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Federal Reserve’s Interest Rates Increase and Behaviour

Enrique Muñoz-Salido



Why U. S. Federal Reserve increase interest rates? How does the Fed efficiently use financial information? Which effect does it make in the City of London?

After the recently increase by the Federal Reserve –U.S.’ central bank– of the interest rates, there are a number of questions up in the air. Carrying out a monetary base strategy, it tries to influence the real side of the economy by exercising a sophisticated mechanism on the financial side of the economy in order to impact on the demand for non-interest bearing money –as traditionally Keynesians support.

Basically speaking, there is a positive relation between money and the demand for cash. If income goes up so the demand for money goes up. If interest rates of bonds go up the demand for money goes down. If the transactions cost goes up, then also the demand for cash goes up. Bearing in mind the Baumol-Tobin model of the transactions demand for money (Baumol, 1952; Tobin, 1956), it can be stated that the trade-off between the liquidity provided by holding money or the ability to carry out transactions –which only applies to monetary base and possibly M1– and the interest forgone by holding one’s assets in the form of non-interest bearing money –cash– has three key variables on demand for money. These three factors are the nominal interest rate, the level of real income –the model find the optimum amount of money demand given a certain level of income– and the fixed transaction costs of transferring one’s wealth between liquid money and interest-bearing assets. In order to set the working ground for policymakers it is necessary to add up to this formulation the target every central bank wants to achieve, which is to keep inflation around the 2% as well as keeping the economy operating at its full level of employment –recalling that the latter rate differs among countries. In this context the U.S.’ central bank has taken out an ace up its sleeve by raising its interest rates to between 0.25 and 0.5 per cent.

The great question is whether the Fed will achieve its target. If it is looked at the economic theory, it can be held a blooming prospect upon the aforementioned strategy. If reality doesn’t follow the economic theory it could just due to an untrusting situation within the economy by the people. If people do not put their money inside banks yet the interest rates are higher, it indicates they don’t trust in the economy right now which wouldn’t be consistent with the economic theory. Other factor which influences the credibility of the central bank relates to its track records –the way that central bank has met what it was announced that was going to be achieved. What mainly contributes to it is the degree of dependence which central banks takes with. The more independent the central bank is the more likely is to achieve its objectives.

Another powerful tool for monetary policy target achieving is the information role. As this manoeuvre had been anticipated, it provides a great case study of the ability of financial markets to efficiently process information. The monopolistic money supplier central bank uses the aforementioned information tool to get people aware of its purposes and make them react in the way it wants them to react.

Regarding to the role that the information plays on this market situation, it can be considered the relation between the U.S. Federal Reserve information and the behaviour of interest rates. It has been found by researchers at the University of California, Berkeley that exists an asymmetry between the Fed’s and the market’s information, which would explain why interest rates of maturities rise following contradictory monetary policy actions. As economic theory of interest rates suggests, a shift by the Fed to narrow monetary policy is likely to temporarily raise short-term rates but cut them in the long run and should cut rates on bonds of long maturities. Researchers conclude that the Fed has information about future inflation that market participants do not have. The information revealed by the Fed policy actions explains the behaviour of interest rates following monetary contraction (Romer and Romer, 2000). In the light of this outcome and as economic literature backs up, a 1% increase in broad stock indexes is caused by a hypothetical unanticipated 25-basis-point cut in the Federal funds rate target. Board members of Governors of the Federal Reserve System state that “the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stocks prices can explain the stock market’s reaction to the Federal Reserve policy” (Bernanke and Kuttner, 2005).

This financial manoeuvre has direct effects on the Sterling pound as it doesn’t force the hand of the Bank of England but puts pressure on it to respond. Even independent experts warn that an increase looks inevitable, there is no rush to rise rates in the U.K. following the Bank of England Governor Mark Carney’s statements. Technically speaking, an increase in US interest rates would theoretically rise the value of the dollar against the Sterling pound and other currencies such as the Eurozone. Historically, British interest rates closely followed US interest rates due to the strong financial and transactional inter-connections between both. Hence, it can be asserted that the UK is bound to follow but not yet. It could be considered this wait as a strategy to better fight against this systematic risk factor which lies ahead of the whole economy.

Enrique is an MSc Candidate in Social Anthropology at Regent’s Park College, University of Oxford. His research interests lie at the intersection of human behaviour and social interactions and his top analytical skills comprise macro and micro data analysis and statistical methods. Prior to joining Oxford, Enrique completed his MSc in Economics (distinction) at the University of Brighton, UK, where he was a Santander Scholar, and his undergraduate degree at the Autonomous University of Barcelona, Spain.

