CNBC’s John Carney on Krugman and MMT

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>   John Carney loving on us again

Yes!

Paul Krugman Goes MMT on Italy

By John Carney

November 11 (CNBC) — It seems pretty clear that the school of thought known as Modern Monetary Theory has made a big impact on Paul Krugman’s thinking.

As Cullen Roche at Pragmatic Capitalism points out, just a few months ago the spread between bonds issued by Japan and Italy, which have similar debt and demographic issues, was perplexing Krugman.

“A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.

…I actually don’t have a firm view. But it seems to be an important puzzle to resolve.”

But today’s column is basically right out of MMT.

“What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of Third World countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.”

News recap comments

The news flow from last week was so voluminous it was nearly impossible to process. For good measure I want to start today’s commentary with a simple recap of what happened.

On the negative side

· Greece called a referendum and threw bailout plans up in the air taking Greek 2yrs from 70% to 90% or +2000bps.
· Italian 10yr debt collapsed 40bps with spreads to Germany out 70bps. The moves were far larger in the 2yr sector.
· France 10y debt widened 25bps to Germany. At one point spreads were almost 40 wider.
· Italian PMI and Spanish employment data were miserable.
· German factory orders plunged 4.3 percent on the month.
· The planned EFSF bond for 3bio was pulled.
· Itraxx financials were +34 while subs were +45.
· Draghi predicted a recession for Europe along with disinflation.
· The G20 was flop – there was no agreement on IMF involvement in Europe.
· The US super committee deadline is 17 days away with no clear agreement.
· The 8th largest US bankruptcy in history took place.
· US 10yr and 30yr rallied 28bps, Spoos were -2.5%, the Dax was -6% and EURUSD was -3%.
· German CDS was up 16bps on the week.

On the positive side

· The Fed showed its hand with tightening dissents now gone and an easing dissent in place.

Too bad what they call ‘easing’ at best has been shown to do nothing.

· The Fed’s significant downside risk language remained intact.

Downside risks sound like bad news to me.

· In the press conference Ben teed up QE3 in MBS space.

Which at best have been shown to do little or nothing for the macro economy.

· US payrolls, claims, vehicle sales and productivity came in better than expected.

And the real output gap if anything widened.

· S&P earnings are coming in at +18% y/y with implied corporate profits at +23 percent q/q a.r.

Reinforces the notion that it’s a good for stocks, bad for people economy.

· Mortgage speeds were much faster than expectations suggesting some easing refi pressures.

And savers holding those securities saw their incomes cut faster than expected.

· The ECB cut 25bps and indicated a dovish forward looking stance.

Which reduced euro interest income for the non govt sectors

· CME Margins were reduced.

Just means volatility was down some.

· There was a massive USDJPY intervention which may be a precursor to a Swiss style Japanese policy easing.

Which, for the US, means reduced costs of imports from Japan, which works against US exports, which should be a good thing for the US as it means for the size govt we have, taxes could be lowered to sustain demand, but becomes a bad thing as our leadership believes the US Federal deficit to be too large and so instead we get higher unemployment.

· The Swiss have indicated they want an even weaker CHF – possibly EURCHF 1.40.

When this makes a list of ‘positives’ you know the positives are pretty sorry

· The Aussies cut rates 25bps

Cutting net interest income for the economy.

President Obama entering the fray

More of the blind leading the blind. The one thing they all agree on, at great expense to global well being, is the budget deficits are all too large and the need for shared sacrifice and all that.

No chance for anything constructive to come out of any of this.

And these masters of their money machines don’t even know how to inflate, as they all desperately try to inflate with their versions of quantitative easing, which, functionally, is just another demand draining tax.

*DJ Merkel, Obama Discussed How To Boost EFSF Firepower Without ECB
*DJ Obama To Merkel: We Are Totally Invested In Your Success – Source
*DJ Geithner, Schaeuble May Meet To Discuss IMF Role In Euro Crisis -Source

Fed’s Plosser comments

They see it all about managing expectations.

So with the announcement they managed interest rate expectations a bit lower out to 2013.

But now they are concerned they managed expectations about economic growth and employment lower as well, which they believe works to lower actual growth and employment.

So now they are trying to adjust both a bit back in the other directions.

