary policy influences housing prices through the level of interest rates (cost of credit, discount rate, attractiveness vis-à-vis other investments). The housing market affects aggregate demand through construction activity and its influence on consumption (wealth and income effects). Housing booms and busts can threaten financial and macroeconomic stability, and thus ultimately also feed through to consumer price inflation. Central banks can thus not ignore housing market developments. But monetary policy is too crude an instrument to target house prices. A new class of instruments – macroprudential policies – has been created and fills this gap since the Global Financial Crisis. Moreover, housing prices are substantially driven by structural housing policies which affect housing supply and demand. At the same time, including owner-occupied housing in the consumer price basket helps to adequately feed this important part of households’ expenditure into central banks’ reaction functions. While monetary policies worldwide have undoubtedly played a central role in containing the economic fallout from COVID-19, potential side effects, such as shooting up housing prices, and the proportionality of long-lasting unconventional monetary policy measures need to gain increasing attention as economies are bouncing back from the COVID crisis.

Why should central banks pay attention to a specific sector such as the housing market?

Central banks worldwide are mandated with ensuring price stability, subject to this (or in parallel with, as in the US Fed) also with supporting growth and employment. Their price stability objective is usually coined in terms of consumer price inflation. Monetary policy is a rather “crude” instrument, which affects aggregate demand broadly, and cannot usually be targeted towards developments in specific sectors. So, why should monetary policy care about developments in a specific sector such as the housing market?

There are several channels in which housing is relevant for the transmission of monetary policy impulses such as changes in official interest rates or in bond market yields through QE. First, the level of short-term and long-term interest rates influences mortgage credit rates. So, it makes purchasing a home more (or less) affordable. Thus, demand for housing – and thus employment, aggregate demand and ultimately also consumer price inflation – rises (or falls). Mortgage loans make up 77% of euro area households’ total borrowing (ECB, 2021). The growth of euro area mortgage loans continued its upward trend observed since 2016 to reach around 5% in nominal terms most recently.  In 2019, in the EU and euro area gross value added in the construction sector made up 5.4% and 5%, respectively, of GDP, with a wide range of 1.7% to 7.4% across EU countries, though. Construction projects are typically financed to a substantial extent through credit. So, financing costs exert a potentially strong effect on construction activity.

Figure 1. Housing makes up a major part of households’ lending and is an important economic sector

Positive and negative wealth and income effects from house price rises

Second, the value of an asset is influenced by the net present value of the stream of income from this asset. In the case of housing, this income can either be rental income or the implicit income from using the house (in the case of owner-occupied housing). If the discount rate falls (as implied by lower official interest rates), then the net present value of a home rises. Looser monetary policy thus, ceteris paribus, raises real estate prices. This rise in housing prices can affect household consumption in various ways. First, it can entail that households feel richer and can take out an additional mortgage on their house, to finance other expenditures. In this case, we observe a positive wealth effect. Conversely, rising house prices can also imply that for instance young households need to spend a higher fraction of the disposable income on housing, leaving less for other consumption (see e.g. OECD, 2021). In this case, there would be a negative income effect from rising house prices. Whether the positive or negative wealth and income effects prevail, depends on the fraction of homeowners versus tenants and demographic factors. If, for instance homeowners benefiting from wealth increases have a lower propensity to consume than those just buying a home, the net effect on aggregate consumption will likely be negative.

Similarly, rising rents (which are the likely consequence, with some lag and to a certain extent, depending on countries’ institutional and legal frameworks, of higher house prices) will benefit landlords, while tenants will have less of their income left for other consumption. Assuming that renters are wealthier and have a lower propensity to consume than tenants, then a rise in house prices and rents will on aggregate dampen consumption for non-housing goods. A very similar argument applies to households which take out a loan to finance their homes: higher house prices imply the need for a bigger loan, implying lower disposable household income after loan servicing.

Thus, the wealth and income effects from residential price swings also imply substantial redistributive effects across individuals and demographic groups (see e.g. OECD, 2021).

Figure 2. Real estate price developments in the euro area

Source: ECB (2021).

