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Posts Tagged ‘inflation targeting’

Bank Rate ‐ first rise for more than 10 years

On 2 November, the Bank of England raised Bank rate from 0.25% to 0.5% – the first rise since July 2007. But was now the right time to raise interest rates? Seven of the nine-person Monetary Policy Committee voted to do so; two voted to keep Bank Rate at 0.25%.

Raising the rate, on first sight, may seem a surprising decision as growth remains sluggish. Indeed, the two MPC members who voted against the rise argued that wage growth was too weak to justify the rise. Also, inflation is likely to fall as the effects of the Brexit-vote-induced depreciation of sterling on prices feeds through the economy. In other words, prices are likely to settle at the new higher levels but will not carry on rising – at least not at the same rate.

So why did the other seven members vote to raise Bank Rate. There are three main arguments:

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.
There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.
With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

As the Governor stated at the press conference:

In many respects, the decision today is straightforward: with inflation high, slack disappearing, and the economy growing at rates above its speed limit, inflation is unlikely to return to the 2% target without some increase in interest rates.

But, of course, the MPC’s forecasts may turn out to be incorrect. Many things are hard to predict. These include: the outcomes of the Brexit negotiations; consumer and business confidence and their effects on consumption and investment; levels of growth in other countries and their effects on UK exports; and the effects of the higher interest rates on saving and borrowing and hence on aggregate demand.

The Bank of England is well aware of these uncertainties. Although it plans two more rises in the coming months and then Bank Rate remaining at 1% for some time, this is based on its current assessment of the outlook for the economy. If circumstances change, the Bank will adjust the timing and total amount of future interest rate changes.

There are, however, dangers in the rise in interest rates. Household debt is at very high levels and, although the cost of servicing these debts is relatively low, even a rise in interest rates of just 0.25 percentage points can represent a large percentage increase. For example, a rise in a typical variable mortgage interest rate from 4.25% to 4.5% represents a 5.9% increase. Any resulting decline in consumer spending could dent business confidence and reduce investment.

Nevertheless, the Bank estimates that the effect of higher mortgage rates is likely to be small, given that some 60% of mortgages are at fixed rates. However, people need to refinance such rates every two or three years and may also worry about the rises to come promised by the Bank.

Articles
Bank of England deputy says interest rate rise means pain for households and more hikes could be in store Independent, Ben Chapman (3/11/17)
UK interest rates: Bank of England shrugs off Brexit nerves to launch first hike in over a decade Independent, Ben Chu (2/11/17)
Bank of England takes slow lane after first rate hike since Reuters, David Milliken, William Schomberg and Julian Satterthwaite (2/11/17)
First UK rate rise in a decade will be a slow burn Financial Times, Gemma Tetlow (2/11/17)
The Bank of England’s Rate Rise Could Spook Britain’s Economy Bloomberg, Fergal O’Brien and Brian Swint (3/11/17)
Bank of England hikes rates for the first time in a decade CNBC, Sam Meredith (2/11/17)
Interest rates rise in Britain for the first time in a decade The Economist (2/11/17)

Bank of England publications
Bank of England Inflation Report Press Conference, Opening Remarks Financial Times on YouTube, Mark Carney (2/11/17)
Bank of England Inflation Report Press Conference, Opening Remarks Bank of England, Mark Carney (2/11/17)
Inflation Report Press Conference (full) Bank of England on YouTube (2/11/17)
Inflation Report Bank of England (November 2017)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 1 November 2017 Bank of England (2/11/17)

Questions

  1. Why did the majority of MPC members feel that now was the right time to raise interest rates whereas a month ago was the wrong time?
  2. Why did the exchange rate fall when the announcement was made?
  3. How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?
  4. Can monetary policy affect potential output, or only actual output?
  5. If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?
  6. Why does the MPC effectively target inflation in the future (typically in 24 months’ time) rather than inflation today? Note that Mark Carney at the press conference said, “… it isn’t so much where inflation is now, but where it’s going that concerns us.”
  7. To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?
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Do countries have the right tools to steer economies though turbulent times?

In three interesting articles, linked below, the authors consider the state of economies since the financial crisis of 2007–8 and whether governments have the right tools to tackle future economic shocks.

There have been some successes over the past 10 years, in particular keeping inflation close to central bank targets despite considerable shocks (see the Vox article). Also unemployment has fallen in most countries and to very low levels in some, including the UK.

