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Articles for the ‘Essentials of Economics 6e: Ch 12’ Category

Inflation back down to 2%

A recession is typically characterised by high unemployment, low or negative growth and low inflation, due to a lack of aggregate demand. However, since 2009, inflation levels in the UK have only added to the pressures facing the government and the Bank of England. Not only had there been a problem of lack of demand, but the inflation target was no longer being met.

Inflation had increased to above 5% – a figure we had not been accustomed to for many years. With interest rates at record lows with the aim of boosting aggregate demand, demand-pull inflation only added to cost-push pressures. However, data released by the ONS shows that inflation, as measured by the CPI, has now fallen back to its 2% target. Having been at 2.1% in November 2013, the figure for December 2013 fell by 0.1 percentage points.

The data for December include some of the energy price rises from the big six, but do not include the full extent of price decreases and discounting initiated by retailers in the lead up to Christmas. The key factors that have helped to keep prices down include some of the discounting throughout December and falling food prices, in particular bananas, grapes and meat.

With inflation back on target, pressures have been removed from the Bank of England to push up interest rates. Mark Carney has said that interest rates will remain at 0.5% until unemployment falls to 7%. With unemployment fast approaching this target, there has been speculation that interest rates would rise, but with inflation falling back on target, these pressures have been reduced. (Click here for a PowerPoint of the chart.) Referring to this, Jeremy Cook, the chief economist at World First said:

The lack of inflation will help stay their hand especially if the pace of job creation seen in the second half of last year also shows.

These thoughts were echoed by Rob Wood, the chief UK economist at Berenberg Bank:

Inflation is the BoE’s ‘get out of jail free’ card for this year … The lack of inflation pressure gives them room to delay a first hike until next year.

Many economists now believe that the CPI rate of inflation is likely to remain at or below the target, in particular if productivity growth improves. This belief is further enhanced by the fact that tax rates are stable, the pound is relatively strong and the previous upward pressure on commodity prices from China is now declining. Some economists believe that CPI inflation could fall to 1.5% this year and the Treasury has said that it is ‘another sign that the Government’s long-term economic plan is working’. The following articles consider this latest macroeconomic data.

UK inflation falls to Bank of England’s 2pc target in December The Telegraph, Szu Ping Chan (14/1/14)
UK inflation falls to 2% target rate in December BBC News (14/1/14)
Carney’s lucky streak continues as UK inflation slows to 2% Financial Times, Claire Jones (14/1/14)
UK inflation fall gives Bank of England a lift Wall Street Journal, Richard Barley(14/1/14)
Inflation falls to Bank of England target Reuters, William Schomberg and Ana Nicolaci da Costa (14/1/14)
Inflation hits Bank of England’s target of 2% in December Independent, John Paul Ford Rojas (14/1/14)

Questions

  1. What is the relationship between interest rates and aggregate demand?
  2. Which factors have led to the reduction in the rate of inflation?
  3. Why have the latest data on inflation rates reduced the pressure on the Bank of England to increase interest rates?
  4. Why do stable tax rates, a strong pound and reduced pressure from China on commodity prices suggest that the CPI measures of inflation is likely to remain at similarly low levels?
  5. Why has the RPI increased while the CPI has fallen?
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Predicting the future of interest rates

Interest rates in the UK have been at 0.5% since mid-2009, when they were reduced with the objective of stimulating the economy, through encouraging consumption and investment. Over the past 12 months, economic recovery has begun and with the housing market rising by 8.4% over the past year, what can we expect from interest rates?

Interest rates are a powerful tool of monetary policy and affect many of the components of aggregate demand. As such, they are also a key tool in achieving low and stable inflation rates and keeping unemployment low. Unemployment has been falling, as the economic recovery has taken hold, but is still above the 7% level that the Bank of England has said is needed before rates are increased. However, with the improvements in the housing market, some are now expecting interest rates to go up sooner than previously thought. (Click here for a PowerPoint of the chart.)

28 economists were questioned about the future of interest rates in the UK and 93% of those asked were of the opinion that interest rates will still be at 0.5% by the end of 2014. Furthermore, more than 50% think that interest rates will not begin to go up until the second half of 2015 and 15% suggest that they will not increase until 2016.