Housing booms and busts threaten financial and macroeconomic stability

There is a second reason why central banks carefully look at housing market developments, which has gained prominence in the Global Financial Crisis (GFC): housing market bubbles can trigger and fuel economic booms, which subsequently end up in deep busts. Monetary policy can fuel such housing booms by making credit very cheap, thus encouraging excessive leverage among households. Real estate booms can also, at a more structural level, entail that an excessive fraction of economic activity goes into construction (as was the case in several countries prior to the GFC). Once the housing bubble bursts, a deep financial crisis can be the result, which requires the central bank to take emergency measures to prevent a collapse of the financial system, but also to dampen the resulting recession and the accompanying excessive fall of consumer price inflation, way below the central bank’s target, potentially even into negative territory. Some economists thus argue that central banks should “lean against the wind” in the face of rising real estate prices. Even if the central bank might not target asset prices, leaning against the wind might be justified since it also helps to cushion excessive swings in consumer price inflation which may be triggered by real estate booms and busts. Others argue that such “preemptive” monetary policy tightening entails high macroeconomic costs in terms of foregone employment and output. Monetary policy is, according to this view, too crude a tool to take real estate prices into account and should exclusively focus on consumer price inflation.

Macroprudential policies as a new tool to address housing cycles

This is why, notably after the GFC, a consensus has emerged that an additional set of instruments, “macroprudential rules”, should be applied to cool down overheating asset price developments, e.g. by raising loan-to-value ratios or loan service-to-income ratios applied by banks when they grant housing credits (see e.g. ESRB, 2021, ECB, 2021 and OECD, 2021). These new policies have been implemented around the world and experience is accumulating in their application. Note, however, that in practice the stylized notion of two totally separate tools for two clearly distinct economic goals – monetary policy to stabilize consumer price inflation, and macroprudential policies to prevent asset booms and busts – does not fully do justice to a far more complex reality.

Including owner-occupied housing in consumer price inflation to better reflect households’ comprehensive cost of living developments in central banks’ reaction functions

One way how home prices feed into the central bank’s reaction function is by including the cost of accommodation in the consumer price index. This is already the case for rents. By contrast, at least in most European countries, it is not yet the case for owner-occupied homes. This implies that the cost of housing for owner-occupiers (including e.g. young families buying a home) is neglected in the measurement of consumer prices and thus in the central bank’s reaction function; it also implies that house price bubbles risk to escape the central bank’s formal reaction function. Including owner-occupied housing is thus useful for improving the metrics used to inform monetary policy.

Side effects and proportionality of monetary expansion gain weight as economies bounce back from COVID

Another way how asset price developments, including house prices, can enter the central bank’s reaction function is through explicit consideration of side effects and the proportionality of monetary policy measures. Not even the best medicine comes without side effects. To take the current situation of the COVID crisis, clearly central banks had to step in to contain damage to our economies. Central banks are aware of the “side effects” of these policies, such as rising stock prices but also, in many countries, further rising house prices. To contain the latter, e.g. the ECB explicitly excluded mortgage credit from eligibility for meeting banks’ lending benchmarks in order to benefit from preferential interest rates on the ECB’s Targeted Long-Term Refinancing Operations (TLTROs).

As mentioned, asset price increases in general, and housing price rises more specifically, may also entail large wealth gains for those already owning these assets, implying large distributive effects. Stronglyexpansionary, unconventional monetary policies over long periods thus ultimately raise the question of proportionality. It is not straightforward how to weigh the benefits against the (potential) costs – there is substantial uncertainty and any decisions ultimately rely on careful judgement. What seems clear, though, is that as the duration of expansionary monetary policy measures extends and as signs of “exuberance” in asset markets including residential real estate markets intensify, while the economy seems clearly back on track, the case for taking side effects and proportionality duly into account is becoming more urgent. 

References

ECB (2021). Financial Stability Review, May.

ESRB (2021). Lower for longer – macroprudential policy issues arising from the low interest rate environment June 2021. Report by the Joint Task Force of ESRB Advisory Technical Committee (ATC), ESRB Advisory Scientific Committee (ASC), and ESCB Financial Stability Committee (FSC), June.

Fell, J., and T. Shakir (2021). May 2021 Financial Stability Review. Presentation at SUERF-Baffi Bocconi Webinar, May 19, 2021.

OECD (2021), Brick by Brick: Building Better Housing Policies, OECD Publishing, Paris, https://doi.org/10.1787/b453b043-en.




Will new monetary policy frameworks succeed in achieving inflation targets?