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231,000 New Jobs Added in Western Balkans amid Ongoing Economic Challenges, Emigration

MD Staff



A 3.9 percent increase in employment over the last year has led to the creation of 231,000 new jobs throughout the six countries of the Western Balkans, according to the “Western Balkans Labor Market Trends 2018” report, launched today by the World Bank and the Vienna Institute for International Economic Studies (wiiw). Unemployment also fell from 18.6 percent to 16.2 percent, reaching historic lows in some countries.

Leading the way for employment in the region was Kosovo, which saw an increase of 9.2 percent, followed by Serbia (4.3 percent), Montenegro (3.5 percent), Albania (3.4 percent), FYR Macedonia (2.7 percent), and Bosnia and Herzegovina (1.9 percent). Despite this progress, however, low activity rates – particularly among women and young people – along with high rates of long-term unemployment and a prevalence of informal work, continue to pose challenges for sustained economic growth in the region.

“The region has made great strides in improving labor market outcomes over the last year – meaning more people are finding jobs,” says Linda Van Gelder, World Bank Country Director for the Western Balkans. “However, we continue to see high rates of people who are not in employment, education or in training programs and we need to find ways to link them to future opportunities.”

Youth unemployment of 37.6 percent is a key challenge for the region. However, this rate is down from last year and nearly every country in the region is experiencing the lowest levels of youth unemployment since 2010. Country rates range from 29 percent in Montenegro and Serbia, to more than 50 percent in Kosovo. According to the report, it may be difficult for young people who become detached from jobs or education for long periods to reintegrate into the labor market. They also face a wage gap, earning up to 20 percent less than those who find employment sooner.

The report also notes that female employment rates are on the rise but they still remain low by European standards. The employment rate for women across the region stands at 43.2 percent, varying from a low of 13.1 percent in Kosovo to a high of 52.3 percent in Serbia. The gender gap in employment has also narrowed since 2010, ranging from 28.9 percentage points in Kosovo to 9.8 percentage points in Montenegro.

“Economic trends in the region look to be headed in the right direction,” says Robert Stehrer, Scientific Director of the Vienna Institute for International Economic Studies. “Getting more people, particularly young and women into employment remains one of the key challenges in the region to sustain economic and social convergence.”

A number of obstacles to employment need to be addressed to reduce ongoing emigration from the region, especially common among young, educated people. In order to address this, further knowledge is needed. Countries in the region should synchronize their data on emigration and improve the registration and publication of migration statistics. By utilizing high-quality data that is in-line with international standards on workforce composition – both domestically and internationally – will produce accurate analysis of labor market dynamics in the region and allow for the design of policies that can simultaneously address the challenges of emigration and reap the benefits of migration.

Better linkages between secondary graduates and the labor market, as well as earlier interventions to retain students, can improve opportunities for employment. Policies, such as child care, care facilities for the elderly, flexible work arrangements and more part-time jobs would also promote labor market integration among women.

The report was produced with financial support from the Austrian Ministry of Finance.

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Economic Growth in Gulf Region Set to Improve following a Weak Performance in 2017

MD Staff



The Gulf Cooperation Council (GCC) region witnessed another year of disappointing economic performance in 2017 but growth should improve in 2018 and 2019, according to the World Bank’s biannual Gulf Economic Monitor released today in Kuwait.

The region eked out growth of just 0.5% in 2017 – the weakest since 2009 and down from 2.5% the previous year. The GCC region’s economies experienced flat or declining growth as lower oil production and tighter fiscal policy took a toll on activity in the non-oil sector. External debt issuance continued to rise to help finance large fiscal deficits.

Economic growth is expected to strengthen gradually, helped by the recent partial recovery in energy prices, the expiration of oil production cuts after 2018, and an easing of fiscal austerity. The World Bank expects growth to firm to 2.1% in 2018 and rise further to 2.7% in 2019. Growth in Saudi Arabia is expected to rebound close to 2% in 2018-19 and to strengthen similarly elsewhere in the region.

“Policy attention is shifting towards deeper structural reforms needed to sever the region’s longer-term fortunes from those of the energy sector,” said Nadir Mohammed, World Bank Country Director for the GCC. “While the recent increase in oil prices provides some breathing space, policy makers should guard against complacency and instead double down on reforms needed to breathe new life into sluggish domestic economies, to create jobs for young people and to diversify the economic base. Any slippage could negatively impact the credibility of the policy framework and dampen investor sentiment.

Looking forward, there are several downside risks that may weigh on activity. Lower than expected oil prices could exert pressure on the OPEC producers to extend or deepen their production reduction agreement and dampen medium-term growth in the GCC countries.

Although fiscal and current account balances are improving, the region continues to face large financing needs and remains vulnerable to shifts in global risk sentiment and the cost of funding. Geopolitical developments and relations within the region could slow growth prospects. Slippage in the implementation of country reform plans arising from weak institutional capacity will rob the GCC of the benefits of fiscal adjustment and of deeper structural reforms that aim to diversify their economies.

