Category: Economics for Business: Ch 26

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.

The rate of inflation in the UK is measured using the Consumer Prices Index (CPI). This is made up of a basket of goods and the ONS updates this ‘basket’ each year to ensure it is representative of what the average UK household buys. The basket contains 700 items, with 180,000 individual prices collected each month.

In recent years, items such as lip gloss have been added to the basket of goods and in the latest adjustment, the ONS has added tablet computers, amongst other things. This is a market that has seen enormous growth. It has been added to the basket as a means of giving a more accurate representation of the price changes faced by the average consumer. The ONS has made it clear that items are not added simply because they are new or removed simply because spending on them has fallen.

‘In each of these cases, the item has not been added because spending has increased or because the product is new on the market … It is purely as part of the rebalancing of the basket to improve its representation of overall price change.’

It is essential that these changes are made each year, as consumer buying habits do fluctuate considerably. One area in particular has been consumer responses to changes in technology. For example, developing and printing colour film has been removed as, with the development of digital cameras, this is no longer reflective of what a representative household spends its money on. Further to this, some items that have previously been used in calculating the RPI have now been added to the CPI, again to give a clearer picture of household spending in the UK. The following articles consider what’s in and what’s out.

Teenage fiction and iPads now in official UK shopping basket Guardian, Julia Kollewe (13/3/12)
Tablet computers added to UK inflation basket BBC News (13/3/12)
New items used to calculate inflation BBC News, Emma Simpson (23/3/12)
Tablet Computers Enter ‘Inflation Basket’ Sky News, Darren Morgan (ONS) (13/3/12)
Inflation basket of goods 2012: full list of what’s out and what’s in Guardian, Simon Rogers (13/3/12)
Tablet computers added to inflation basket of goods Telegraph (13/3/12)
How has the UK’s ‘inflation’ basket has changed? Metro, Ross McGuinness (27/3/12)
iPad and Galaxy added to inflation index Financial Times, Norma Cohen (13/3/12)

Questions

  1. What is the difference between the CPI and RPI? Which is usually higher? Explain your answer.
  2. How is the CPI calculated and hence how is inflation measured?
  3. What impact has technological progress had on the basket of goods that the representative household purchases? Do you think that technological progress make it more or less important for the basket of goods to be reviewed annually?
  4. Do you think products such as the iPad should be included in the CPI? Are they truly representative?
  5. In the second Guardian article, you can access a list of the products that are ‘in and out’. Is there anything on there that you think should be in or that should be out? Be sure to justify your answer!

Unemployment figures for the UK have been going in the wrong direction for some time. With consumer expenditure, investment and hence aggregate demand remaining low, job creation has been severely lacking. However, 2 pieces of news have emerged in the last couple of days, which as David Cameron said was ‘a massive confidence boost for the UK economy’. Tesco and Nissan have both announced the creation of thousands of new jobs.

Over the next 2 years, Tesco has said that it will create 20,000 new jobs through store improvement and the opening of new stores. Whilst it is not clear how many will be full-time, part-time or apprenticeship placements, it still represents net job creation. This huge investment represents what many are calling a ‘fight-back’ from Tesco, who issued its first profit warning in 20 years, following weak Christmas trading. That announcement slashed their shares by over £5bn and is perhaps partly responsible for this planned investment.

Despite this good news, criticisms have emerged that the major supermarkets are simply inflating the job creation figures and that the actual number of new jobs will be significantly less than the 20,000 suggested. This follows allegations made towards Asda, who claimed to have created 30,000 jobs. However, evidence from records at Companies House suggests that new job creation by the company was closer to 7,000. Whatever the true figure, it still means new jobs, which can only help UK unemployment data.

In addition to this, Nissan has also announced that it will be creating 2,000 new jobs, as it begins production on a new model at its Sunderland factory. The jobs will be created as part of a £125m investment, including a £9.3m grant from the government. This is especially good news, given the area where many of these jobs will emerge. The North East is a region that has been hit particularly hard by the recession and the grant from the government has come from its regional growth fund. Nissan has said that even in hard economic times, it is possible to sell cars, as long as they are competitively priced. Neither of the plans discussed above will create jobs immediately, but perhaps the key is that it creates confidence, which is a rarity in the UK with the current economic situation. The following articles consider these job creation plans and their wider implications.

Tesco plans to create 20,000 UK jobs over 2 years BBC News (5/3/12)
Tesco to create 20,000 jobs in UK fight-back Telegraph, Jamie Dunkley (6/3/12)
Tesco’s UK boss defends ‘new jobs’ claims Sky News (5/3/12)
Tesco to freshen up with 20,000 new staff Financial Times, Andrea Felsted (5/3/12)
Now Tesco creates 20,000 jobs – with pay Independent (9/5/11)
Nissan to build new car in Sunderland BBC News (6/3/12)
Nissan pledges 2,000 new jobs at North East plant Sky News, Gerard Tubb (6/3/12)
Nissan Invitation compact car set to create 2,000 jobs Telegraph, Roland Gribben and David Millward (6/3/12)
Nissan to create 2,000 new jobs by building compact car in Sunderland Guardian, Dan Milmo(6/3/12)

Questions

  1. Explain the process by which net job creation should provide a boost to the economy.
  2. Will these new jobs have any impact on the government’s budget deficit?
  3. Why is there concern that the supermarkets are inflating the employment creation figures?
  4. What type of unemployment has been created by the recession? Why have certain areas, such as the North East been affected so badly by the recession and austerity measures?
  5. Which factors could have led to Tesco’s weaker trading figures towards then end of 2011? Why did this lead to a £5bn loss in the value of the group’s shares?
  6. Nissan has said that cars can be sold as long as they are competitively priced. To what extent do you think price is the main competitive weapon in the market for cars and in the supermarket industry?