By Damien Puy, Łukasz Rawdanowicz and Kimiaki Shinozaki, OECD Economics Department

Monetary policy has been successful in influencing financial markets, the first stage of monetary policy pass‑through to demand and inflation. But over the past two decades, core inflation in advanced economies has rarely risen above targets. Recently discussed and implemented changes to monetary policy frameworks, which all depend crucially on the inflation expectations channel, could help improve the effectiveness of monetary policy and achieve stable and higher inflation. However, challenges with controlling inflation expectations, the uncertainty surrounding their effect on demand, along with continued structural changes holding down inflation all point to caution (OECD, 2020).

Monetary policy reviews

A combination of deep structural changes and unexpected shocks has challenged the way monetary policy is conducted in many advanced countries. The secular decline in productivity growth and inflation, along with the reduction in the so-called neutral interest rates, which balance aggregate demand and supply, have significantly increased the risk that policy rates hit the zero lower bound. The global financial crisis and the COVID-19 pandemic, both of which prompted very accommodative policy and an enlargement of monetary policy tools, including purchases of public and private assets, forward guidance and negative policy interest rates, further highlighted the limits of conventional monetary policy measures.

In this context, radical and comprehensive alternatives to current frameworks have been discussed in both academic and policy circles and several central banks in advanced economies have embarked on formal monetary policy reviews. The alternatives include raising the inflation target and one of the so-called make-up strategies, like targeting an explicit price (or nominal GDP) level, where past misses of the target should be compensated in the future. Their efficacy crucially hinges on the population’s understanding of, and reaction to, monetary policy commitments and strong effects of demand-supply imbalances on inflation – i.e. a steep Phillips curve. The Bank of Japan’s “inflation‑overshooting commitment” announced in September 2016 can be regarded as a form of a make-up strategy. Similarly, the switch to a flexible form of average inflation targeting (FAIT) will take the US Federal Reserve closer to a price-level targeting, since the FOMC will de facto aim to make up for past inflation misses. The ECB is in the process of reviewing its framework.

Inflation expectations

When interest rates are low and close to the ZLB, the scope to stimulate demand through yield curve changes, and in turn inflation, is limited. In this case, inflation expectations become the main available channel to boost inflation, as assumed by many make-up strategies. However, three challenges may reduce the effectiveness of inflation expectations as a practical policy channel.

  • Although firms set prices of most goods and services, little is known about their inflation expectations. Surveys of firms’ aggregate inflation expectations are rare and of limited quality, in contrast to surveys of households’ expectations (Coibion et al., 2020a).
  • Both households and businesses are generally poorly informed about realised and expected inflation, or inflation targets, and their expectations have been persistently above targets (figure below). Households have a limited understanding of monetary policy announcements and expectations of neither households nor firms seem to respond much to such communications (Coibion et al., 2020a; Coibion et al., 2020b).
  • Evidence is mixed about the impact of inflation expectations on households’ consumption. Under some circumstances, households’ expectations about future price changes can have a powerful impact on their consumption decisions (like for VAT rate increases). However, a durable boost to household consumption due to monetary policy forward‑guidance, even when well understood by consumers, may be less certain. Higher expected inflation may not stimulate aggregate consumption durably if real income is expected to decline or stagnate. With constant nominal income, higher inflation could just shift demand from non-essential goods and services to necessities. Higher inflation may also increase perceived uncertainty and result in higher household saving. Moreover, the effects of monetary policy are uncertain and refer to a distant future, which may be discounted by households and businesses in their consumption and investment decisions.

Structural shifts in supply and demand

Over the past three decades, a combination of structural changes in advanced economies, which are largely beyond monetary policy decisions and communications, have aggravated the challenge for central banks in attaining their inflation targets.