Over the longer term, the enduring dominance of the hydrocarbon sector in the GCC economies argues for the vigorous implementation of structural reforms.  The terms of trade shocks in 2008-09 and in 2014-16 barely dented the dominance of the hydrocarbon sector in the GCC, with the bulk of the adjustment so far driven by spending cuts rather than the emergence of other traded sectors.

Structural reforms should focus on economic diversification, private sector development, and labor market and fiscal reforms. The GCC states’ long-term ambitions are articulated in various country vision statements and investment plans, and aspire to build competitive economies that utilize the talents of their people.

Implementing these structural transformation programs requires continuing political commitment from the GCC governments.

Saudi Arabia has shown considerable leadership in this regard: the 12 “vision realization plans” associated with its Vision 2030 aspirations aim to significantly transform the economy over the next 15 years by lifting the private sector share of the economy from 40 to 65% and the small and medium enterprise contribution to GDP from 20 to 35%.

Transforming from an oil-dependent economy to a self-propelled, human capital-oriented one requires some fundamental changes in the mindset; some also call this a new social contract,” said Kevin Carey, Practice Manager at the World Bank.  “GCC countries do not need to discard their existing social contracts but rather to upgrade them to reflect new realities of low for long oil prices, increasing global competition and the long-term threats from technological and climate change.”

As with other Arab countries, the GCC states also face sustainability, equity and welfare challenges related to their pension systems. These issues need to be addressed urgently to prevent any negative impact on economic growth, fiscal sustainability, and labor market stability.

Among the potential solutions that could help improve pension outcomes, the Gulf Economic Monitor underscores the importance of improving efficiency by reducing the prevailing fragmentation in many of the GCC pension systems; making access and contributions as simple and systematic as possible through the strengthening of ID and IT systems and the capabilities of pension administration bodies; and strengthening the governance of pension institutions. If GCC countries wish to attract global talent, they will also need to consider potential solutions for expatriates that help to meet their long-term pension and financial security needs.

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Poland: Build on current economic strength to innovate and invest in skills and infrastructure

MD Staff



Poland’s economic growth remains strong. Rising family benefits and a booming jobs market are lifting household income while poverty rates and inequality are falling, says a new OECD report.

In its latest Economic Survey of Poland, the OECD encourages policy-makers to build on the country’s current economic strength and social progress in order to tackle major remaining challenges. To sustain rising living standards Poland has to develop its capacity to innovate and invest in skills and infrastructure, as is acknowledged in the government’s Strategy for Responsible Development. The report says that the level of expenditure on research and development, despite recent welcome rises and tax incentives, remains weak. Vocational training suffers from limited business engagement which is hindering many of the country’s plentiful small enterprises from modernising and improving productivity.

Poland is also ageing rapidly. The working age population is projected to decline markedly over the coming decades. The lowering of the retirement age risks increasing poverty among the elderly, particularly women, says the OECD. Women often have patchy career paths and their retirement age is now set to remain unusually low. Workers should be made aware of the benefits of working longer for their future pension income, the report says.

Despite efforts to improve childcare, it remains insufficient and expensive, especially in rural areas. More investment in childcare is required as part of a range of measures to help combine work and family life and strengthen the number of women in employment.

Presenting the Survey in Warsaw, OECD Deputy Secretary-General Mari Kiviniemi said, “Poland is in a strong position. A dynamic job market together with the Family 500 + programme has helped make economic development more inclusive. Many people now benefit from new opportunities and rising incomes.”

“The time is ripe to ensure that living standards continue to rise. Strengthening innovation, improving infrastructure and investing in skills will be crucial. With rising labour and skills shortages, many employers now realise how important it is to invest in training. The government must seize this opportunity to engage with them.”

Measures to improve tax compliance have succeeded in shrinking the public deficit despite higher spending on social benefits. But more resources – or shift in how they are used – will be needed to raise  spending in priority areas such as public infrastructure, healthcare and higher education and research.

Limiting reduced VAT rates, increasing environmental taxes and giving a stronger role to the progressive personal income tax would raise additional revenue while contributing to more equity and a greener environment.

Plans to reform higher education and improve research excellence and industry-science co-operation are welcome, the report says. The general health status of Poles and access to healthcare are very unequal, while environmental quality is below the average of OECD countries. Tax rates on air and water pollution and on CO2 emissions are low and many environmentally harmful fuel uses are exempt from taxation. Raising environmental taxes would provide stronger incentives to replace ageing coal-intensive equipment with greener alternatives.

A clear immigration policy strategy is also needed to better monitor integration of foreigners in line with labour market needs, the protection of their rights and their access to education and training.

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