The last two weeks have been quite busy for macroeconomists, HM Treasury staff and statisticians in the UK. The Chancellor of the Exchequer, Mr Phillip Hammond, delivered his (fairly upbeat) Spring Budget Statement on 13 March, highlighting among other things the ‘stellar performance’ of UK labour markets. According to a Treasury Press Release:
Employment has increased by 3 million since 2010, which is the equivalent of 1,000 people finding work every day. The unemployment rate is close to a 40-year low. There is also a joint record number of women in work – 15.1 million. The OBR predict there will be over 500,000 more people in work by 2022.
To put these figures in perspective, according to recent ONS estimates, in January 2018 the rate of UK unemployment was 4.3 per cent – down from 4.4 per cent in December 2017. This is the lowest it has been since 1975. This is of course good news: a thriving labour market is a prerequisite for a healthy economy and a good sign that the UK is on track to full recovery from its 2008 woes.
The Bank of England welcomed the news with a mixture of optimism and relief, and signalled that the time for the next interest rate hike is nigh: most likely at the next MPC meeting in May.
But what is the practical implication of all this for UK consumers and workers?
For workers it means it’s a ‘sellers’ market’: as more people get into employment, it becomes increasingly difficult for certain sectors to fill new vacancies. This is pushing nominal wages up. Indeed, UK wages increased on average by 2.6 per cent year-to-year.
In real terms, however, wage growth has not been high enough to outpace inflation: real wages have fallen by 0.2 per cent compared to last year. Britain has received a pay rise, but not high enough to compensate for rising prices. To quote Matt Hughes, a senior ONS statistician:
Employment and unemployment levels were both up on the quarter, with the employment rate returning to its joint highest ever. ‘Economically inactive’ people — those who are neither working nor looking for a job — fell by their largest amount in almost five and a half years, however. Total earnings growth continues to nudge upwards in cash terms. However, earnings are still failing to outpace inflation.
An increase in interest rates is likely to put further pressure on indebted households. Even more so as it coincides with the end of the five-year grace period since the launch of the 2013 Help-to-Buy scheme, which means that many new homeowners who come to the end of their five year fixed rate deals, will soon find themselves paying more for their mortgage, while also starting to pay interest on their Help-to-buy government loan.
Will wages grow fast enough in 2018 to outpace inflation (and despite Brexit, which is now only 12 months away)? We shall see.
Data, Reports and Analysis
- What is monetary policy, and how is it used to fine tune the economy?
- What is the effect of an increase in interest rates on aggregate demand?
- How optimistic (or pessimistic) are you about the UK’s economic outlook in 2018? Explain your reasoning.
On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.
A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.
These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.
The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.
But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.
The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).
Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.
Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.
Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.
It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.
For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.
Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)
Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)
- Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
- Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
- What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
- Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables
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.
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)
- 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?
- Why did the exchange rate fall when the announcement was made?
- How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?
- Can monetary policy affect potential output, or only actual output?
- 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?
- 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.”
- To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?
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.
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)
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)
- Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
- Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
- 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?
- Why are the pressures on government expenditure likely to increase in the coming years?
- 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?
- 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?
- Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
- What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
- 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?
- What are the arguments for and against using ‘people’s QE’?
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.
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)
- What is the mechanism whereby a change in Bank Rate affects other interest artes?
- Use an aggregate demand and supply diagram to illustrate the difference between demand-pull and cost-push inflation.
- 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.
- For what reason might aggregate demand prove more buoyant that the MPC predicts?
- 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?
- Why are real wage rates falling at a time when unemployment is historically very low?
- What determines the amount that higher prices paid by importers of products are passed on to consumers?