  • Globalisation, technological progress and market concentration: The integration of low-wage emerging‑market economies, in particular China, into global value chains (GVCs) combined with trade liberalisation over the past three decades has led to a substantial decline in production costs, expanded supply massively and increased import competition, putting a downward pressure on domestic producer goods prices. Globalisation has also coincided with a rapid technological progress in the production of many goods or their components, including electronics, adding to downward price pressures. The ensuing stronger import competition and rising market concentration can reduce the pass-through from wages to prices in goods-producing sectors.
  • Retail sector and network industries: In the United States, over the past three decades, the retail sector has changed from one with many small firms to one dominated by large firms, with large retailers increasingly sourcing from China (Smith, 2019). The rise of general merchandisers selling goods from different industries could have led to reduced margins on some goods to attract clients as profits are maximised at the chain level and not for individual goods. The past decades have also witnessed a global rise of e‑commerce, which could have damped prices by increasing price transparency and eroding profit margins, notably in some traditionally face-to-face businesses. A growing importance of network industries in services (like communication, TV and music streaming services, air transport) has also likely contributed to muted inflation developments. Maximisation of their profits depends on market share gains, limiting possibilities to increase prices persistently.
  • Weakening demand and large supply: Limited price pressures resulting from globalisation and technological progress may have been weakened further by the relative saturation of demand for many durable goods compared with ample production capacities. When a new product is developed, demand for it grows very fast and income elasticity of demand is high, stimulating production capacity and technological progress and leading over time to lower prices. When the desired level of possession of the product has been attained, “new demand” for buying the good for the first time vanishes and demand is driven by replacement or renewal motives only. As this phenomenon may affect many durable household products in advanced economies (cars, home appliances, etc.), the scope to increase prices for such goods, that still account for a considerable part of the consumption basket, may be limited by the fear of a fall in demand.

If the above structural trends persist in advanced economies, central banks may continue to struggle to achieve persistently higher inflation in the future. There is, however, large uncertainty about future structural developments, partly related to uncertain long-term impacts of the COVID-19 crisis.

Bibliography

Coibion, O., Y. Gorodnichenko, E. S. Knotek II and R. Schoenle (2020a), “Average Inflation Targeting and Household Expectations”, Federal Reserve Bank of Cleveland Working Paper, 20-26.

Coibion, O., Y. Gorodnichenko, S. Kumar and M. Pedemonte (2020b), “Inflation Expectations as a Policy Tool?”, Journal of International Economics, 124.

OECD (2020), “Issue Note 3. Post-financial- crisis changes to monetary policy frameworks: Driving factors and remaining challenges”, in Chapter 2 of OECD Economic Outlook, Volume 2020, Issue 2, OECD Publishing, Paris.

Smith, D. (2019), “Concentration and Foreign Sourcing in the U.S. Retail Sector”, 2019 Meeting Papers, 1258, Society for Economic Dynamics.




Right here, right now: The quest for a more balanced policy mix

Laurence Boone, Chief Economist, OECD and Marco Buti, Director General, DG Economic and Financial Affairs, European Commission

After years of solid growth, worldwide economic activity has slowed down sharply in 2019 while global trade has stalled. Policymakers have the difficult task of addressing the immediate policy challenges to support economic growth while also preparing our economies for the future. This column argues that while monetary policy is widely recognised as facing increasing constraints, fiscal policy and structural reforms need to play a stronger role. In particular, fiscal policy could become more supportive, notably in the euro area. Undertaking the right type of public investment now – in infrastructure, education or to mitigate climate change – would both stimulate our economies and contribute to making them stronger and more sustainable.

Over the past few years, economies in the OECD and in particular in the EU had been growing at cruising speed, after having seemingly shrugged off the remains of the global financial crisis. The US is experiencing its longest bout of uninterrupted positive GDP growth on record. Similarly, despite lower growth performance, the EU has been growing for 25 quarters and its unemployment rate is now at its lowest since 2000.

Yet, worldwide growth has been decelerating sharply in 2019, dragged by a global trade and investment slump along with, in Europe and most notably in Germany, a steep drop in manufacturing activity. Recent indicators suggest that growth could weaken further (IMF 2019). Rising uncertainty has been driving this slowdown, as a result of increasing economic tensions between China and the US, geopolitical developments in the Middle East (with the associated risk of a sharp rise in oil prices), and the political deadlock over Brexit. The materialisation of these risks could put the world economy on a collision course. Even if they remain only looming threats, high and increasingly entrenched uncertainty is sufficient to put a brake on investment and growth.

The impact of these tensions is exacerbated by a number of structural developments, in particular in Europe. The drop in potential growth, evident since the 2000s, has prompted concerns of ‘secular stagnation’ affecting the US and Europe. An important driver could be the slow diffusion of technologies: as Anzoategui et al (2019) argue, much of the slowdown in productivity after the recession can be attributed to lower technology adoption. In addition, demographic change is taking a toll on growth potential while the appetite for reforms has slowed.