What happens to interest rates will depend on many things, including changes in productivity, unemployment trends, wage growth and inflation. It is also likely to depend on economic changes in countries around the world. The following articles consider the future of interest rates.

UK interest rates to stay at 0.5% in 2014 – economists BBC News (3/1/14)
It is high time we raised interest rates and returned to normality The Telegraph, Jeremy Warner (2/1/14)
BoE will ‘move goalposts’ on interest rates Financial Times, Chris Giles and Claire Jones (1/1/14)
Interest rate rise with no wage increase ‘will push heavily-indebted to edge’ The Guardian, Heather Stewart (2/12/14)
BoE may lower jobless rate guidance, but not this month – Reuters poll Reuters, Suzanne Plunkett (3/1/14)

Questions

  1. Explain how each component of aggregate demand will be affected by changes in interest rates.
  2. How do interest rates affect unemployment?
  3. Interest rates are used to keep inflation on target. Explain how this is done.
  4. What might be the effect on the macroeconomic objectives if interest rates are increased?
  5. What are the arguments (a) for increasing Bank rate and (b) for maintaining it at the current 0.5% level?
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Abenomics – one year on

It is one year since the election of Shinzo Abe in Japan. He immediately embarked on a radical economic policy to stimulate the Japanese economy, which had suffered from years of stagnation. There have been three parts (or three arrows) to his policy: fiscal policy and monetary policy to stimulate aggregate demand and supply-side policy to increase productivity.

As the previous post explains:

“The first arrow is monetary policy. The Bank of Japan has engaged in extensive quantitative easing through bond purchases in order to drive down the exchange rate (see A J-curve for Japan?), stimulate expenditure and increase the rate of inflation. A target inflation rate of 2% has been set by the Bank of Japan. Part of the problem for the Japanese economy over the years has been stagnant or falling prices. Japanese consumers have got used to waiting to spend in the hope of being able to buy at lower prices. Similarly, Japanese businesses have often delayed stock purchase. By committing to bond purchases of whatever amount is necessary to achieve the 2% inflation target, the central bank hopes to break this cycle and encourage people to buy now rather than later.

The second arrow is fiscal policy. Despite having the highest debt to GDP ratio in the developed world, Japan is embarking on a large-scale programme of infrastructure investment and other public works. The package is worth over $100bn. The expansionary fiscal policy is accompanied by a longer-term plan for fiscal consolidation as economic growth picks up. In the short term, Japan should have no difficulty in financing the higher deficit, given that most of the borrowing is internal and denominated in yen.

The third arrow is supply-side policy. On 5 June, Shinzo Abe unveiled a series of goals his government would like to achieve in order to boost capacity and productivity. These include increasing private-sector investment (both domestic and inward), infrastructure expenditure (both private and public), increasing farmland, encouraging more women to work by improving day-care facilities for children, and deregulation of both goods, capital and labour markets. The prime minister, however, did not give details of the measures that would be introduced to achieve these objectives. More details will be announced in mid-June.”

In the webcast and article below, Linda Yueh, the BBC’s Chief Business Correspondent, considers how effective the policies are proving and the challenges that remain.

Webcast
Has Abenomics fixed Japan’s economic fortunes? BBC News, Linda Yueh (16/12/13)

Articles
Why Abenomics holds lessons for the West BBC News, Linda Yueh (13/12/13)
Japanese business confidence hits six-year high, Tankan survey shows The Guardian (16/12/13)

Data
World Economic Outlook Database IMF (Oct 2013)
Bank of Japan Statistics Bank of Japan
Economic Outlook Annex Tables OECD
Country statistical profile: Japan 2013 OECD (15/11/13)

Questions

  1. Demonstrate on (a) an aggregate demand and supply diagram and (b) a Keynesian 45° line diagram the effects of the three arrows (assuming they are successful) in meeting their objectives.
  2. Why has Japan found it so hard to achieve economic growth over the past 20 years?
  3. How has the Japanese economy performed over the past 12 months?
  4. What lessons can be learnt by the UK and eurozone countries from Japan’s three arrows?
  5. Why is the second arrow problematic, given the size of Japan’s general government debt? Does the proportion of Japanese debt owed overseas affect the argument?
  6. In what ways do the three arrows (a) support each other; (b) conflict with each other?
  7. Why is the structure of the labour market in Japan acting as a break on economic growth? What policies are being, or could be, pursued to tackle these structural problems?
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1.43 trillion reasons for economists to better understand households

As of 31 October 2013, British households had a stock of debt close to £1.43 trillion. Economists are increasingly recognising that the financial well-being of economic agents is an important macroeconomic issue. The financial position of households, businesses and governments can be expected to affect behaviour and, hence, economic activity.

