Bank rate in the UK has been at the historically low level of 0.5% since March 2009 and the MPC decision on 13 January was to leave the rate unchanged (see also). But inflation has been well above the Bank of England’s target of 2% since December 2009 and it could well rise further as international commodity prices are soaring. Some economists are thus arguing that Bank rate should rise. This is crucial, they say, to dampen inflationary expectations.
Other economists, however, argue that aggregate demand is likely to remain depressed and that the economy is operating with a large negative output gap. What is more, house prices are falling, as are real wages (see Bosses gain – workers’ pain)
In the following extract from BBC Radio 4’s Today Programme, two economists, Charles Goodhart and Willem Buiter, both former members of the MPC, debate the issue.
Podcast
Should interest rates rise? BBC Today Programme (13/1/11)
Data
Economic and Labour Market Review, Office for National Statistics (For inflation data see Tables Chapter 3, Table 3.01; for interest rates see Tables Chapter 5, Table 5.08)
Monetary Policy Committee Decisions Bank of England
Questions
- What are the arguments for a rise in Bank rate at the current time?
- What are the arguments against a rise in Bank rate at the current time?
- What information would you require to decide which of the arguments was the more powerful?
- Why is it difficult to decide the size of the output gap?
- To what extent do the arguments for and against a rise in Bank rate depend on the factors determining expectations, and what expectations are important here?
- To what extent are exchange rates relevant to the effectiveness of interest rate policy?
Two reports on business confidence in the UK have just been published. The first, by Lloyds TSB Commercial, is its twice-yearly Business in Britain Report. The second is the Quarterly Economic Survey by the British Chambers of Commerce. Both reports paint a mixed picture about business confidence.
First the good news: the export sector is booming. Demand for exports is being boosted by (a) the depreciation of the pound, with the sterling exchange rate index some 20% lower now compared with the start of 2008 and (b) rapid economic growth in China, India and many other developing countries. Not surprisingly many exporting companies are looking to a bright future and are willing to invest.
Now the bad news. Domestic demand for many products is declining, especially services. This is not surprising given the rise in VAT, cuts in public spending and consumers cautious about their employment and income prospects in the coming year. With rapid cost-push inflation from higher oil and commodity prices, real incomes are set to fall and with it the level of real consumer demand (see Bosses gain – workers’ pain).
So where is the economy heading? The mixed picture painted by the two reports mean that the economy is likely to remain on the cusp. But with the export sector being much smaller than the domestic market, worries are likely to persist that economic growth may well slow significantly and the economy might return to recession. The main hope is that the restocking and replacement investment that follow a recession may be enough to provide just enough extra demand to avoid the ‘double dip’.
Articles
UK Business Confidence Hit By Domestic Demand Fears-Survey NASDAQ, Emma Haslett (4/1/11)
More doom and gloom as business confidence falls? Management Today, Nicholas Winning (5/1/11)
Smaller businesses do not share optimism Financial Times, Brian Groom (5/1/11)
New Year business confidence hit by domestic demand fears The Telegraph, James Hurley (5/1/11)
UK’s fragile services sector risks undermining recovery, BCC warns The Telegraph, Philip Aldrick (11/1/11)
Companies fear double-dip recession Oxford Mail, Andrew Smith (10/1/11)
Firms ‘planning investment freezes’ Press Association (4/1/11)
Surveys paint bleak picture for British economy Reuters, David Milliken (11/1/11)
Kern Says U.K. Services Industry Growth Is `Mediocre’ Bloomberg, Watch Video, David Kern (11/1/11)
UK economic growth rate slowing, BCC says BBC News (11/1/11)
Reports
Business in Britain, December 2010 Lloyds TSB Commercial (January 2011)
Quarterly Economic Survey, Q4 2010: Summary British Chambers of Commerce (January 2011)
Quarterly Economic Survey, Q4 2010: Tables British Chambers of Commerce (January 2011)
Data
Interest Rates and Exchange Rates Bank of England (for sterling effective exchange rates)
Economic and Labour Market Review Office for National Statistics (see Tables Chapter 1, worksheets in Table 1.03 for components of aggregate demand)
Business and Consumer Surveys European Commission, Economic and Financial Affairs (see latest ESI – Economic Sentiment Indicator, Table 1)
Questions
- Summarise the findings of the two reports.