A better policy set-up is needed to lift economies back to growth

The conjunction of cyclical and structural impediments to growth calls for a review of the customary economic policy response to a deteriorating economic climate. Current inflation and policy rates, which are expected to remain at their low levels, suggest that ever more accommodative monetary policy will not be enough to revive GDP growth. At the same time, nominal GDP growth rates being above interest rates paid on public debt for most countries, and set to remain there for long, increase the space for public investment.

Since the outset of the financial crisis, monetary policy has remained exceptionally accommodative, bringing interest rates close to zero (see Figure 2). In particular, the Fed continues to take expansionary measures, while the Bank of Japan maintains an extraordinary degree of monetary accommodation. Zooming in on the euro area, the ECB announced a fresh stimulus package in September as it cut the deposit rate further by 10 basis points and relaunched its quantitative easing (QE) programme, together with expanded forward guidance. However, monetary policy faces increasing constraints.

The other policy instruments in the toolbox – both fiscal and structural – thus need to help. Together with the structural reforms needed to lift productivity durably, public investment could be put to use to halt the ongoing slowdown and prepare the ground for stronger and more sustainable economies. In fact, the same factors that constrain monetary policy are a bonanza for fiscal policy, which jointly with structural reforms can lift growth in a sustainable way.

Fiscal interventions are more powerful when inflationary pressures are low and monetary policy is likely to accommodate fiscal expansions as long as inflation remains below target. The euro area as a whole has fiscal room to manoeuvre, even though the situation differs markedly across countries. But while the slowdown is becoming entrenched, under current plans, fiscal levers are not being activated: on average in the euro area, the fiscal stance is expected to be broadly neutral in the next two years.

At the same time, the appetite for reforms with potential to lift growth and employment in the longer term – such as easing barriers to entrepreneurship, improving and expanding training, and supporting R&D and technology adoption – has waned, as shown by the implementation of the Going for Growth recommendations (OECD 2019a) or EU country-specific recommendations. Yet, such reforms are needed to reverse the slowdown in productivity that started even before the crisis but was exacerbated by the hysteresis effects of the Great Recession on investment and skills. Structural reforms are also needed to make growth more environmentally sustainable, by aligning policies and regulation with the goal of transition to a low-carbon economy (OECD 2015).

In addition, reforms are easier to implement when accompanied by a supportive policy mix, while in times of faltering demand, structural reforms alone may weigh on inflation and already weak demand (Eggertsson et al. 2014). In effect, reforms introduced when the economy is weak have a better chance of succeeding when undertaken together with supportive macroeconomic policies and renewed public investment, and when they put more weight on measures that also boost demand in the short term, such as strengthening job search assistance and training and improving the tax structure (Caldera Sanchez et al. 2016). Simulations on the euro area run by the OECD for its Economic Outlook illustrate how combining a temporary public investment push with productivity-enhancing reforms can help bring forward the long-term benefits of reforms (OECD 2019b,c).

There is a strong case for a more supportive fiscal policy in the euro area

In the euro area, the inadequacy of a policy mix relying exceedingly on the monetary policy pillar is becoming particularly obvious, as notably emphasised by the institution itself (Draghi 2019). Meanwhile, the ‘reflationary’ efforts conducted by the ECB are meeting increasing resistance both within and outside the institution.

Consequently, the usual arguments for relying mainly on automatic budgetary stabilisers and monetary policy when dealing with adverse shocks to the euro area may have to be reconsidered. In particular, modelling work done by the European Commission (In’t Veld 2019) shows that when monetary policy is constrained by the zero-rate floor, fiscal stimulus has a stronger impact on growth in the short term and a more benign effect on the debt ratio in the long term.

While the benefits of a more supportive fiscal policy already appear sizeable at the current juncture, depending on how events unfold, the failure to act could result in snowballing negative effects going much beyond those captured in the usual simulations. In particular, the lack of action may increase the risk of the economy moving to inferior equilibria where deteriorating expectations of growth, employment and price developments, as well as private sector balance sheet effects, may further add to the current downward spiral. In these circumstances, the costs of too little stimulus in a worsening economy are likely to outweigh the costs of too much stimulus should a more favourable scenario materialise. The large compounded downward risks call for a risk-based approach to fiscal policy, with more pre-emptive rather than reactive policy action.

In absence of a common euro area budget, the current situation offers an opportunity for a truly coordinated approach to a supportive but differentiated fiscal stance in the 2020 budget plans. A more active role for fiscal policy in the policy mix would require differentiation between Member States with fiscal space and Member States with high debt, taking into account the divergent sustainability challenges. Furthermore, it is also important to improve the quality and composition of public finances, in particular boosting investment to ease the climate transition, and step up structural reforms.