*DJ Fed’s Plosser: FOMC Statement On Econ Too Negative -Bloomberg Radio
*DJ Fed’s Plosser: Extending Policy To ’13 `Inappropriate’ -Bloomberg Radio
*DJ Fed’s Plosser: Expects Will Have To Raise Rates Before ’13 -Bloomberg Radio

Basel 3 proposals


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This comes down to the questions of:

What are banks?
What is the role of bank capital?
What are the dynamics of capital ratios?

1. What are banks?

Banks are public private partnerships presumably established and maintained for public purpose.

The presumed public purpose is to maintain and service a payments system and to make loans that further public purpose.

With most nations having learned the ugly way that the liability side of banking is not the place for market discipline,
they use a variety of methods to sustain credible deposit insurance.

With, for all practical purposes, unlimited govt. insured funding available, regulation falls on bank assets and capital.

Regulation determines what assets are ‘legal’ and presumably in line with public purpose. Regulators monitor all bank assets for compliance and assurance that bank assets are ‘worthy’ of the government deposit insurance.

2. What is the role of bank capital?

Banks can be government owned or privately owned.

When banks are 100% public institutions, government determines the price of risk, as expressed by the risk premium charged for specific loans.

As public private institutions, private capital is in a first loss position and risk is priced by private sector agents.

The US and most nations have presumably determined public purpose is served by having the private sector price loans.

Hence banks are public private partnerships with private owners investing prescribed quantities of capital.

3. What are the dynamics of capital ratios?

The capital ratios determine the minimum legal percentage of private funds at risk for the legal bank assets.
For example, a 10% capital ration would mean that private capital is providing 10% of the value of the assets as a first loss piece.

Higher capital ratios reduce both the risk and the returns on the private invested capital.

This also alters the banking system’s cost of raising capital, and thereby also alters interest rates charged by banks.

Conclusion

This understanding is not evident at the level of public policy formation, and the results are not encouraging.

The question of public purpose of capital ratios seems for the most part to be limited to the possibility of 100% of the private capital being lost, and the risk to ‘tax payer money.’

I don’t see any discussion of the larger issues of public purpose for which private bank ownership is presumably established.

And I see no need for international cooperation.

As with fiscal policy, the public purpose of each nation is better served dealing with its own insured banks unilaterally.

From GS this morning:

  • Renewed focus on bank Capital ratios – in light of G20 and the statement from Basel committee yesterday. Waiting for a more formal piece from our analysts on this – but essential conclusion from the number of press pieces around today and the Basel statement is that banks, globally, will need to improve the quality and extent of capital ratios. Nothing new in that message – but the momentum towards formalisation of this process gathering pace. Looks likely that we will get a proposal on ‘Basel 3’ by end of year – impact assement early next year and implementation by the end of 2010. Legislation that will a ) force banks to increase capital ratios b ) replace some of the hybrid capital they have raised previously in form of preference shares or subdebt with common equtiy and c ) limit share dividends in good times to increase captial buffers in downturns. Would like to get some details from our equtiy analysts here – for the moment a very mixed set of views on the implications. FT disputes recent positive price action in bank stocks given the size of equtiy issuance that is likely to be needed in medium term as these proposals take shape. Others suggest that the Basel statement has a notable skew towards banks being able to build capital ratios organically over time by limiting dividends and retaining earnings – purposefully ensuring that there is no snap requirement for capital raising once legislation is proposed. Despite this we suspect that two sectors are still vulnerable here a ) banks with high leverage ratios ( i.e european banks with large non retail operations – particularly given IFRS doesn’t net derivative exposures ) b ) those banks with high proportion of hybrid capital ( i.e particuarly those banks with large gvt investment via preference shares )


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BERNANKE’S OP ED WSJ: THE FED’S EXIT STRATEGY


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The big concern is managing inflation expectation not realizing that inflation is not a function of inflation expectations:

The Fed’s Exit Strategy

By Ben Bernanke

July 21 (WSJ) — The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis.

There is no evidence of that.

They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

Yes. Though the measures taken missed the direct approach and instead involved a myriad of complex and expensive programs that burned through precious political capital and delayed the repair of those markets.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

They continue to believe that lower interest rates fan inflation and higher interest rates fight inflation.

I suggest theory and econometric evidence show that with current institutional arrangements the opposite is true.

The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

Nothing could be easier. This is a non issue.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

What else could they do? Lending doesn’t diminish reserve balances in aggregate. This is accounting, not theory. And clearly the FOMC doesn’t know this.

But as the economy recovers, banks should find more opportunities to lend out their reserves.