- Using the data in Table 1.03 of the Economic and Labour Market Review, calculate the percentage of UK GDP accounted for by each of the main elements of aggregate expenditure.
- Why is the manufacturing sector as a whole experiencing relatively strong economic growth?
- If the service sector shrank by x% and the manufacturing sector grew by x%, what would be likely to happen to the rate of economic growth in the economy? What else would you need to know to establish the precise rate of economic growth?
- The BCC said both the government and the Bank of England must “act forcefully to support growth”. What measures would this include?
- If real wages fall, what could cause real aggregate demand to rise in these circumstances?
- What is likely to drive the level of investment in the coming months?
Here’s an interesting example of oligopoly – one you probably haven’t considered before. It’s the art market. And it’s not just one market, but a whole pyramid of markets. At the bottom are the ‘yearning masses’ of penny-poor artists, from students to those struggling to make a living from their art, with studios in their attic, garden shed or kitchen table. At the top of the pyramid are those very few artists that can earn fantastic sums of money by selling to collectors or top galleries. Then there are all the layers of markets in between, where artists can earn everything from a modest to a reasonable income.
The pyramid is itself depicted as a work of art, which you can see in the linked article below. It’s worth studying this piece of art carefully as well as reading the article.
A guide to the market oligopoly system Reuters, Felix Salmon (28/12/10)
Questions
- Identify the increasing barriers to entry as you work up the art market pyramid.
- Are there any other market imperfections in the art market that you can identify from the diagram?
- What are the key differences between the ‘primary market, tier 1’, the ‘primary market, tier 2’ and ‘the secondary market’?
- Are artists ‘rational maximisers’? If so, what is it they are trying to maximise? If not, why not?
- How would you set about determining the ‘worth’ of a piece of art? How do possible future value of a piece of art determine its present value?
Two reports released by Incomes Data Services tell dramatically contrasting stories about pay in the UK. One report focuses on average pay in the public and private sectors, which are both likely to fall in real terms in 2011. Most public-sector workers will see a freeze in their wages and, whilst private-sector workers’ pay could rise by an average of 3%, this will still be below the rate of inflation. The press release Pay awards may rise but will trail inflation (6/1/11) to the report stated that:
Private sector pay settlements in 2011 could well be higher than in 2010, as long as the economic recovery remains on track. But following the latest increase in VAT, they are likely to trail inflation, meaning that the cost of living may be set to rise faster than average pay settlements for the second year running.
However, the press release to an earlier report, FTSE-100 bosses see earnings rise 55% (29/10/10), stated that:
FTSE-100 directors saw their total earnings boosted by an average of 55% while across the FTSE 350 as a whole total board pay went up by an average 45%, according to the latest Directors Pay Report, published by Incomes Data Services. (Year to June 2010)
On the back of these increases FTSE 100 chief executives took home £4.9 million on average in total earnings during the year.
Meanwhile, there is continuing public outcry over the levels of bank pay and bonuses. Despite billions of pounds of public money having been poured into banks to prevent their collapse, bank bosses are set to receive huge remuneration packages worth several million pounds in some cases. And, despite being condemned by the government, it seems there is little it can do to curb them.
So what are the causes of the growing income divide between those at the top and everyone else? And what are the economic consequences? The following articles explore the issues.