Illustrative simulations with the Commission’s QUEST model suggest that an increase in public investment of 1% of GDP for two years in Member States with fiscal space, with monetary policy at the zero lower bound, leads to GDP increases of around 1% during that period in the concerned Member States and slightly less for more open economies (Figure 3). In the medium run, even after the stimulus has been removed, output remains above the baseline due to productivity gains from higher investment. Spillovers to other euro area Member States are modest at around 0.1-0.2% of GDP. The resulting effects of a temporary fiscal stimulus on debt to GDP ratios are benign, thanks to higher growth. In the Member States with fiscal space, the debt-to-GDP ratio would increase around by 1½ percentage points in the short run, fading out in the long run. A more persistent expansion in public investment in surplus countries, which would correct past cutbacks, would give a bigger boost to the euro area economy, with larger spillovers to other countries and still a manageable increase in debt ratios compared to the baseline scenario (In’t Veld 2016). Where interest rates are negative, as is presently the case for most countries, the debt dynamics are even more favourable.

High fiscal multipliers and benign effects on debt developments rely on the nature of the fiscal impulse. Investment spending, which supports the economy’s productive capacity and is time-limited in nature, has a stronger impact. A differentiated investment stimulus in line with the spirit of the EU fiscal framework would be most effective.

Now is the time to invest in stronger and more sustainable economies for the future

The case for a more active use of fiscal policy is not only rooted in the critical role it must play to drag weak economies out of the risk zone. The current situation also offers an opportunity not to be missed to address deep economic challenges and invest in the future. The low interest rates at which governments are borrowing, even at long maturities, mean that many of them can more easily undertake investments to raise long-term growth, sustainability and wellbeing without putting strain on public finances.

In the aftermath of the global financial crisis, governments often resorted to cuts in public investment to achieve fiscal consolidation in a way deemed less painful than raising taxes or cutting social spending or the public sector wage bill. Throughout the post-crisis period, this shortfall in public investment has not been made up for. A decade of infrastructures that were not built or were not properly maintained has been taking its toll on productivity and growth potential. It risks turning into persistently missed chances to better connect people, firms and regions to opportunities.

Some countries, such as Germany, are in dire need of stronger investment. Across the EU, almost half of firms are held back in their investment decisions by the inadequacy of transport infrastructure, and the same number by the lack of access to digital infrastructure (Figure 4). High-speed networks are the backbone of a knowledge economy and a pre-condition for firms to innovate and thrive in the near future. Bridging the rural digital divide is also key to reduce regional disparities and improve social cohesion. Further investment in health, education and skills would also support a more durable and more inclusive growth.

At the same time, the need to invest in greening our economies is becoming ever more pressing, as delaying action will entail steeply rising costs of climate change mitigation (IPCC 2018). The growing scale and reach of climate-motivated demonstrations and civil disobedience actions in recent months have given a political urgency to the issue. The energy transition will require more investments – and different investments than under the current trajectory – to decarbonise entire sectors starting with energy, industry and transport. In the EU, President-elect van der Leyen has announced a “Green Deal” to accelerate the transition towards achieving carbon neutrality by 2050 (van der Leyen 2019). Such an initiative could mobilise public and private resources to lift innovation and investment in low-carbon technologies and build more sustainable economies.

Authors’ note: The authors are writing in their personal capacity and their opinions should not be attributed to the OECD or the European Commission. They would like to thank Dorothée Rouzet (OECD), Sven Langedijk and Nicolas Philiponnet (both European Commission) for their support and assistance on this column. 

This post was previously released on 18 October 2019 on the VOX CEPR Policy Portal

References

Anzoategui D, D Comin, M Gertler and J Martinez (2019), “Endogenous Technology Adoption and R&D as Sources of Business Cycle Persistence,” American Economic Journal: Macroeconomics 11(3): 67-110.

Caldera Sánchez, A, A de Serres and N Yashiro (2016), “Reforming in a difficult macroeconomic context: A review of the issues and recent literature“, OECD Economics Department Working Paper No. 1297.

Draghi M (2019), Hearing at the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 23 September.  

Eggertsson G, A Ferrero and A Raffo (2014), “Can structural reforms help Europe?”, Journal of Monetary Economics 61: 2-22.

