Pearson - Always learning

All your resources for Economics

RSS icon Subscribe | Text size

Posts Tagged ‘Monetary Policy Committee’

A portent of tighter monetary policy in the UK?

On the 15th June, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate on hold at its record low of 0.25%. This was not a surprise – it was what commentators had expected. What was surprising, however, was the split in the MPC. Three of its current eight members voted to raise the rate.

At first sight, raising the rate might seem the obvious thing to do. CPI inflation is currently 2.9% – up from 2.7% in April and well above the target of 2% – and is forecast to go higher later this year. According to the Bank of England’s own forecasts, even at the 24-month horizon inflation is still likely to be a little above the 2% target.

Those who voted for an increase of 0.25 percentage points to 0.5% saw it as modest, signalling only a very gradual return to more ‘normal’ interest rates. However, the five who voted to keep the rate at 0.25% felt that it could dampen demand too much.

The key argument is that inflation is not of the demand-pull variety. Aggregate demand is subdued. Real wages are falling and hence consumer demand is likely to fall too. Thus many firms are cautious about investing, especially given the considerable uncertainties surrounding the nature of Brexit. The prime cause of the rise in inflation is the fall in sterling since the Brexit vote and the effect of higher import costs feeding through into retail prices. In other words, the inflation is of the cost-push variety. In such cirsumstances dampening demand further by raising interest rates would be seen by most economists as the wrong response. As the minutes of the MPC meeting state:

Attempting to offset fully the effect of weaker sterling on inflation would be achievable only at the cost of higher unemployment and, in all likelihood, even weaker income growth. For this reason, the MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.

The MPC recognises that the outlook is uncertain. It states that it stands ready to respond to circumstances as they change. If demand proves to be more resilient that it currently expects, it will raise Bank Rate. If not, it is likely to keep it on hold to continue providing a modest stimulus to the economy. However, it is unlikely to engage in further quantitative easing unless the economic outlook deteriorates markedly.

Articles
The Bank of England is moving closer to killing the most boring chart in UK finance right now Business Insider, Will Martin (16/6/17)
UK inflation hits four-year high of 2.9% Financial Times, Gavin Jackson and Chloe Cornish (13/6/17)
Surprise for markets as trio of Bank of England gurus call for interest rates to rise The Telegraph, Szu Ping Chan Tim Wallace (15/6/17)
Bank of England rate setters show worries over rising inflation Financial TImes, Chris Giles (15/6/17)
Three Bank of England policymakers in shock vote for interest rate rise Independent, Ben Chu (15/6/17)
Bank of England edges closer to increasing UK interest rates The Guardian, Katie Allen (15/6/17)
Bank of England doves right to thwart hawks seeking interest rate rise The Guardian, Larry Elliott (15/6/17)
Haldane expects to vote for rate rise this year BBC News (21/6/17)

Bank of England documents
Monetary policy summary Bank of England (15/6/17)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 14 June 2017 Bank of England (15/6/17)
Inflation Report, May 2017 Bank of England (11/5/16)

Questions

  1. What is the mechanism whereby a change in Bank Rate affects other interest artes?
  2. Use an aggregate demand and supply diagram to illustrate the difference between demand-pull and cost-push inflation.
  3. If the exchange rate remains at around 10–15% below the level before the Brexit vote, will inflation continue to remain above the Bank of England’s target, or will it reach a peak relatively soon and then fall back? Explain.
  4. For what reason might aggregate demand prove more buoyant that the MPC predicts?
  5. Would a rise in Bank Rate from 0.25% to 0.5% have a significant effect on aggregate demand? What role could expectations play in determining the nature and size of the effect?
  6. Why are real wage rates falling at a time when unemployment is historically very low?
  7. What determines the amount that higher prices paid by importers of products are passed on to consumers?
Share in top social networks!

Interest rates still at 0.5%

In 2009, interest rates in the UK were cut to a record low of 0.5%. Since that point, there has been almost unanimous agreement amongst the members of the Monetary Policy Committee to keep rates at this low. It is only in the last couple of months when some have even voted to raise rates. However, this month, interest rates were once again held at 0.5%.

The low interest rates have played a key part in creating an economic stimulus for the UK economy. With low interest rates, some of the key components of aggregate demand are stimulated and this in turn is crucial in creating a growth environment. However, with the recovery of the UK economy, there are now expectations that interest rates may soon begin to rise. Perhaps adding to this expectation is the fact that the bank’s stimulus programme has remained unchanged at £375bn. As more data is released that continues to show the positive progress of the UK economy, it becomes increasingly likely that interest rates will soon rise.