We can calculate the net financial wealth of households as the difference between their stock of financial assets (savings) and their financial liabilities (debt). The latest figures from the Bank of England’s Money and Credit show that as of Halloween 2013, British households had amassed a stock of debt of £1.4296 trillion. It is certainly a large figure since it not far short of the expected GDP figure for 2013 of around £1.6 trillion.

The chart above helps to show that of the aggregate household debt, £1.271 trillion is secured debt (debt secured against property). The remaining stock of £158.589 billion is unsecured debt (e.g. overdrafts, outstanding credit card debt and personal loans). In short, 89 per cent of the stock of outstanding household debt is mortgage debt. (Click here to download a PowerPoint of the chart.)

In January 1994 the stock of secured debt stood at £358.75 billion and the stock of unsecured debt at £53.773 billion. 87 per cent of debt then was secured debt and, hence, little different to today. The total stock of debt has grown by 247 per cent between January 1994 and October 2013. Unsecured debt has grown by 199 per cent while secured debt has grown by 254 per cent.

But, consider now the path of debt between the end of October 2008 and October 2013. During this period, the monthly series of the stock of unsecured debt has fallen on 52 occasions and risen on only 9 occasions. In contrast, the stock of secured debt has fallen on only 10 occasions and often by very small amounts. Consequently, the stock of unsecured debt has fallen by 22.8 per cent between the end of October 2008 and October 2013. In contrast, the stock of secured debt has risen by 3.9 per cent. The total stock of debt has risen by 0.1 per cent over this period and, therefore, it is essentially unchanged.

The amount of debt accumulated by households is example of the increasing importance of the financial system in our everyday lives. The term financialisation helps to capture this. Financialisation means that economists need to think much more about how financial institutions and the financial well-being of people, businesses and governments affect economic activity. There is little doubt that the financial position or financial health of economic agents, such as households, affects their behaviour. We would expect in the case of households for their financial well-being to exert an influence on their propensities to spending or save. But, just how is an area in need of much, much more research.

Articles
UK household debt hits record high BBC News (29/11/13)
Average household debt ‘doubled in last decade’ Telegraph, Edward Malnick (20/11/13)
£1,430,000,000,000 (that’s £1.43 trillion): Britain’s personal debt timebomb Independent, Andrew Grice (20/11/13)

Data
Money and Credit – October 2013 Bank of England
Statistical Interactive Database Bank of England

Questions

  1. Outline the ways in which the financial system could impact on the spending behaviour of households.
  2. Why might the current level of income not always be the main determinant of a household’s spending?
  3. How might uncertainty affect spending and saving by households?
  4. Explain what you understand by net lending to individuals. How does net lending to individuals affect stocks of debt?
  5. Outline the main patterns seen in the stock of household debt over the past decade and discuss what you consider to be the principal reasons for these patterns.
  6. What factors might explain the rather different pattern seen in the growth of debt since October 2008 compared with that in earlier part of the 2000s?
  7. What do you understand by the term financialisation? Of what importance is this phenomenon to economic behaviour?
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Deflation danger in the eurozone

‘Deflation could be replacing debt as the main problem – and there’s nothing to suggest the ECB is up to the job.’ So begins the linked article below by Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley.

The good news in this is that worries about debt in eurozone countries are gradually receding. Indeed, this week Ireland officially ended its reliance on a bailout (of €67.5 billion) from the EU and IMF and regained financial sovereignty (see also).