European Investment Bank (2018), EIB Investment Survey

IMF (2019), World Economic Outlook 2019: Global Manufacturing Downturn, Rising Trade Barriers, October. 

In’t Veld, J. (2016), “Public Investment Stimulus in Surplus Countries and their Euro Area Spillovers”, Economic Brief N°16, European Economy. 

In’t Veld, J. (2019), “Productive spending and public debt in a low interest rate environment”, mimeo. 

IPCC (2018), Global Warming of 1.5 ºC.

OECD (2015), Aligning Policies for a Low-carbon Economy, OECD Publishing.

OECD (2019a), Economic Policy Reforms 2019: Going for Growth, OECD Publishing.  

OECD (2019b), OECD Economic Outlook, Volume 2019 Issue 1, OECD Publishing.  

OECD (2019c), OECD Economic Outlook, Interim Report September 2019, OECD Publishing.

Von der Leyen, U (2019), “A Union that strive for more – Political guidelines for the next European Commission 2019-2024”, European Commission.82




Policymakers: Act now to break out of the low-growth trap and deliver on our promises

By Catherine L. Mann, OECD Chief Economist

Policymaking is at an important juncture. Without comprehensive, coherent and collective action, disappointing and sluggish growth will persist, making it increasingly difficult to make good on promises to current and future generations.

Global growth has languished over the past eight years as OECD economies have struggled to average only 2 per cent per year, and emerging markets have slowed, with some falling into deep recession. In this Economic Outlook the global economy is set to grow by only 3.3 per cent in 2017. Continuing the cycle of forecast optimism followed by disappointment, global growth has been marked down, by some 0.3 per cent, for 2016 and 2017 since the November Outlook.

The prolonged period of low growth has precipitated a self-fulfilling low-growth trap. Business has little incentive to invest given insufficient demand at home and in the global economy, continued uncertainties, and a slowed pace of structural reform. In addition, although the unemployment rate in the OECD is projected to fall to 6.2 per cent by 2017, 39 million people will still be out of work, almost 6.5 million more than before the crisis. Muted wage gains and rising inequality depress consumption growth. Global trade growth, at less than 3 per cent on average over the projection period, is well below historical rates, as value-chain intensive and commodity-based trade are being held back by factors ranging from spreading protectionism to China rebalancing toward consumption-oriented growth.

Negative feedback-loops are at work. Lack of investment erodes the capital stock and limits the diffusion of innovations. Skill mismatches and forbearance by banks capture labour and capital in low productivity firms. Sluggish trade prospects slow knowledge transfer. These malignant forces slow down productivity growth, constraining potential output, investment, and trade. In per capita terms, the potential of the OECD economies to grow has halved from just below 2 per cent 20 years ago to less than one per cent per year, and the drop across emerging markets is similarly dramatic. The sobering fact is that it will take 70 years, instead of 35, to double living standards.

The low-growth trap is not ordained by demographics or globalization and technological change. Rather, these can be harnessed to achieve a different global growth path – one with higher employment, faster wage growth, more robust consumption with greater equity. The high-growth path would reinvigorate trade and more innovation would diffuse from the frontier firms as businesses respond to economic signals and invest in new products, processes, and workplaces.

What configuration of fiscal, monetary, and structural policies can propel economies from the low-growth trap to the high-growth path, safeguarding living standards for both young and older generations?

Monetary policy has been the main tool, used alone for too long. In trying to revive economic growth alone, with little help from fiscal or structural policies, the balance of benefits-to-risks is tipping. Financial markets have been signalling that monetary policy is overburdened. Pricing of risks to maturity, credit, and liquidity are so sensitized that small changes in investor attitude have generated volatility spikes, such as in late 2015 and again in early 2016.

Fiscal policy must be deployed more extensively, and can take advantage of the environment created by monetary policy. Governments today can lock in very low interest rates for very long maturities to effectively open up fiscal space. Prioritized and high-quality spending generates the capacity to repay the obligations in the longer term while also supporting growth today. Countries have different needs and initial situations, but OECD research points to the kind of projects and activities that have high multipliers, including both hard infrastructure (such as digital, energy, and transport) and soft infrastructure (including early education and innovation). The right choices will catalyse business investment, which, as the Outlook of a year ago argued, is ultimately the key to propelling the economy from the low-growth trap to the high-growth path.