But economic growth has generally remained well below the levels prior to the financial crisis, with low productivity growth being the main culprit. Indeed, many people have seen no growth at all in their real incomes over the past 10 years, with low unemployment being bought at the cost of a growth in zero-hour contracts and work in the gig economy. And what economic growth we have seen has been largely the result of taking up slack through unprecedentedly loose monetary policy.

Fiscal policy, except in the period directly following the financial crisis, has generally been tight as governments have sought to reduce their deficits and slow down the growth in their debt.

But what will happen if economies once more slow? Or, worse still, what will happen if there is another global recession? Do countries have the policies to tackle the problem this time round?

Quantitative easing could be used again, but many economists believe that it will have more limited scope if confined to the purchase of assets in the secondary market. Also, there is little scope for reducing interest rates, which, despite some modest rises in the USA, remain at close to zero in most developed countries.

One possibility is a combination of monetary and fiscal policy, where new money is used to finance government expenditure on infrastructure, such as road and rail, broadband, green energy, hospitals and schools and colleges. This would avoid the need for governments to borrow on open markets as the spending would be financed by new government securities purchased directly by the central bank.

An objection to such ‘people’s quantitative easing‘, as it has been dubbed, is that it would effectively end the independence of central banks. This independence has been credited by many with giving central banks credibility in controlling inflation. Would inflationary expectations rise with people’s quantitative easing and, with it, actual inflation? A lot would depend on the extent to which this QE could still be conducted within a framework of targeting inflation and whether people’s expectations of inflation could be managed jointly by the government and central bank.

Articles
How should recessions be fought when interest rates are low? The Economist. Free exchange (21/10/17)
The economy is failing. We need to think radically about how to fix it The Guardian, Liam Byrne (25/10/17)
Elusive inflation and the Great Recession Vox, David Miles, Ugo Panizza, Ricardo Reis, Ángel Ubide (25/10/17)

Videos
Economics since the crisis Vox on YouTube. Charles Goodhart (11/10/17)
Is the system broken? Vox on YouTube, Anat Admati (12/10/17)
Signs of a crisis Vox on YouTube, Christian Thimann (19/10/17)
Policy stances since 2007 Vox on YouTube, Paul Krugman (29/10/17)
Did policymakers get it right? Vox on YouTube, Paul Krugman (4/10/17)

Questions

  1. Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
  2. Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
  3. Why have central banks appeared to have been so successful in keeping inflation close to target despite negative and positive demand- and supply-side shocks?
  4. Why are the pressures on government expenditure likely to increase in the coming years?
  5. How would a temporary price-level target help to tackle a recession when the economy next bumps into the ZLB? What would limit its success?
  6. Is it appropriate for central banks to stick to an inflation target in times when there is an adverse supply-side shock resulting in cost-push inflation?
  7. Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
  8. What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
  9. What are the arguments for and against using helicopter money to boost private expenditure during a future recession where interest rates are already near the ZLB?
  10. What are the arguments for and against using ‘people’s QE’?
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A fall in the UK natural rate of unemployment?

When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)

The NAIRU is a similar, although not identical, concept to the natural rate of unemployment. The natural rate is the equilibrium rate consistent with an overall long-term balance of aggregate labour demand and supply: i.e. the rate after short-term cyclical movements in unemployment have been discounted. It is thus a long-term concept.

The NAIRU, although similar, focuses on the relationship between inflation and unemployment. With inflation caused solely by demand-side factors, the natural rate and the NAIRU will be similar if not identical. However, if cost-push factors change – say there is a poor harvest, which pushes up food prices and inflation (temporarily), or a substantial depreciation of the exchange rate caused by political factors (such as Brexit) – the NAIRU would increase, at least in the short term, as a higher rate of unemployment would be necessary to stop inflation rising. In the long term, although being defined differently, the NAIRU and the natural rate will be the same.

In practice, because the Bank of England is targeting inflation at a 24-month time horizon, the NAIRU for the UK at that point could also be seen as the natural rate.

So with the Bank of England not raising interest rates despite the considerable fall in the unemployment rate, does this imply a fall in the natural rate of unemployment? The answer is yes. The reason has to do with changes in the structure of the labour market.

The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.

Tax and benefit reforms over the years have increased the incentive for the unemployed to take work.

Perhaps the biggest factor is a greater flexibility in the labour market. As union power has waned and as people are increasingly working on flexible contracts, including zero-hour contracts, so this has moderated wage increases. At the same time, many firms are facing increased competition both from abroad and domestically via the Internet. This has put downward pressure on prices and hence on the wages firms are willing to pay.

The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.