The bad news is that this does not mark the end of austerity. Indeed, many eurozone countries could get stuck in a deflationary trap, with austerity policies continuing to depress aggregate demand. Eurozone inflation is less than 1% and falling. Broad money supply growth is now below that of the US dollar, the yen and sterling (see chart: click here for a PowerPoint).

The ECB has been far more cautious than central banks in other countries in acting to prevent recession and deflation. Unlike the USA, Japan and the UK, which have all engaged in extensive quantitative easing, the ECB had been reluctant to do so for fear of upsetting German opinion and taking the pressure off southern European countries to reform.

But as Eichengreen points out, the dangers of inaction could be much greater. What is more, quantitative easing is not the only option. The ECB could copy the UK approach of ‘funding for lending’ – not for housing, but for business.

Europe’s economic crisis could be mutating again The Guardian, Barry Eichengreen (10/12/13)

Questions

  1. What problems are created by falling prices?
  2. What effect would deflation have on debt and the difficulties in repaying that debt?
  3. What measures have already been adopted by the ECB to stimulate the eurozone economy? (Search previous articles on this site.)
  4. Why have such measures proved inadequate?
  5. What alternative policies are open to the ECB?
  6. What are the arguments for the ECB being given a higher inflation target (such as 3 or 4%)?
  7. What are the arguments for and against relaxing fiscal austerity in the eurozone at the current time?
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The burden of debt

Household debt in the UK has reached a record level. Individuals now owe £1430 billion. This compares with the UK’s general government debt of £1443 billion – also at a record level. These figures are illustrated in the chart (click here for a PowerPoint).

But these figures are nominal. If you look at the real figures (i.e. corrected for inflation), household debt has been falling. In today’s prices, household debt peaked at £1668 billion in March 2008. Also, if you look at household debt as a proportion of GDP, it fell from a peak of 100.96% in May 2009 to 87.43% in July 2013 (see chart). However, since then it has begun rising again, standing at 87.65% in October 2013.

So has household debt become less of a problem? In aggregate terms, the answer is probably yes. However, it is too early to know whether a continuing recovery in the economy will be fuelled by real debt rising again and whether the recovery will encourage people to take on higher levels of debt?

For many people, however, debt has become more and more of a problem. In other words, the aggregate figures conceal what has happened in terms of the distribution of debt. According to a Centre for Social Justice (CSJ) study:

Indebted households in the poorest 10 per cent of the country have average debts more than four times their annual income. Average debt repayments within this group amounted to nearly half their gross monthly income.

And the poorest families, often with very poor credit ratings, are frequently forced to turn to payday lenders, charging sky-high interest rates (see Capping interest rates on payday loans: a government U-turn?).

As mainstream banks reduced access to credit following the financial crash, the market for short-term high-cost credit (payday lenders, pawnbrokers, rent-to-buy and doorstop lenders) increased dramatically and is now worth £4.8 billion a year.

Payday lenders have increased business from £900 million in 2008/09 to just over £2 billion (or around 8 million loans) in 2011/12. Around half of payday loan customers reported taking out the money because it was the only form of credit they could get. The number of people going to loan sharks is also said to have increased – the most recent estimate puts it at 310,000 people.

With rising energy and food bills hitting the poorest hardest, this section of the population could find debt levels continuing to rise, especially if interest rates rise. As Chris Pond, who chaired the CJS study, stated:

The costs to those affected, in stress and mental disorders, relationship breakdown and hardship is immense. But so too is the cost to the nation, measured in lost employment and productivity and in an increased burden on public services.

Articles
£1,430,000,000,000 (that’s £1.43 trillion): Britain’s personal debt timebomb Independent, Andrew Grice (20/11/13)
Average household debt ‘doubled in last decade’ The Telegraph, Edward Malnick (20/11/13)
UK household debt hits record high BBC News (29/11/13)
UK debt crisis: poorest face ‘perfect storm’ Channel 4 News (20/11/13)
One in five struggle with serious debt The Telegraph, Nicole Blackmore (27/11/13)
It doesn’t matter what we do with Wonga: personal debt is about to rocket The Telegraph, Tim Wigmore (26/11/13)
Poorest families ‘need more help over debt’ BBC News (20/11/13)