Again, that doesn’t diminish total reserves held by the banks at the fed.

That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—

Only if the borrowing to spend increases aggregate demand, which is certainly possible.

unless we adopt countervailing policy measures.

Those would be rate hikes, which add income to the non govt sectors and can add to inflation via the cost channel as well as the fiscal channel.

When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

They have no effect on the economy in any case.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid.

These are just exchanges of financial assets which have no effect on the economy.

However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Yes, increasing interest rates is a simple matter operationally.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Yes.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Yes, for many, many years. It’s the obvious way to go.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Yes, someone in government who did not understand reserve accounting and monetary operations excluded those accounts at the Fed.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Yes, offers interest bearing alternatives to reserve balances.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

Yes, offers interest bearing alternatives to reserve balances.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Why??? It’s all the same government.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Yes, and, more important, this can be used to set the term structure of rates the same way treasury securities do. They are functionally identical.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Yes, which also support longer term rates at higher levels.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

And only limits the growth of broad money (which presumably matters even though the fed stopped publishing M3 because they found no evidence it did matter) if the higher rates limit borrowing.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.


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Richard Koo on fiscal policy and interest rates


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Met Richard years ago. Seems he’s still confused on fiscal policy:

Bond issues to fund capital injections will not lead to higher interest rates

Right! The CB sets rates. Too bad he didn’t stop here rather than try to explain the process.

Japan’s second round of capital injections was four times the size of the first, and some question the ability of US capital markets to absorb such a large emission of government debt. However, the 1989 S&L crisis demonstrated that funds raised for the purpose of rescuing the financial sector will not lead to higher interest rates.

True!

This is because, unlike fiscal outlays for public works, money spent to rescue the financial system does not reduce the amount of investment funds available in the financial markets.

Huh???

Assume, for example, that the government issues $100 of Treasury bonds to recapitalize a troubled bank.

And then makes a payment to the bank.

The bank receiving the capital injection would credit its capital account by $100 and then invest that $100. In effect, there will be $100 in the market to be invested regardless of whether the government issues debt to rescue the bank.

The $100 gets credited to the banks account at the CB. The bank can leave it there or look for alternatives.

Purchases of alternatives in the private sector cause the banks $100 to be ‘wire transferred’ to another bank.

That means the bank’s account at the CB is reduced by $100 and another bank’s account at the CB is increased by $100.

Because the $100 represents capital, the bank’s investment should be liquid and easily convertible into cash. The asset that best fills this bill is government securities

Ok.

If the bank decides to buy government debt with the money, the government will have another $100 to fund a capital injection.

I assume he means new government debt as he started with the government issuing $100 of bonds and recapitalizing the bank.

Two rubs.

First:

The government would only issue additional bonds if it wanted to (deficit) spend additional funds.

And it if wanted to issue bonds and (deficit) spend new funds, it would do so whether this particular bank wanted to buy the bonds or not. That is, the bank wanting to buy bonds is not the enabling force for (deficit) spending.

Second:

The sale of the original $100 of bonds reduced total bank reserves by $100 and the payment of the $100 to the bank added $100 to total bank reserves. So the initial bond issue and the recapitalization left bank reserves offset each other leaving total bank reserves unchanged. Institutionally, issuing new bonds starts a new series of transactions, and, again, that particular bank is not the enabling force.

If, on the other hand, the government uses that $100 to build bridges or roads, that money will leave the capital markets and be spent on wages or construction materials, producing a corresponding decrease in the amount of investment funds available.

I don’t follow this distinction at all.

In this case, as before, the Treasury borrowing $100 reduces bank balances at the CB by $100, and the Treasury spending $100 as above adds $100 to bank balances at the CB, leaving total bank balances (reserves) unchanged.

In short, money spent on public works projects leads to higher interest rates because it does not find its way back to the capital markets.

Not the case, interest rates go to where the CB sets them, one way or another.


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2008-09-16 JN Highlights


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Highlights:

Aug Consumer Sentiment Hits Record Low For 3rd Month
Govt Panel To Call For Cutting Corporate Tax To 30% By FY15
Ota Reelected As New Komeito Leader For Another 2 Years
Extra Budget To Total 1.81tn Yen, Govt Eyes 400bn Yen Bonds
Lehman Failure Not To Mar Japan Financial System: Ibuki
BOJ Injects Y1.5tln To Calm Markets
New-Condo Offerings Tumble 38% In Tokyo, Rise 7% In Osaka For Aug
Forex Focus: Yen To Benefit From Banking Woes
Stocks: Slide To 3-Year Low As Banks, Insurers Tumble
Bonds: Surge After Lehman Bankruptcy, Market Turmoil

 

Note Japan’s proposed fiscal responses: cutting corp tax and extra budget, while the proposed increased consumption tax has been delayed.