A negative outlook for the UK economy – at least that’s what Moody’s believes. The credit rating agency has put the UK economy’s sovereign credit rating, together with 2 other European nations (France and Austria) on the ‘negative outlook’ list.

The UK currently has a triple A rating and we have been able to maintain this despite the credit crunch and subsequent recession. However, with weak economic data and the continuing crisis in the eurozone, Moody’s took the decision to give the UK a ‘negative outlook’, which means the UK, as well as France and Austria have about a 30% chance of losing their triple A rating in the next 18 months.

Both Labour and the Coalition government have claimed this decision supports their view of the economy. Labour says this decision shows that the economy needs a stimulus and the Coalition should change its stance on cutting the budget deficit. However, the Coalition says that it shows the importance the Credit ratings agencies attach to budget deficits. Indeed, Moody’s statement showed no signs that it feels the UK should ease up on its austerity measures. The statement suggested the reverse – that a downgrade would only occur if the outlook worsened or if the government eased up on its cuts. The Coalition’s focus on cutting the deficit could even be something that has prevented the UK being put on the ‘negative watch’ list, as opposed to the ‘negative outlook’ list. The former is definitely worse than the latter, as it implies a 50% chance of a downgrade, rather than the current 30%.

The triple A rating doesn’t guarantee market confidence, but it does help keep the cost of borrowing for the government low. Indeed, the UK government’s cost of borrowing is at an historic low. A key problem therefore for the government is that there is a certain trade-off that it faces. Moody’s says that 2 things would make the UK lose its rating – a worsening economic outlook or if the government eases on its austerity plans. However, many would argue that it is the austerity plans that are creating the bad economic outlook. If the cuts stop, the economy may respond positively, but the deficit would worsen, potentially leading to a downgrade. On the other hand, if the austerity plans continue and the economy fails to improve, a downgrade could also occur. The next few days will be crucial in determining how the markets react to this news. The following articles consider this issue.

The meaning of ‘negative’ for Mr Osborne and the UK BBC News, Stephanomics, Stephanie Flanders (14/2/12)
Relaxed markets remain one step ahead of Moody’s move The Telegraph, Philip Aldrick (14/2/12)
George Osborne tries to be positive on negative outlook for economy Guardian, Patrick Wintour (14/2/12)
Moody’s wants it may cut AAA-rating for UK and France Reuters, Rodrigo Campos and Walter Brandimarte (14/2/12)
Moody’s rating decision backs the Coalition’s path of fiscal consolidation The Telegraph, Damian Reece (14/2/12)
Moody’s rating agency places UK on negative outlook BBC News (14/2/12)
Britain defends austerity measures New York Times, Julia Werdigier 14/2/12)

Questions

  1. What does a triple A rating mean for the UK economy?
  2. Which factors will be considered when a ratings agency decides to change a country’s credit rating? What similarities exist between the UK, France and Austria?
  3. Which political view point do you think Moody’s decision backs? Do you agree with the Telegraph article that ‘Moody’s rating decision backs the Coalition’s path of fiscal consolidation’?
  4. If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
  5. How do you think markets will react to this news? Explain your answer.
  6. What action should the government take: continue to cut the deficit or focus on the economic outlook?
  7. Why has the eurozone crisis affected the UK’s credit rating?

The housing market has long been seen as a crucial element in stimulating the British economy. For this reason various incentives had been introduced to encourage people to buy properties. (Click here for a PowerPoint of the chart.)

One such strategy was the stamp duty holiday. Stamp Duty Land Tax is paid by the purchaser of a property against a purchase price and the cost of it will rise through each price band. The stamp duty holiday meant that first-time buyers were free from the 1% stamp duty on homes that cost under £250,000. However, this holiday is due to end from March 2012, as according to the government, the holiday has been ineffective. Indeed, in the Autumn statement documents, the government said:

‘The government is publishing analysis showing that the stamp duty land tax relief for first-time buyers has been ineffective in increasing the number of first time buyers entering the market.’

The government has said that instead it will focus on other strategies that provide better value for money. Such schemes include a mortgage guarantee scheme and the FirstBuy scheme launched last year, both of which aim to help those struggling to finance the purchase of their first properties.

According to the Land Registry, property prices have fallen by over 1% over the past year, so fewer properties will face the stamp duty land tax, but this data does little to instill confidence in the housing market being the stimulus that the economy needs. By stimulating the housing market, construction jobs should be created and this in turn should create a much needed multiplier effect helping to boost other sectors within the economy. The following articles consider this latest development.

Stamp duty rush boosts January valuations Mortgage Strategy, Tessa Norman (11/2/12)
New deals for buyers as stamp duty holiday ends BBC News, Susannah Streeter (11/2/12)
Autumn Statement: Stamp duty concession to end BBC News (29/11/11)
First-time buyers boost mortgage market activity FT Adviser, Michael Trudeau (9/2/12)
When shared ownership turns sour Guardian, Rupert Jones (10/2/12)

Questions

  1. Why does the housing market play such a crucial role in the economy?
  2. What is the multiplier effect? How will new jobs in the construction industry help other sectors in the economy?
  3. Why has the stamp duty holiday been ‘ineffective’ in stimulating the housing market?
  4. How have the other schemes introduced by the government created incentives in the housing market?
  5. Why have January valuations improved? Use a demand and supply diagram to illustrate your explanation.