Despite the fact that interest rates will inevitably increase, Mark Carney has said that any increase will be slow and gradual to minimise the effect on consumers, especially home-owners. Mortgage payments are typically the biggest expenditure for a household and so any increase in interest rates will certainly put added pressure on home-owners and with wage growth still remaining slow, there are concerns of the impact this may have. Perhaps this may continue to deter some of the Committee for voting in favour of interest rate rises. There does appear to be some conflict between economists as to what the next step is likely to be. Yael Selfin is the economics director at KPMG and said:

With inflationary pressures still subdued, it is no surprise that rates have been held … Despite recent revisions to GDP and productivity, there is still room for further improvements in productivity, to mop up some of the rise in demand over the coming months. Steady falls in unemployment and strong economic growth are likely to see rates rising in February next year.

However, Andrew Goodwin, who is the senior economic adviser to the EY ITEM Club commented that:

On one hand, the stronger performance might convince some members that the economy is sufficiently robust to withstand the steady tightening of policy, although it should be noted that the Bank routinely builds into its forecasts the expectation of some upward revisions to the recent historical data … On the flip side, the revisions also provide some ammunition for those of a dovish persuasion, with evidence that a stronger productivity performance has had little feed through into inflationary pressures.

The key question therefore appears to be not whether interest rates will increase, but when. The MPC certainly considers inflation when making its decisions, but over the past few years, it is economic growth which has probably been the biggest influence. The data for the UK economy over the coming months, as well as the fast-approaching General Election, will prove crucial in determining exactly when interest rates increase. The following articles consider this monetary policy change.

UK interest rates held at record low of 0.5% BBC News (4/9/14)
Bank of England holds interest rates at 0.5pc for 66th month The Telegraph, Szu Ping Chan (4/9/14)
Timing of UK interest rate hike mired in UK services sector conundrum International Business Times, Lianna Brinded (3/9/14)
Interest rates expected to hold Mail Online, Press Association (31/8/14)
Bank of England holds rates despite robust recovery Reuters, Andy Bruce (4/9/14)
Bank of England keeps record-low rate on weak inflation Bloomberg, Scott Hamilton (4/9/14)

Questions

  1. By outlining the key components of aggregate demand, explain the mechanisms by which interest rates will affect each component.
  2. How can inflation rates be affected by interest rates?
  3. Why is there a debate between economists and the MPC as to when interest rates should be increased?
  4. If interest rates do increase, how is this likely to affect home-owners?
  5. What are the advantages and disadvantages of a slow and gradual rise as opposed to one big rise?
Share in top social networks!

The MPC – looking for a remit (Part 1: the options)

Although the Monetary Policy Committee (MPC) of the Bank of England is independent in setting interest rates, until recently it still had to follow a precise remit set by the government. This was to target inflation of 2% (±1%), with interest rates set to meet this target in 24 months’ time. But things have changed since the new Governor, Mark Carney, took up office in July 2013. And now things are not so clear cut.

The Bank announced that it would keep Bank Rate at the current historically low level of 0.5% at least until unemployment had fallen to 7%, subject to various conditions. More generally, the Bank stated that:

The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.

This ‘forward guidance’ was designed to provide more information about future policy and thereby more certainty for businesses and households to plan.

But unemployment has fallen rapidly in recent months. It fell from a 7.7% average for the three months May to July 2013 to 7.1% for the latest available three months (September to November 2013). And yet there is still considerable slack in the economy.

It now, therefore, looks highly unlikely that the MPC will raise Bank Rate as soon as unemployment falls below 7%. This then raises the question of how useful the 7% target has been and whether, if anything, it has created further uncertainty about future MPC decisions.

The following still appears on the Bank of England website:

The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.

But this raises two questions: (a) how do you measure ‘economic slack’ and (b) what constitutes a substantial reduction?

So what should the Bank do now? What, if any, forward guidance should it offer to the markets? Will that forward guidance be credible? After all, credibility among businesses and households is an important condition for any policy stance. According to Larry Elliott in the first article below, there are five options.