So what is the natural rate of unemployment today? It is certainly much lower than 7%; the consensus is that it is probably below 5%. As Kristin Forbes, External MPC Member of the Bank of England stated in a recent speech:

[Unemployment] is forecast to increase gradually from its current 4.8% to a high of 5.0% in the second half of 2017, before falling back to its current rate by the end of 2019. To put this in context, 5.0% was previously believed to be around the UK’s natural rate of unemployment – the rate below which unemployment could not fall without wages picking up to levels inconsistent with sustaining inflation around the 2% target. Unemployment at 5.0% is also below the average unemployment rate for the UK over the pre-crisis period from 1997 to 2007 (when it was 5.5%).

She went on to discuss just what the figure is for the natural, or ‘equilibrium’, rate of unemployment (U*). One problem here is that there is considerable uncertainty over the figure in the current forecast made by the Bank.

[An] assumption in the forecast about which there is substantial uncertainty is of the equilibrium unemployment rate – or U* for short. Since I have been on the MPC, the Committee has assumed that U* was around 5%. This implied that the more by which unemployment exceeded 5%, the more slack existed in the economy, and the less upward momentum would be expected in wages (controlling for other factors, such as productivity growth).

As part of our annual assessment of regular supply-side conditions this January, Bank staff presented several pieces of analysis that suggested U* may be lower than 5% today [see, for example]. The majority of the MPC voted to lower our estimate of U* to 4.5%, based partly on the persistent weakness of wage growth over the past few years after accounting for other factors in our models. [See page 20 of the February 2017 Inflation Report.]

My own assessment, however, suggested that although U* was likely lower than 5% today, it is likely not as low as 4.5%. If true, this would suggest that there is less slack in the economy than in the MPC’s central forecast, and wage growth and inflation could pick up faster than expected.

Against that, however, uncertainty related to Brexit negotiations could make firms more cautious about raising wages, thereby dampening wage growth no matter where unemployment is relative to its equilibrium. Moreover, even if we could accurately measure the level of U* in the economy today, it could easily change over the next few years as the labour force adjusts to any changes in the movement of labour between the UK and European Union.

Determining the precise figure of the current natural rate of unemployment, and predicting it for the medium term, is very difficult. It involves separating out demand-side factors, which are heavily dependent on expectations. It also involves understanding the wage elasticity of labour supply in various markets and how this has been affected by the increased flexibility of these markets.

Articles
When will Britons get a pay rise? The Guardian, Phillip Inman (26/2/17)
BoE decision, Inflation Report – Analysts react DigitalLook, Alexander Bueso (2/2/17)
Bank of England hikes UK economic growth forecasts but warns of rising inflation The Telegraph, Szu Ping Chan (2/2/17)

Bank of England publications
Inflation Report Bank of England (February 2017)
A MONIAC (not manic) economy Bank of England Speeches, Kristin Forbes (8/2/17)
The labour market Bank of England Speeches, Michael Saunders (31/1/17)

Questions

  1. Distinguish between the following terms: natural rate of unemployment, NAIRU, equilibrium rate of unemployment, disequilibrium rate of unemployment.
  2. For what reasons did the Monetary Policy Committee members feel that the equilibrium rate of unemployment might be as low as 4.25%?
  3. Why might it be as high as 5%?
  4. How are changes in migration trends likely to affect (a) wage growth and (b) unemployment?
  5. How is the amount of slack in an economy measured? What impact does the degree of slack have on wage growth and inflation?
  6. What is meant by the ‘gig’ economy? How has the development of the gig economy impacted on unemployment and wages?
  7. Why has there been a considerable rise in self employment?
  8. How may questions of life style choice and control over the hours people wish to work impact on the labour market?
  9. If people are moving jobs less frequently, does this imply that the labour market is becoming less flexible?
  10. Why may firms in the current climate be cautious about raising wages even if aggregate demand picks up?
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Doves from above

With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?

The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).

The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.

The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.

One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)

The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.

Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)

Questions

  1. Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
  2. Go through each of the methods and consider the problems they are likely to create/have created.
  3. How important is it that monetary policy measures affect people’s expectations?
  4. What effects do the measures have on the distribution of income between borrowers and savers?
  5. What are annuities? How are these affected by policies of monetary easing?
  6. How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
  7. Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
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Rethinking monetary policy targets

Should the object of monetary policy be simply one of keeping inflation within a target range? In a speech given on 9 October, the Governor of the Bank of England, Sir Mervyn King, questioned whether the interest-rate setting policy of the Monetary Policy Committee (MPC) has been too narrow.

He considered whether interest rates should have been higher before the financial crisis and crash of 2007–9. This could have helped to reduce the asset price bubble and discouraged people from taking out excessive loans.

