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A gathering storm (Part 1)

This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.

The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.

In the introduction to the report, the Governor, Mervyn King, writes:

Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.

And at the news conference launching the report, he said:

We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.

The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.

The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:

Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.

We look in more detail at the question of lost capacity in Part 2.

Articles
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)

Inflation Report
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)

Additional Data
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial Affairs
Annual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury

Questions

  1. What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
  2. Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
  3. How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
  4. Why may capacity have been lost since the financial crisis of 2008?
  5. Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
  6. What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
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