Same in most nations around the world.

Fiscal responses ‘work’ while interest rate cuts don’t.

The US tax rebates worked while there is no econometric evidence the rate cuts did anything, except maybe make things worse as they reduced personal income and contributed psychologically to a USD sell off and spike in import prices that probably hurt consumers at least as much as it helped exporters.

The Fed could to anything today from unchanged to a 50 cut.

They seemed to have decided to use interest rates for ‘monetary policy’ and other tools for ‘market functioning’.

So for market functioning they just expanded the scope of the TAF and the Treasury lending facility, and may do more of that type of thing at today’s meeting, including adjusting the terms of the discount rate.

The question is whether falling commodities and the stronger USD will lead to a further rate cut.

What the Fed knows and has recognized since the Bear Stearns episode is that markets are going to open every day and do their thing, as the last week’s activity has demonstrated.

The Fed’s perceived risk of markets simply not opening and not trading has subsided.

Also, with the Treasury take over of the agencies mtg rates have dropped over 50 bp and availability of mortgage funding has been sustained.

The Fed considers this an ‘easing of financial conditions’ and is the move they’ve wanted to see to support housing, which has shown signs of stabilizing.

And the Treasury has shown it’s there to ‘write the check’ as it sees the need to prevent systemic risk.

So from that point of view there has already been a substantial ease in ‘financial conditions’, and the Fed may not see a need for further immediate ease.

Their forecasts will continue to show ‘moderating inflation and continued downside risks to growth’.

It all depends on their fear factor. They could leave fed funds unchanged or cut up to 50, depending on their concern regarding systemic risk.


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AS: Fed moves


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I’ve been recommending the following for the Fed for quite a while (see Proposals for the Fed):

  1. Lower the discount rate the Fed Funds rate and:
    1. Accept a pledge of any bank legal collateral from any member bank.
    2. Impose no restriction on quantity borrowed.
    3. Impose no restriction on the duration of any member bank borrowing.
  1. Likewise, remove collateral restrictions on the TAF operations.
    1. Set the maturity and interest rate for each TAF operation.
    2. Leave demand open-ended, rather than the current policy of limiting quantity.

Failure to implement the above shows a failure to understand fundamental monetary operations.

These policy changes would alleviate critical liquidity issues, and not, per se, alter net bank reserve demand (not that the size of the bank reserve ‘matters’).

Part of the current crisis is due to the failure to implement the above changes that would have:

  1. Normalized bank liquidity.
  2. Prevented the forced sales of investment grade, unimpaired, bank legal assets.
  3. Allowed banks to finance bank legal assets for third parties.
  4. Allowed markets to function to deleverage impaired assets.

The Fed is slowly moving in that direction, but, unfortunately, not proactively to ‘fix’ a flawed institutional structure, but reactively as things fall apart in no small part due to lack of action:

Federal Reserve lowers standards for collateral from primary dealers

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

Also, Schedule 2 TSLF auctions will be conducted each week; previously, Schedule 2 auctions had been conducted every two weeks. In addition, the amounts offered under Schedule 2 auctions will be increased to a total of $150 billion, from a total of $125 billion. Amounts offered in Schedule 1 auctions will remain at a total of $50 billion. Thus, the total amount offered in the TSLF program will rise to $200 billion from $175 billion.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.


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2008-08-13 UK News Highlights


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Highlights:

BoE Cuts Growth Forecasts, Jobless Climbs
U.K. Unemployment Rose the Most Since 1992 in July
Surge in credit card debt charge-offs
U.K. Homebuilders Fall as Unemployment Rise May Worsen Slump

 
 
Article snip:

BoE Cuts Growth Forecasts, Jobless Climbs (Bloomberg) The BoE cut its forecast for U.K. economic growth and held out the prospect of lower interest rates as unemployment rose the most in almost 16 years in July. Governor Mervyn King said the inflation rate will fall below the 2 % target in two years if policy makers keep the benchmark interest rate at 5 %.

But not if they cut is the implication as well.


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