Report
More than 5,000 people a year ‘homeless’ as household debt crisis deepens, CSJ warns Centre for Social Justice Press Release (20/11/13)

Data
Monthly amounts outstanding of total (excluding the Student Loans Company) sterling net lending to individuals and housing associations (in sterling millions) seasonally adjusted Bank of England
Public Sector Finances First Release – Public Sector Consolidated Gross Debt ONS
Household debt (Economics Indicators update) House of Commons Library (29/11/13)

Questions

  1. What are the macroeconomic implications of rising levels of household debt?
  2. Why may an economy which has high levels of household debt be more subject to cyclical fluctuations in real GDP?
  3. What are the problems of having a recovery driven largely by increased consumer expenditure?
  4. Why have many people in the poorest sectors of society found their debt levels rising the fastest?
  5. Why may rising levels of debt of the most vulnerable people make it harder for the Bank of England to use conventional monetary policy if recovery becomes established?
  6. What policies could be pursued to try to reduce the debts of the poorest people?
  7. Discuss the effectiveness of these various policies.
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Over 100,000 zombies trading

A constant feature of the UK economy (and of many other Western economies) has been record low interest rates. Since March 2009, Bank Rate has stood at 0.5%. Interest rates have traditionally been used to keep inflation on target, but more recently their objective has been to stimulate growth. However, have these low interest rates had a negative effect on the business environment?

Interest rates are a powerful tool of monetary policy and by affecting many of the components of aggregate demand, economic growth can be stimulated. This low-interest rate environment is an effective tool to stimulate consumer spending, as it keeps borrowing costs low and in particular can keep mortgage repayments down. However, this policy has been criticised for the harm it has been doing to savers – after all, money in the bank will not earn an individual any money with interest rates at 0.5%! Furthermore, there is now a concern that such low interest rates have led to ‘zombie companies’ and they are restricting the growth potential and recovery of the economy.

A report by the Adam Smith Institute suggests that these ‘zombie companies’ have emerged in part by the low-interest environment and are continuing to absorb resources, which could otherwise be re-allocated to companies with more potential, productivity and a greater contribution to the economic recovery. During a recession, there will undoubtedly be many business closures, as aggregate demand falls, sales and profits decline until eventually the business becomes unviable and loans cannot be repaid. Given the depth and duration of the recent recessionary period, the number of business closures should have been very large. However, the total number appears to be relatively low – around 2% or 100,000 and the report suggests that the low interest rates have helped to ‘protect’ them.

Low interest rates have enabled businesses to meet their debt repayments more easily and with some banks being unwilling to admit to ‘bad loans’, businesses have benefited from loans being extended or ‘rolled over’. This has enabled them to survive for longer and as the report suggests, may be preventing a full recovery. The report’s author, Tom Papworth said:

Low interest rates and bank forbearance represent a vast and badly targeted attempt to avoid dealing with the recession. Rather than solving our current crisis, they risk dooming the UK to a decade of stagnation … We tend to see zombies as slow-moving and faintly laughable works of fiction. Economically, zombies are quite real and hugely damaging, and governments and entrepreneurs cannot simply walk away.

The problem they create is that resources are invested into these companies – labour, capital, innovation. This creates an opportunity cost – the resources may be more productive if invested into new companies, with greater productive potential. The criticism is that the competitiveness of the economy is being undermined by the continued presence of such companies and that this in turn is holding the UK economy back. Perhaps the interest rate rise that may happen this time next year may be what is needed to encourage the re-allocation of capital. However, a 0.5 percentage point rise in interest rates would hardly be the end of the world for some of these companies. Perhaps a more focused approach looking at restructuring is the key to their survival and the allocation of resources to their most productive use. The following articles and the report itself consider the case of the trading dead.