But then there is the question of the exchange rate. Would higher interest rates have pushed the exchange rate even higher, with damaging effects on exports? Today the trade weighted exchange rate is some 20% lower than before the crash. The government hopes that this will encourage a growth in exports and help to fuel recovery in demand. But as Dr King said, “The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time.”

Then there is the question of economic growth. Should a target rate of growth be part of the MPC’s target? Should the MPC adopt a form of Taylor rule which targets a weighted average of the inflation rate and the rate of economic growth?

Certainly monetary policy today in the UK and many other countries is very different from five years ago. With interest rates being close to zero, there is little scope for further reductions; after all, nominal rates cannot fall below zero, otherwise people would be paid for borrowing money! So the focus has shifted to the supply of money. Several attempts have been made to control the money supply through programmes of quantitative easing. Indeed many economists expect further rounds of quantitative easing in the coming months unless there is a substantial pick up in aggregate demand.

So what should be the targets of monetary policy? The following articles look at Dr King’s speech and at various alternatives to a simple inflation target.

Articles
Mervyn King says must face up to monetary policy’s limits’ Reuters, David Milliken and Sven Egenter (9/10/12)
Bank of England’s Mervyn King defends low interest rates pre-crisis The Telegraph, Emma Rowley (9/10/12)
Banks should have had a leverage cap before crash, says Mervyn King The Guardian, Heather Stewart and Phillip Inman (9/10/12)
King Says BOE Must Keep Targeting Inflation as Tool Revamp Looms Bloomberg, Scott Hamilton and Svenja O’Donnell (9/10/12)
After 20 years, time to change Merv’s medicine? Channel 4 News blogs, Faisal Silam (9/10/12)
King signals inflation not primary focus Financial Times, Norma Cohen and Sarah O’Connor (9/10/12)
Should Bank start the helicopter? BBC News, Stephanie Flanders (12/10/12)

Speech
Twenty years of inflation targeting Bank of England speeches, Mervyn King (9/10/12)

Questions

  1. What are the arguments for using monetary policy to target a particular rate of inflation?
  2. Would it ever be a good idea to adjust the targeted rate of inflation up or down and if so when and why?
  3. Explain how a Taylor rule would work and in what ways it is superior or inferior to pursuing a simple inflation target.
  4. Are attempts to control the money supply through quantitative easing (or tightening) consistent or inconsistent with pursuing an inflation target? Explain.
  5. What are the arguments for and against abandoning targeting in monetary policy and replacing it with discretionary policy that takes a number of different macroeconomic indicators into account?
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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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4.4% and rising?

In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. Since then it has remained at the same level. Interest rates are used by the Bank of England, which aims to keep inflation at the 2% target within a 1% gap either side. However, inflation has been above 3% for some 15 months and the latest figures for February 2011 show that inflation is rising. In January, it was 4%, but data for February calculates an inflation rate of 4.4% – significantly above the Bank of England’s target rate of 2% and above the forecast rate for the month.

One of the causes of such high inflation is the price of fuel, food and clothing. No-one can have failed to notice that petrol prices are higher than ever and this is one of the factors contributing to an increase in the level of prices throughout the economy. Clothing and footwear costs, which rose by 3.6% after the January sales have also contributed to this rising figure and will put increasing pressure on the MPC to raise interest rates in the not so distant future.

In the February 2011 meeting of the Monetary Policy Committee, interest rates were kept at 0.5%, despite markets pricing the chance of a rate rise at 20%. The negative growth experienced in the final quarter of 2010 is likely to have influenced this decision, but will the inflation data we’re now seeing influence the next meeting of the MPC. This undoubtedly puts pressure on the central bank to increase interest rates to try to get inflation back on target. The cost? It could put the recovery in jeopardy and create the possibility of a double-dip recession. There is a conflict here and whatever happens to interest rates, some groups will say it’s the wrong decision. As David Kern said:

“The MPC must be careful before it takes action that may threaten the fragile recovery, particularly in the face of a tough austerity plan.”

Perhaps the Budget will provide us with some more information about how the government intends to cut the hole in public finances, ensure that the economy does not fall back into recession and keep inflation under control.