Articles
Bank of England’s method of setting interest rates needs reviewing The Guardian, Larry Elliott (9/2/14)
Mark Carney set to adjust Bank interest rate policy BBC News (12/2/14)
Forward guidance: dead and alive BBC News, Robert Peston (11/2/14)
What “forward guidance” is, and how it (theoretically) works The Economist (11/2/14)
BOE’s forward guidance 2.0: Cheap talk, or big change? Market Watch (11/2/14)

Bank of England pages
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England

Questions

  1. What data would you need to have in order to identify the degree of economic slack in the economy?
  2. Why is it difficult to obtain such data – at least in a reliable form?
  3. Why might the issuing of the forward guidance last July have itself contributed to the fall in unemployment?
  4. Why is it difficult to obtain such data – at least in a reliable form?
  5. Why is credibility an important requirement for policy?
  6. Why may LFS unemployment be a poor guide to the degree of slack in the economy?
  7. Discuss the relative merits of each of the five policy options identified by Larry Elliott.
Share in top social networks!

Questions of credibility

The Bank of England was granted independence to set interest rates back in 1997. In setting rates its looks to meet the government’s annual inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point).

The economic benefits of delegating interest rate decisions to a body like the Monetary Policy Committee (MPC) are often taken for granted. But, in David Blanchflower’s article in the Independent Newspaper on 14 May, the former MPC member questions whether, at least in recent years, better decisions would have been made by the Treasury and the Chancellor of the Exchequer. In other words, could politicians have made more appropriate monetary policy choices?

Central bank independence has become increasingly popular. Many governments have taken steps to depoliticise monetary policy choices and to hand over important powers, such as setting interest rates, to central bankers. One of the main advantages, it is argued, is that politicians are no longer able to manipulate monetary policy choices in order to try and affect their popularity and their chances of being re-elected. The policy announcements of central bankers are said to be more credible because they do not have the incentive to deviate from their announced policy. For instance, the low inflation announcements of elected policy-makers lack credibility because politicians have an incentive to inflate the economy and so boost growth and employment prior to the election.

The incentive for a pre-election dash for growth means that the general public are reluctant to bargain for low wage increases in case policy is loosened or is looser than it should be given the prevailing economic climate. In this case, it might mean that interest rates are lower than they would otherwise be in the run up to the election. In order to protect their spending power households bargain for higher wage increases than they would if the policy announcements could be trusted. In contrast, the low inflation announcements of central bankers have credibility and so inflation will be lower. In terms of economic jargon, central bank independence will reduce inflation bias as well as promoting economic stability.

Blanchflower questions whether the path of interest rates in the UK between 1997 and 2007 would have been materially different should the Treasury have been setting interest rates rather than the MPC. But, he believes that:

Interest rates would probably have been higher in 2007 as the housing boom was ranging and house price to earnings ratios approached unsustainable levels. Alistair Darling has made it clear he would have cut rates earlier in 2008, if it had been left to him….

Blanchflower argues that part of the reason that the Treasury might have made better choices in the more recent past is the narrow remit of the Bank of England to target inflation. He argues:

Now is the time to consider switching to a dual mandate that would include growth, which would give much needed flexibility.

Blanchflower calls into question the idea that targeting inflation alone can bring stability. The recent past he argues simply dispels this notion. To help form your own views try having a read of the full article and then answer the questions below.

David Blanchflower Article
The recession deniers have gone strangely quiet this month Independent, David Blanchflower (14/05/12)

Questions

  1. If economic growth is a good thing, why might we want to reduce the chances of policymakers manipulating policy to attempt a pre-election dash for growth?
  2. What do you understand by credible economic policy announcements? How might a lack of credibility affect the economy’s rate of inflation?
  3. What does central bank independence mean for the conduct of monetary policy in the UK? In answering this you might wish to visit the Bank of England website and read about the UK’s monetary policy framework.
  4. Try summarising David Blanchflower’s argument against the inflation rate remit of the Bank of England.
  5. What do you consider to be the possible dangers of widening the Bank of England’s remit beyond just targeting the annual rate of CPI inflation?
  6. Central bank independence is one way in which governments can constrain their discretion over economic policy. In what other ways can they constrain their policy choices?
  7. Do you think governments should have full discretion over their policy choices or do you think there should be limits?
Share in top social networks!

An economic puzzle

Between December 2007 and March 2009, the Bank of England reduced Bank Rate on several occasions in order to stimulate the economy and combat recession. By March 2009, the rate stood at a record low of 0.5%. Each month the Monetary Policy Committee meets to decide on interest rates and since March 2009, the members’ decision has consistently been that Bank Rate needs to remain at 0.5%.