Report
The Trading Dead The Adam Smith Institute, Tom Papworth November 2013

Articles
Zombie firms threaten UK’s economic recovery, says thinktank The Guardian, Gyyn Topam (18/11/13)
Zombie companies ‘probably have no long term future’ BBC News (18/11/13)
Rate rise set to put stake through heart of zombie companies Financial Times, Brian Groom (14/11/13)
Why we can still save the zombie firms hindering the UK economic rival City A.M., Henry Jackson (18/11/13)
Breathing new life into zombies The Telegraph, Rachel Bridge (9/11/13)

Questions

  1. Which components of aggregate demand are affected (and how) by low interest rates?
  2. Why do low interest rates offer ‘protection’ to vulnerable businesses?
  3. How is the reallocation of resources relevant in the case of zombie companies?
  4. If interest rates were to increase, how would this affect the debts of vulnerable businesses? Would a small rate irse be sufficient and effective?
  5. What suggestions does the report give for zombie companies to survive and become more productive?
  6. Is there evidence of zombie companies in other parts of the world?
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Back to the target (almost)

The Consumer Prices index (CPI) measures the rate of inflation and in October, this rate fell to 2.2%, bringing inflation to its lowest level since September 2012. For many, this drop in inflation came as a surprise, but it brings the rate much closer to the Bank of England’s target and thus reduces the pressure on changing interest rates.

The CPI is calculated by calculating the weighted average price of a basket of goods and comparing how this price level changes from one month to the next. Between September and October prices across a range of markets fell, thus bringing inflation to its lowest level in many months. Transport prices fell by their largest amount since mid-2009, in part driven by fuel price cuts at the big supermarkets and this was also accompanied by falls in education costs and food. The Mail Online article linked below gives a breakdown of the sectors where the largest price falls have taken place. One thing that has not yet been included in the data is the impact of the price rises by the energy companies. The impact of his will obviously be to raise energy costs and hence we can expect to see an impact on the CPI in the coming months, once the price rises take effect.

With inflation coming back on target, pressures on the Bank of England to raise interest rates have been reduced. When inflation was above the target rate, there were concerns that the Bank of England would need to raise interest rates to cut aggregate demand and thus bring inflation down.

However, the adverse effect of this would be a potential decline in growth. With inflation falling to 2.2%, this pressure has been removed and hence interest rates can continue to remain at the record low, with the objective of stimulating the economy. Chris Williamson from Markit said:

The easing in the rate of inflation and underlying price pressures will provide greater scope for monetary policy to be kept looser for longer and thereby helping ensure a sustainable upturn in the economy … Lower inflation reduces the risk of the Bank of England having to hike rates earlier than it may otherwise prefer to, allowing policy to focus on stimulating growth rather than warding off rising inflationary pressures.

The lower rate of inflation also has good news for consumers and businesses. Wages remain flat and thus the reduction in the CPI is crucial for consumers, as it improves their purchasing power. As for businesses, a low inflation environment creates more certainty, as inflation tends to be more stable. Businesses are more able to invest with confidence, again benefiting the economy. Any further falls in the CPI would bring inflation back to its target level of 2% and then undoubtedly concerns will turn back to the spectre of deflation, though with the recent announcements in energy price rises, perhaps we’re getting a little ahead of ourselves! Though we only need to look to countries such as Spain and Sweden where prices are falling to realise that it is certainly a possibility. The following articles consider the data and the impact.

UK inflation falls in October: what the economists say The Guardian, Katie Allen (12/11/13)
British inflation hits 13-month low, easing pressure on central bank Reuters, David Milliken and William Schomberg (12/11/13)
UK inflation falls to 2.2% in October BBC News (1211/13)
UK inflation falls to 13-month low: reaction The Telegraph (12/11/13)
Fall in inflation to 2.2% welcome by government The Guardian, Katie Allen (12/11/13)
Inflation falls to lowest level for a year as supermarket petrol price war helps ease the squeeze on family finances Mail Online, Matt Chorley (12/11/13)
Inflation falls to its lowest level for more than a year as consumers benefit from petrol pump price war Independent, John-Paul Ford Rojas (12/11/13)
UK inflation slows to 2.2%, lowest level in a year Bloomberg, Scott Hamilton and Jennifer Ryan (12/11/13)
Are we facing deflation? Let’s not get carried away The Telegraph, Jeremy Warner (12/11/13)