UK inflation revives talk of early interest rate rise Reuters, David Milliken and Christina Fincher (22/3/11)
How to inflation-proof your savings Telegraph, Emma Simon (22/3/11)
UK inflation rate rises to 4.4% in February BBC News (22/3/11)
Interest rates: What the economists say Guardian (10/2/11)
Q&A: Impact of rising inflation Guardian, Phillip Inman (22/3/11)
Inflation soars to over double target rate Sky News, Hazel Baker (22/3/11)
Inflation and public borrowing add to budget 2011 headaches Guardian, Larry Elliott (22/3/11)
Inflation cutting savers’ options BBC News, Kevin Peachey (22/3/11)
Inflation: What the economists say Guardian (22/3/11)

Questions

  1. Is inflation likely to continue going up? What might stop the rise?
  2. Why are interest rates such an important tool of monetary policy?
  3. What is the relationship between interest rates and inflation?
  4. What are the costs of high inflation? Does anyone benefit?
  5. Who would gain and who would lose if interest rates are increased in the next MPC meeting?
  6. Which factors have contributed towards rising inflation in the UK? Is it cost-push or demand-pull inflation?
  7. Why does this pose a dilemma for the government in terms of public finances and the recession?
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Wisdom of hindsight

Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.

According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:

CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.

It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.

Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)

Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)

Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England

Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)

Questions

  1. Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
  2. Explain the difference between the forecasts and the outturn.
  3. Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
  4. What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
  5. Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
  6. What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
  7. How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
  8. Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
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Bank rate

In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.

However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:

“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.

Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”

Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.

BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)

Questions

  1. Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
  2. What is the relationship between interest rates and inflation?
  3. What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
  4. How has the recent speculation affected fixed rate mortgages?
  5. What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
  6. What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
  7. Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?
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Mixed messages on interest rates

What will happen to interest rates over the next two or three years? There is considerable disagreement between economists on this question at the moment.

There are those who argue that recovery in the UK, the USA and Europe is faltering. With much tighter fiscal policy being adopted as countries attempt to claw down their deficits, there is a growing fear of a double-dip recession. In these circumstances central banks are likely to keep interest rates at their historically low levels for the foreseeable future and could well embark on a further round of quantitative easing (see Easy money from the Fed?). But what about inflation? With demand still expanding in developing countries and commodity prices rising, won’t cost pressures on inflation continue? Those who forecast that interest rates will stay low, argue that the pressure on commodity prices will ease as global demand slows. Also, in the UK, now that sterling is no longer depreciating, this will remove a key ingredient of higher inflation.

These views are not shared by other economists. They argue that interest rates could soar over the next two years. In fact, one economist, Andrew Lilico, the Chief Economist at Policy Exchange argues that interest rates in the UK will reach 8% by 2012. Central to their argument is the role of the money supply. The monetary base has been expanded enormously through programmes of quantitative easing. And yet, consumer credit has fallen. When the economy does eventually start to recover strongly, Lilico and others argue that there is a danger that consumer credit and broad money will expand rapidly, thereby fuelling inflation. But won’t the spare capacity that has built up during the recession allow the increase in aggregate demand to be met by a corresponding increase in output, thereby keeping inflation low. No, say these economists. A lot of capacity has been lost and output cannot easily expand to meet a rise in demand.

It’s not uncommon for economists to disagree! See, by reading the articles below, if you can unpick the arguments and establish where the disagreements lie and whose case is the strongest.

Articles
America’s century is over, but it will fight on Guardian, Larry Elliott (23/8/10)
Rates to remain low for foreseeable future Interactive Investor, Rhian Nicholson (18/8/10)
BoE gets benefit of doubt on inflation – for now Reuters, Christina Fincher (19/8/10)
BGilts reflect continued uncertainty AXA Elevate, Tomas Hirst (23/8/10)
A bull market in pessimism The Economist (19/8/10)
Interest rates ‘may hit 8%’ by 2012 says think tank BBC News (22/8/10)
Interest rates ‘may hit 8pc’ in two years Telegraph, Philip Aldrick (21/8/10)
Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says Bloomberg, Scott Lanman and Simon Kennedy (23/8/10)
Inflation, not deflation, Mr. Bernanke Market Watch, Andy Xie (22/8/10)
Inflation comes through the door and wisdom flies out of the window Telegraph, Liam Halligan (21/8/10)

Data
British Government Securities, Yields Bank of England
Bankstats: Data on UK money and lending Bank of England

Questions

  1. Summarise the arguments of those who believe that interest rates will stay low for the foreseeable future.
  2. Summarise the arguments of those who believe that interest rates will be significantly higher by 2010.
  3. What factors will be the most significant in determining which of the two positions is correct?
  4. Why are the yields on long-term bonds a good indicator of people’s expectations about future inflation and monetary policy?
  5. Why has consumer credit fallen? Why might it rise again?
  6. Why may unemployment not fall rapidly as the economy recovers? Is this an example of hysteresis?
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