Although the UK economy has been making tentative steps towards recovery, it is still in a very vulnerable state. Last month, the Bank of England extended its programme of quantitative easing to a total £325bn stimulus. This, together with the decision to keep interest rates down and with the shock fall in manufacturing output contributing towards first quarter growth of just 0.1%, is a key indication that the UK economy is still struggling, even though the central bank thinks it unlikely that the UK will re-enter recession this year.

Monetary policy in the UK has been very much geared towards stimulating economic growth, despite interest rates typically being the main tool to keep inflation on target at 2%. The problem facing the central bank is that economic growth and inflation are in something of a conflict. Low interest rates to stimulate economic growth also create a higher inflation environment and that is the trade-off the economy has faced. Inflation has been well above its target for some months (a high of 5.2% in September 2011), and the low interest rate environment has done little to deflate the figure. After all, low interest rates are a monetary instrument that can be used to boost aggregate demand, which can then create demand-pull inflation. However, inflation is now slowly beginning to fall, but this downward trend could be reversed with the sky high oil prices we are recently experiencing. If inflation does begin to creep back up, the Monetary Policy Committee will once again face a decision: keep Bank Rate low and continue with quantitative easing to stimulate the economy or increase Bank Rate to counter the higher rate of inflation.

The data over recent months has been truly inconsistent. Some indicators suggest improvements in the economy and the financial environment, whereas others indicate an economic situation that is moving very quickly in the wrong direction. A key factor is that the direction the UK economy takes is very much dependent on the world economy and, in particular, on how events in the eurozone unfold. The following articles consider some of the latest economic developments.

UK economy grew 0.1% to avoid recession, says NIESR Guardian, Katie Allen (5/4/12)
UK interest rates held at 0.5% BBC News (5/4/12)
UK just about avoided recession in Q1, NIESR says Telegraph, Angela Monaghan (5/4/12)
Bank of England keeps interest rates on hold at 0.5pc Telegraph (5/4/12)
UK economy ‘weak but showing signs of improvement’ BBC News (3/4/12)
Bank of England holds on quantitative easing and interest rates Guardian, Katie Allen (5/4/12)
Faith on Tories on economy hits new low Financial Times, Helen Warrell (6/4/12)

Questions

  1. Which factors will the Monetary Policy Committee consider when setting interest rates?
  2. Using a diagram to help your answer, illustrate and explain the trade-off that the MPC faces when choosing to keep interest rates low or raise them.
  3. What is quantitative easing? How is it expected to boost economic growth in the UK?
  4. Which factors are likely to have contributed towards the low growth rate the UK economy experienced in the first quarter of 2012?
  5. Explain the trends that we have seen in UK inflation over the past year. What factors have caused the figure to increase to a high in September and then fall back down?
  6. What do you expect to happen to inflation over the next few months? To what extent is your answer dependent on the MPC’s interest rate decisions?
  7. Although the official figures suggest that the UK avoided a double-dip recession, do you agree with this assessment? Explain your answer.
Share in top social networks!

Brazil’s unexpected rate cut

The Brazilian economy is an emerging superpower (see A tale of two cities), but even its growth slowed in the second quarter of the year, although the economy still appears to be growing above capacity. In reaction to that latest economic data, the central bank slashed interest rates by 50 basis points to 12%. The Central Bank said:

‘Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed up, for example, by large and widespread reductions to the growth forecasts of the main economic regions.’

Rates had previously been hiked up 5 times in the year to tackle rising inflation, which has been some way above its inflation target. Such tightening policies have become commonplace in many emerging economies to prevent overheating. However, following this reversal of policy, questions have been raised about the independence of the central bank, as some politicians have recently been calling for a cut in rates, including President Rousseff himself. As Tony Volpon at Nomura Securities said:

‘They gave in to political pressure. The costs will likely be much higher inflation and a deterioration of central bank credibility…It has damaged the inflation-targeting regime.’

Many believe the rate cut is premature and the last thing the economy needs given the inflationary pressures it’s been facing. Huge spending cuts have been announced to bring inflation back under control, together with the previous rate rises, so this cut in interest rates to stimulate growth is likely to put more pressure on costs and prices. Only time will tell exactly how effective or problematic this new direction of monetary policy will be.