Articles: IDS reports
Year of pain predicted for workers.. while bosses’ salaries continue to grow Daily Record, Magnus Gardham (7/1/11)
Another 12 months of pay freeze misery for workers… but bosses enjoy a huge 55% salary increase Daily Mail, Becky Barrow (6/1/11)
Private-sector pay set to trail behind inflation People Management, Michelle Stevens (6/1/11)
Private pay deals to lag behind inflation Financial Times, Brian Groom (6/1/11)
UK boardroom pay rises 55% in an age of austerity Guardian, Simon Goodley and Graeme Wearden (29/10/10)
Private sector pay ‘to trail inflation’ in 2011 BBC News (6/1/11)
Staff morale warning over bosses’ pay rises Independent, Jon Smith (6/1/11)
‘Dose of reality’ call over top pay BBC Today Programme, Robert Peston, Brendan Barber and Garry Wilson (6/1/11)
‘Severe squeeze’ on average pay BBC Today Programme, Ken Mulkearn (Editor of the Incomes Data Services pay review) (6/1/11)
UK inflation rate rises to 3.7% BBC News , Ian Pollock (18/1/11)
Articles: bankers’ bonuses
Bank bonuses ‘to run to billions in 2011’ BBC News, (7/1/11)
Cameron says banks ‘should pay smaller bonuses’ BBC News, (9/1/11)
David Cameron warns RBS over bonuses Guardian, (9/1/11)
Banks say ‘no’ to bonus backdown Management Today, Andrew Saunders (7/1/11)
Banks to pay out billions in bonuses BBC News blogs: Peston’s Picks, Robert Peston (6/1/11)
Why government can’t stop big bonus payments BBC News blogs: Peston’s Picks, Robert Peston (7/1/11)
Diamond: ‘I am compelled to pay big bonuses’ BBC News blogs: Peston’s Picks, Robert Peston (11/1/11)
Data
Average Weekly Earnings Incomes Data Services
Questions
- Why are average earnings likely to be less than the rate of inflation in 2011?
- Why were the directors of the FTSE 100 companies paid an average 55% pay increase for the year to October 2010?
- To what extent can marginal productivity theory explain the huge increases of bosses of top companies?
- If remuneration committees base executive pay increases on the average of the top 25% of increases of equivalent people in other companies (to stop ‘poaching’), what will be the implications for executive pay rises over time?
- What market failures are there in determining executive pay?
- What will be the implications for staff morale if their earnings are falling in real terms while their bosses are receiving huge pay increases? Should these implications be taken into account when deciding executive remuneration packages?
- Are shareholders in FTSE 100 companies likely to welcome the pay increases of their top executives? If so, why? If not, why not?
Every six months the Bank of England publishes its Financial Stability Report. “It aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities and the wider public in managing and preparing for these risks.”
In the latest report, published on 17 December 2010, the Bank expresses concern about the UK’s exposure to problems overseas. The two most important problems are the continuing weaknesses of a number of banks and the difficulties of certain EU countries in repaying government bonds as they fall due and borrowing more capital at acceptable interest rates. As the report says:
Sovereign and banking system concerns have re-emerged in parts of Europe. The IMF and European authorities proposed a substantial package of support for Ireland. But market concerns spilled over to several other European countries. At the time of writing, contagion to the largest European banking systems has been limited. In this environment, it is important that resilience among UK banks has improved over the past year, including progress on refinancing debt and on raising capital buffers. But the United Kingdom is only partially insulated given the interconnectedness of European financial systems and the importance of their stability to global capital markets.
The Bank identifies a number of specific risks to the UK and global financial systems and examines various policy options for tackling them. The following articles consider the report.
Articles
Bank warns of eurozone risks to UK as EU leaders meet Independent, Sean O’Grady (17/12/10)
Deep potholes on the road to recovery Guardian, Nils Pratley (17/12/10)
It’s reassuring that regulators are still worried about financial stability The Telegraph, Tracy Corrigan (17/12/10)
Europe is still searching for stability and the UK must find it too Independent, Hamish McRae (17/12/10)
Shafts of light between the storm clouds The Economist blogs: ‘Blighty’ (17/12/10)
Report
Financial Stability Report, December 2010: Overview Bank of England
Financial Stability Report, December 2010: Links to rest of report Bank of England
Questions
- What are the most important financial risks facing (a) the UK; (b) eurozone countries?
- What is the significance of the rise in banks’ tier-1 capital ratios since 2007?
- Which is likely to be more serious over the coming months: banking weaknesses or sovereign debt? Explain.
- What is being done to reduce the risks of sovereign default?
- Why might the weaker EU countries struggle to achieve economic growth over the next two or three years?
- How do interest rates on government debt, as expressed by bond yields, compare with historical levels? What conclusions can you draw from this?
- What is likely to happen to bond yields in the USA, the UK and Germany over the coming months?
- What has been the effect of the extra £200 billion that the Bank of England injected into the banking system through its policy of quantitative easing?