Questions

  1. How is the CPI calculated?
  2. Use an AD/AS diagram to illustrate how prices have been brought back down. Is the reduction in inflation due to demand-side or supply-side factors?
  3. What are the benefits of low inflation?
  4. The Telegraph article mentions the possibility of deflation. What is deflation and why does it cause such concern?
  5. Explain why a fall in the rate of inflation eases pressure on the Bank of England.
  6. How does the rate of inflation affect the cost of living?
  7. Is a target rate of inflation a good idea?
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Downgrading France

Nearly two years ago, France lost its triple A credit-rating and the news has only got worse. Unemployment has risen and economic growth in France has remained low and this is one of the reasons why France’s credit rating has been downgraded further from AA+ to AA. A high credit rating doesn’t guarantee market confidence, but it does help to keep the cost of borrowing for the government low. Thus, this downgrading could spell trouble for French borrowing costs.

Standard and Poor’s (S&P), who downgraded the French credit rating, is expecting government debt to rise to 86% of gross domestic product and believes that unemployment will remain above 10% until 2016. While the French government has put various reforms in place to boost the struggling economy, S&P don’t believe they are sufficient and have been very public in criticising the government’s effort. They were quoted as saying:

We believe the French government’s reforms to taxation, as well as to product, services and labour markets, will not substantially raise France’s medium-term growth prospects and that on-going high unemployment is weakening support for further significant fiscal and structural policy measures.

Following the downgrading, the return for those investors purchasing French debt did begin to rise, echoing the theory that the cost of borrowing would rise. The yield on French government 10-year bonds increased from 2.158% to 2.389%. The outlook given to France by S&P was ‘stable’, implying that there is a relatively low chance that S&P would change France’s credit-rating again in the next two years.

Many were surprised at the downgrading of France’s credit rating, but this may be the nudge that President Hollande needs to push through extensive labour market reforms with the aim of reducing unemployment and generating growth in the economy. Despite this latest move by S&P, the other credit rating agencies have yet to take similar action. Perhaps they are more convinced by the Finance Minister, Pierre Moscovici who claims that France’s debt is ‘one of the safest and most liquid in the world.’ He commented that:

They are underestimating France’s ability to reform, to pull itself up … During the last 18 months the government has implemented major reforms aimed at improving the French economic situation, restoring its public finances and its competitiveness.

It will take some time for the full impact of this development in France’s economy to become apparent. The cost of borrowing has already risen only time will tell what will happen to market confidence over the coming weeks. However, what is certain is that pressure is already mounting on Francois Hollande. The following articles consider the French economy.

France told to reform labour market after second credit rating downgrade The Guardian, Phillip Inman (8/13/13)
France’s credit rating cut by S&P to AA BBC News (8/11/13)
S&P lowers France rating on reform doubts, markets unfazed Reuters, Nicholas Vinocur (8/11/13)
Hollande approval rating slumps as France downgraded The Telegraph, James Titcomb (8/11/13)
S&P cuts France’s credit rating by one notch to double-A Wall Street Journal, William Horobin (8/11/13)
Five charts that show the state of the French economy The Telegraph (8/11/13)
France rating downgrade heaps pressure on Francois Hollande Financial Times, Michael Stothard (8/11/13)

Questions

  1. What does a double A rating mean for the French economy?
  2. Which factors will be considered when a ratings agency decides to change a country’s credit rating?
  3. France’s unemployment rate is one of the key factors that S&P has considered. Why is France’s unemployment rate so high? Which type(s) of unemployment are increasing?
  4. Use a diagram to illustrate the unemployment that France is facing.
  5. If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
  6. Markets have been ‘unfazed’ by the downgrade. How do you think markets will react to over the coming weeks? Explain your answer.
  7. What action could the French government take to ensure that S&P is the only ratings agency that downgrades their credit rating?
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The (not so) cool British housing market

UK house prices are incredibly volatile. This helps to explain the fascination that many of us have with the British housing market. According to the latest ONS house Price Index, the average UK house price in August 2013 was 3.8 per cent higher than 12 months earlier. The rates varied across the home nations: 4.1 per cent in England, 1.1 per cent in Northern Ireland, 1 per cent in Wales and -0.7 per cent in Scotland. Here we take a look at international house price inflation rates. Is the British housing market as unique as we think it is?