Brazil’s growth slows despite resilient consumers Reuters, Brian Ellsworth and Brad Haynes (2/9/11)
Brail in surprise interest rate cut to 12% BBC News (1/9/11)
Rousseffl’s ‘Risky’ rate cut means boosting Brazil GDP outweighs inflation Bloomberg, Arnaldo Galvao and Alexander Ragir (2/9/11)
Brazil makes unexpected interest rate cut Financial Times, Samantha Pearson (1/9/11)
Brazil rate cut stirs inflation, political concerns Reuters (1/9/11)

Questions

  1. What is the relationship between the macroeconomic objectives of inflation and economic growth?
  2. Why are there concerns that the recent reduction in the interest rate may worsen inflation? Do you think that a decision has been made to sacrifice Brazil’s inflation-targeting regime to protect its economic growth?
  3. Why are there questions over the independence of the central bank and how will this affect its credibility? What are the arguments for central bank independence?
  4. Growth in Brazil, although lower this year, still remains very strong. Why has the Brazilian economy been able to continue its strong growth, despite worsening economic conditions worldwide?
  5. What type of inflation are emerging economies experiencing? Explain how continuous hikes in interest rates have aimed to bring it back under control.
  6. What is meant by overheating? How will the central bank’s past and current policies contribute towards it?
Share in top social networks!

Busy doing nothing

Each month the Monetary Policy Committee of the Bank of England meets to set Bank Rate – the Bank’s repo rate, which has a direct impact on short-term interest rates and an indirect effect on other interest rates, such as mortgage rates and bond yields. Ever since March 2009, Bank Rate has been 0.5%. So each month the MPC has met and decided to do nothing! The latest meeting on 4 and 5 May was no exception.

And it is not just the Bank of England. The Fed in the USA has kept interest rates at between 0 and 0.25% ever since December 2008. The ECB had maintained its main interest rate at 1% for two years from May 2009. Then last month (April) it raised the rate to 1.25%, only to keep it unchanged at that level at its meeting on 5 May.

So is all this ‘doing nothing’ on interest rates (or very little in the case of the ECB) a sign that the economies of the UK, the USA and the eurozone are all ticking along nicely? Are they in the ‘goldilocks’ state of being neither too hot (i.e. too much demand and excessive inflation) or too cold (i.e. too little demand and low growth, or even recession)? Or does the apparent inaction on interest rates mask deep concerns and divisions within the decision-making bodies?

The three central banks’ prime concern may be inflation, but they are also concerned about the rate of economic growth. If inflation is forecast to be above target and growth to be unsustainably high, then central banks will clearly want to raise interest rates. If inflation is forecast to be below target and economic growth is forecast to be low or negative, then central banks will clearly want to reduce interest rates.

But what if inflation is above target and will probably remain so and, at the same time, growth is low and perhaps falling? What should the central bank do then? Should it raise interest rates or lower them? This is the dilemma facing central banks today. With soaring commodity prices (albeit with a temporary fall in early May) and the economic recovery stalling or proceeding painfully slowly, perhaps keeping interest rates where they are is the best option – an ‘active’ decision, but not an easy one!

Articles
Central Banks Leave Rates Unchanged News on News (8/5/11)
European Central Bank set for a bumpy ride City A.M., Guy Johnson (9/5/11)
Euro Tumbles Most Against Dollar Since January on Rate Signal; Yen Climbs Bloomberg, Allison Bennett and Catarina Saraiva (7/5/11)
Rates outlook Financial Times, Elaine Moore (6/5/11)
Interest rates on hold amid fears economy is stalling Independent, Sean Farrell (6/5/11)
The decision to hold back on increasing interest rates may turn out to be wrong Independent, Hamish McRae (6/5/11)
Bank of England: Inflation threat from fuel bills BBC News. Hugh Pym (11/5/11)
Andrew Sentance loses last battle over interest rates Guardian, Heather Stewart (5/5/11)
Interest rates: what the experts say Guardian (5/5/11)
King’s Defense of Record-Low Rates in U.K. Is Bolstered by Economic Data Bloomberg, Svenja O’Donnell (5/5/11)
BoE holds rates: reaction The Telegraph, Joost Beaumont, Abn Amro (5/5/11)
UK interest rates kept on hold at 0.5% BBC News (5/5/11)
Bank of England Signals Rate Increase This Year as Inflation Accelerates Bloomberg, Svenja O’Donnel (11/5/11)
ECB: Clearing the way for an Italian hawk? BBC News blogs: Stephanomics, Stephanie Flanders (5/5/11)
Ben and the Fed’s excellent adventure BBC News blogs: Stephanomics, Stephanie Flanders (27/4/11)
Inflation up. Growth down. Uncertainty everywhere BBC News blogs: Stephanomics, Stephanie Flanders (11/5/11)
Inflation report: analysts expecting a rate rise are wide of the mark Guardian, Larry Elliott (11/5/11)
May’s Inflation Report – three key graphs The Telegraph, Andrew Lilico (11/5/11)
The Errors Of The Inflation Hawks, Part I Business Insider, John Carney (9/5/11)
Errors of Inflation Hawks, Part II CNBC, John Carney (9/5/11)