The high-growth path cannot be achieved without structural policies that enhance market competition, innovation, and dynamism; increase labour market skills and mobility; and strengthen financial market stability and functioning. As outlined in the special chapter in this Outlook, the OECD’s Going for Growth and the comprehensive Productivity for Inclusive Growth Nexus Report of the OECD Ministerial Summit, there is a coherent policy set for each country based on its own characteristics and objectives that can raise productivity, growth and equity.

The need is urgent. The longer the global economy remains in the low-growth trap, the more difficult it will be to break the negative feedback loops, revive market forces, and boost economies to the high-growth path. As it is, a negative shock could tip the world back into another deep downturn. Even now, the consequences of policy inaction have damaged prospects for today’s youth with 15 per cent of them in the OECD not in education, employment, or training; have drastically reduced the retirement incomes people are likely to get from pension funds compared to those who retired in 2000; and have left us on a carbon path that will leave us vulnerable to climatic disruption.

Citizens of the global economy deserve a better outcome. If policymakers act, they can deliver to raise the future path of output – which is the wherewithal for economies to make good on promises – to create jobs and develop career paths for young people, to pay for health and pension commitments to old people, to ensure that investors receive adequate returns on their assets, and to safeguard the planet.

 




Does monetary policy increase income and wealth inequality?

by Rory O’Farrell, Łukasz Rawdanowicz, and Kei-Ichiro Inaba,  Macroeconomic Policy Division, OECD Economics Department

As asset prices have risen in recent years, so have concerns that monetary policy, and quantitative easing in particular, has increased inequality. Concern has moved from being the preserve of central bankers and the pages of the financial media to entering popular discourse with calls for “People’s QE” in the United Kingdom. However, recent research shows that not only are the impacts via financial channels of such policies on inequality small, they even have the potential to reduce it.

Monetary policy effects on inequality are ambiguous in theory. A fall in interest rates reduces debt servicing costs and returns on financial assets and may increase, reduce or leave unchanged income inequality. The impact depends on the relative size of variable-rate liabilities and interest-paying assets, or the ease at which rates can be re-negotiated, and on differences in the distributions of income, assets and liabilities. Similarly, an increase in asset prices has an uncertain impact on the inequality of net wealth (households’ assets minus liabilities). As poorer households tend to have high debts in relation to assets, their net wealth stands to benefit most from asset price increases.

Interest rate cuts have a small impact on income inequality in advanced economies. Simulations show that the Gini coefficient – a popular measure of inequality – for the income distribution increased in all the countries studied, except the United States, as a result of a 4-percentage point reduction in interest rates. However, this was only a tiny fraction of the overall changes in the Gini coefficient observed during the Great Recession for all the countries except Belgium and Germany (Figure 1). Moreover, these inequality-raising effects of monetary policy could have been partially, or even more than fully, offset by the stabilising effects of monetary easing on employment that benefit low-income workers disproportionally.

Figure 1. Simulated changes in Gini coefficients due to 4 p.p. lower interest rates

Lukasz

Note: Negative changes imply a decline in inequality. Squares mark actual changes in the Gini coefficients for market income between 2007 and 2010.
Source: OECD Income Distribution and Poverty Database; and O’Farrell et al. (2016).

Likewise, asset price changes are unlikely to have had a large effect on net wealth inequality. Even if asset valuations vary by as much as they changed during the Great Recession, it would not alter the Gini coefficients for the net wealth distribution significantly in most of the countries analysed. Moreover, the reversal of asset valuations since 2010 suggests that net effects over the business cycle are even smaller. The muted overall impact of changes in asset prices is in part due to rising house prices generally reducing net wealth inequality and thus offsetting the inequality-raising increase in equity and bond prices.

Interactions between monetary policy and inequality pose communication challenges. Even if cyclical implications of monetary policy for inequality as measured by the Gini coefficient are small, larger losses or gains for very specific and vocal groups tend to attract media attention. This calls for clear explanations of the advantages and disadvantages of various inequality measures and all possible channels affecting the overall net effect. It also needs to be communicated that current effects are likely to be reversed during the monetary policy tightening cycle and that inequality fluctuations would be much larger without monetary policy intervention.

References

O’Farrell, R., Ł. Rawdanowicz and K.-I. Inaba (2016), “Monetary policy and inequality”, OECD Economics Department Working Papers, No. 1281, OECD Publishing, Paris.