Let’s begin at home (excuse the pun). If we take the period from 1970 Q1 to 2013 Q2, the average annual rate of house price inflation across the UK is 9.7 per cent. The average rate in England is 9.8 per cent, as it is in Wales too, while in Scotland it is 9.0 per cent and in Northern Ireland it is 8.8 per cent. While the long-term averages of the UK nations are rather more similar than perhaps we might expect, what is quite interesting is the differences that emerge in more recent times. If we take the period from July 2008 to August 2013, the average annual rate of house price inflation in the UK is -0.2 per cent, in England it is 0.1 per cent, in both Wales and Scotland it is -1.0 per cent, while in Northern Ireland it is -11 per cent.

The recent English average is heavily distorted by London and to a lesser extent the rest of the South East. In London and the South East the average annual house price inflation rates since July 2008 have been 2.6 per cent and 0.2 per cent respectively. In all the other English regions the average rate has been negative. In my own region of the East Midlands the average rate has been -1.2 per cent – this is exactly the UK average if both London and the South East are removed from the figures.

Now let’s go international. Chart 1 shows annual house price inflation rates for the UK and six other countries since 1997. Interestingly, it shows that house price volatility is a common feature of housing markets. It is not a uniquely British thing. It also shows that the USA is notable for its relatively robust house price inflation rates of late. In the first half of 2013 annual house price inflation has been running at 7 per cent in America, compared with 2 to 3 per cent here in the UK. In contrast, the Netherlands has seen near-double digit rates of house price deflation over the past year, albeit with a rebound in the third quarter of this year. (Click here to download a PowerPoint of the chart.)

The chart captures very nicely the effect of the financial crisis and subsequent economic downturn on global house prices. Ireland saw annual rates of house price deflation touch 23 per cent in 2009 compared with rates of deflation of 12 per cent in the UK. Denmark too suffered significant house price deflation with prices falling at an annual rate of 15 per cent in 2009.

House price volatility appears to be an inherent characteristic of housing markets worldwide. Let’s now consider the extent to which house prices rise over the longer term. In doing so, we consider real house price growth after having stripped out the effect of consumer price inflation. Real house price growth measures the growth of house prices relative to consumer prices.

Chart 2 shows real house prices since 1996 Q1. (Click here to download a PowerPoint of the chart.) It shows that up to 2013 Q2, real house prices in the UK have risen by a factor of 2.24, i.e. they are two and a quarter times higher. This is a little less than in Sweden where prices are 2.5 times higher.

Chart 2 shows that the increase in real house prices in the UK and Sweden is significantly higher than in the other countries in the sample. In particular, in the USA real house prices in 2013 Q2 are only 1.16 times higher than in 1996 Q1. In the US actual house prices, when viewed over the past 17 years or so, have grown only a little more quickly than consumer prices.

The latest data on house prices suggest that house price volatility is not unique to the UK. However the rate of growth over the longer term relative to consumer prices is markedly quicker than in many other countries. It is this which helps to explain the amount of attention paid to the UK housing market – and not least by policy-makers.

Data
House Price Indices: Data Tables Office for National Statistics

Articles
First time buyers in race to beat house price rises Telegraph, Nicole Blackmore (8/11/13)
House prices soar by £13,000: Values rise at fastest rate for 3 years Express, Sarah O’Grady (7/11/13)
House prices: ‘south-east set to outpace London’ for first time in a decade Guardian, Jennifer Rankin (6/11/13)
UK house prices hit record level, says ONS BBC News, (15/10/13)
UK house prices rise at fastest pace in three years in October – Nationwide Reuter (31/11/13)
Jonathan Portes: UK house prices a ‘force of evil’ BBC News, (5/11/13)

Questions

  1. What is meant by the annual rate of house price inflation? What about the annual rate of house price deflation?
  2. What factors are likely to affect housing demand?
  3. What factors are likely to affect housing supply?
  4. Explain the difference between nominal and real house prices. What does a real increase in house prices mean?
  5. How might we explain the recent differences between house price inflation rates in London and the South East relative to the rest of the UK?
  6. What might explain the very different long-term growth rates in real house prices in the USA and the UK?
  7. Why were house prices so affected by the financial crisis?
  8. What factors help explain the volatility in house prices?
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