Data and information
Inflation Report Bank of England
Inflation Report Press Conference Webcast Bank of England (11/5/11)
Monetary Policy ECB
ECB Interest Rates ECB
Monetary Policy Federal Reserve
US interest rates Federal Reserve

Questions

  1. Why is it exceptionally difficult at the current time for central banks to “get it right” in setting interest rates?
  2. What are the arguments for (a) raising interest rates; (b) keeping interest rates the same and also embarking on another round of quantitative easing?
  3. Should central banks respond to rapidly rising commodity prices by raising interest rates?
  4. Why is inflation in the UK currently around 2 percentage points above the target?
  5. What is likely to happen to inflation in the coming months and why?
  6. Explain the following comment by John Carney in the final article above: “To put it differently, the textbook money multiplier doesn’t exist anymore. This means that Fed attempts to juice the economy by raising the quantity of reserves—the basic effect of quantitative easing—are bound to fail.”.
  7. What has been the recent relationship in the UK between (a) growth in the monetary base and growth in broad money; (b) growth in the monetary base and inflation and economic growth?
Share in top social networks!

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?
Share in top social networks!

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?
Share in top social networks!

The inflation within inflation

In two recent blogs we have analysed the headache facing the Monetary Policy Committee, given the persistence of inflationary pressures in the UK economy, in deciding whether to raise interest rates. In Food for thought, Elizabeth Jones describes how, despite the weakness of aggregate demand, cost pressures have fuelled inflation while John Sloman in Time for a rise in Bank Rate looks at the difficult judgement call for the MPC in risking a marked dampening of aggregate demand by raising rates while, on the other hand, failing to dampen inflationary expectations by not raising rates. In this blog Dean Garratt analyses some of the latest inflation figures as detailed in the latest Consumer Price Indices Statistical Bulletin. In particular, he focuses on the inflation rates within the overall consumer price inflation rate.

You might be wondering what we mean when we refer to inflation rates within the overall inflation rate. In answering this we need to consider how the Office for National Statistics goes about estimating the Consumer Price Index (CPI) and the CPI inflation rate (further details are available in Consumer Price Indices – A Brief Guide produced by the ONS). In order to compile the Consumer Price Index (CPI), each month an organisation collects on behalf of the ONS something in the region of 110,000 prices quotations for around 560 items. But, the key point is that these goods and services fall into one of 12 broad product groups which are referred to as level 1 product groups. These include, for example, food and non-alcoholic beverages and transport.

The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. Once the price information for our representative goods and services has been collected, the prices are compared with their levels in the previous January and the change recorded. These changes are then aggregated in both each product group and across all groups. The price changes are aggregated by weighting them according to the typical share of household spending that each good or service represents. This process is repeated each month in the year so as to always calculate the aggregate change in prices since January. The final step is to link the price changes with those from earlier years to form one long price index, both for each product group and for the overall shopping basket, so that at one arbitrary moment in time the index takes a value of 100.

Once we have our price indices we can calculate annual rates of price inflation. The annual rate of CPI inflation in December 2010 is recorded at 3.7%. This means that the Consumer Price Index was 3.7% higher in December 2010 than it was December 2009. Similarly, the annual rate of CPI inflation in November 2010 of 3.3% means that consumer prices rose by 3.3% between November 2009 and November 2010. Across 2010 as a whole the CPI rose by 3.3%, so in excess of the Bank of England’s inflation rate target range, and significantly up on the 2.2% across 2009. The Bank has a symmetrical inflation rate target of 2% plus or minus 1 percentage point (you may want to read more about the Bank’s Monetary Policy Framework).

Let’s look to delve deeper because price indices are also available for product groups at two lower levels known as level 2 and level 3 product groups. For example, from within the food and non-alcoholic beverages group there is a price index wholly for food and within this one for vegetables. Again annual rates of price inflation can be found for level 2 and level 3 product groups.

If we consider food and non-alcoholic beverages we find an annual rate of price inflation for December of 6.1%. This was its highest annual rate since May 2009. Across 2010 as a whole we find that prices rose by 3.4%, very much in accordance with the overall CPI inflation rate. Inflationary pressures within this category are not new with 2008 seeing prices rises by 9.1% as compared with 3.6% for the overall CPI inflation rate. Over the past 5 years, food and non-alcoholic beverage inflation has typically been running at an annual rate of 5% while overall consumer price inflation has been running at 2.8%.

If we now focus on food alone, we find an annual rate of food price inflation in December of 5.7%. While this is a little lower than with the inclusion of non-alcoholic beverages, it is nonetheless a full 2 percentage points above the overall CPI inflation rate. Across the year as a whole food price inflation comes in bang on 3% highlighting the extent of the inflationary pressures in more recent months. This, however, still falls some way short of the pressures seen in 2008 when food prices rose by 10.1%. If we drop to level 3 to focus on groups within the food category we find inflation rates for oils and fats of 11%, for fish of 9% and for fruit of 8.6%.

Within the 12 broad groups the highest annual rate of price inflation is currently to be found for transport where the annual rate of price inflation in December was 6.5%. Across 2010, transport prices rose by 8.3% which compares a tad unfavourably with the 0.8% increase seen in 2009. If we drop down to the level 3 groups within this category we can trace the source of the price pressures more readily. The cost of air passenger transport in December was up over 12 months by 13.5% and, you may not be surprised to learn, the cost of fuel and lubricants was up by 12.9%.

We finish by noting the only level 1 category to see prices fall across 2010: clothing and footwear. This product group saw prices fall by 1% in 2010. But, even here price pressures have emerged. Between April 1992 and August 2010 clothing and footwear consistently recorded annual rates of price deflation. Since September this has ceased with positive annual rates of inflation. The annual rate of inflation for clothing and footwear in December was estimated at 1.5%. Perhaps those socks in my bottom drawer really will have to last me just a little bit longer!

Articles
Inflation is a blip says Bootle BBC News (21/1/11)
Fuel prices could rise by 4p in April BBC News (22/1/11)
Paul Lewis: Why inflation is starting to buy BBC News (20/1/11)
High levels of inflation remains a worry for Beijing BBC News (20/1/11)
Inflation ‘biggest money worry for families’ BBC News (19/1/11)
UK inflation rate rises to 3.7% BBC News (18/1/11)
Inflation hysterics Financial Times (19/1/11)
Top investors raise alarm on inflation Financial Times, Richard Milne, Dan McCrum and Robert Cookson (21/1/11) )
Inflation hits 3.7% after record monthly increase Guardian UK, Graeme Wearden (18/1/11)
We knew inflation would be bad, but not this bad Guardian, Larry Elliott (18/1/11)
The mystery of clothes inflation and the formula effect The Economist (21/1/11)

Data
Latest on inflation Office for National Statistics (18/1/11)
Consumer Price Indices, Statistical Bulletin, March 2010 Office for National Statistics (18/1/11)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank

Questions

  1. Describe the process of compiling the Consumer Price Index (CPI). Are we comparing the cost of the same basket of goods and services across years? What about within a given year? (Further details are available in Consumer Price Indices – A Brief Guide).
  2. Explain the difference between an increase in the level of prices and an increase in the rate of price inflation. Can the rate of price inflation fall even if price levels are rising? Explain your answer.
  3. Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
  4. What factors do you think lie behind the pressures on; (i) food prices; (ii) clothes prices; and (iii) transport prices? How would your answers help to inform how you would vote on interest rates if you were on the Monetary Policy Committee?
  5. The following are the consumer price index values for all items, food and non-alcoholic beverages, clothing and footwear and transport in 1988, 2009 and 2010. Use these values to calculate the percentage change between 1988 and 2010 and those between 2009 and 2010. Comment on your findings.
    All items: 1988= 63.5; 2009= 110.8; 2010= 114.5
    Food and non-alcoholic beverages: 1988= 68.2; 2009= 123.2; 2010= 127.4
    Clothing and footwear: 1988= 163.8; 2009= 79.6; 2010= 78.8
    Transport: 1988= 55.4; 2009= 112.7; 2010= 122.1
  6. How serious an economic issue do you think inflation is? Illustrate your answer drawing on real-world examples of the impact of inflation.
Share in top social networks!