At its meeting on 6 May, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate at 0.1%. Due to the significant impact of COVID-19 and the measures put in place to try to contain the virus, the MPC voted unanimously to keep Bank Rate the same.
However, it decided not to launch a new stimulus programme, with the committee voting by a majority of 7-2 for the Bank to continue with the current programme of quantitative easing. This involves the purchase of £200 billion of government and sterling non-financial investment-grade corporate bonds, bringing the total stock of bonds held by the Bank to £645 billion.
The Bank forecast that the crisis will put the economy into its deepest recession in 300 years, with output plunging 30 per cent in the first half of the year.
Monetary policy and MPC
Monetary policy is the tool used by the UK’s central bank to influence how much money is in the economy and how much it costs to borrow. The Bank of England’s main monetary policy tools include setting the Bank Rate and quantitative easing (QE). Bank Rate is the interest rate charged to banks when they borrow money from the BoE. QE is the process of creating money digitally to buy corporate and government bonds.
The BoE’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target. Maintaining a low and stable inflation rate is good for the economy and it is the main monetary policy aim. However, the Bank also has to balance this target with the government’s other economic aims of sustaining growth and employment in the economy.
Actions taken by the MPC
It is challenging to respond to severe economic and financial disruption, with the UK economy looking unusually uncertain. Activity has fallen sharply since the beginning of the year and unemployment has risen markedly. The current rate of inflation, measured by the Consumer Price Index (CPI), declined to 1.5% in March and is likely to fall below 1% in the next few months. Household consumption has fallen by around 30% as consumer confidence has declined. Companies’ sales are expected to be around 45% lower than normal and business investment 50% lower.
In the current circumstances, and consistent with the MPC’s remit, monetary policy is aimed at supporting businesses and households through the crisis and limiting any lasting damage to the economy. The Bank has used both main monetary tools to fulfil its mandate and attempt to boost the economy amid the current lockdown. The Bank Rate was reduced to 0.1% in March, the lowest level in the Bank’s 325-year history and the current programme of QE was introduced in March.
What is next?
This extraordinary time has seen the outlook for the all global economies become uncertain. 
The long-term outcome will depend critically on the evolution of the pandemic, and how governments, households and businesses respond to it. The Bank of England has stated that businesses and households will need to borrow to get through this period and is encouraging banks and building societies to increase their lending. Britain’s banks are warned that if they try to stem losses by restricting lending, they will make the situation worse. The Bank believes that the banks are strong enough to keep lending, which will support the economy and limit losses to themselves.
In the short term, a bleak picture of the UK economy is suggested, with a halving in business investment, a near halving in business sales, a sharp rise in unemployment and households cutting their spending by a third. Despite its forecast that GDP could shrink by 14% for 2020, the Bank of England is forecasting a ‘V’ shaped recovery. In this scenario, the recovery in economic activity, once measures are softened, is predicted to be relatively rapid and inflation rises to around the 2 per cent target. However, this would be after a dip to 0.5% in 2021, before returning to the 2 per cent target the following year.
However, there are some suggestions that the Bank’s forecast for the long-term recovery is too optimistic. Yael Selfin, chief economist at KPMG UK, fears the UK economy could shrink even more sharply than the Bank of England has forecast.
Despite the stark numbers issued by the Bank of England today, additional pressure on the economy is likely. Some social distancing measures are likely to remain in place until we have a vaccine or an effective treatment for the virus, with people also remaining reluctant to socialise and spend. That means recovery is unlikely to start in earnest before sometime next year.
There are also additional factors that could dampen future productivity, such as the impact on supply chains, with ‘just-in-time’ operations potentially being a thing of the past.
There is also the ongoing issue of Brexit. This is a significant downside risk as the probability of a smooth transition to a comprehensive free-trade agreement with the EU in January is relatively small. This will only increase uncertainty for businesses along with the prospect of increased trade frictions next year.
Conclusion
The predictions from the Bank of England are based on many assumptions, one of which is that the economy will only be gradually released from lockdown. Its numbers contain the expectations that consumer and worker behaviour will change significantly, and continue for some time, with forms of voluntary social distancing. On the other hand, Mr Bailey expects the recovery to be much faster than seen with the financial crisis a decade ago. However, again this is based on the assumption that measures put in place from the public health side prevent a second wave of the virus.
It also assumes that the supply-side effects on the economy will be limited in the long run. Many economists disagree, arguing that the ‘scarring effects’ of the lockdown may be substantial. These include lower rates of investment, innovation and start ups and the deskilling effects on labour. They also include the businesses that have gone bankrupt and the dampening effect on consumer and business confidence. Finally, with a large increase in lending to tide firms over the crisis, many will face problems of debt, which will dampen investment.
The Bank of England does recognise these possible scarring effects. Specifically, it warns of the danger of a rise in equilibrium unemployment:
It is possible that the rise in unemployment could prove more persistent than embodied in the scenario, for example if companies are reluctant to hire until they are sure about the robustness of the recovery in demand. It is also possible that any rise in unemployment could lead to an increase in the long‑term equilibrium rate of unemployment. That might happen if the skills of the unemployed do not increase to the same extent as they would if they were working, for example, or even erode over time.
What is certain, however, is that the long-term picture will only become clearer when we start to come out of the crisis. Bailey implied that the Bank is taking a wait-and-see approach for now, waiting on the UK government to shed some light about easing of lockdown measures before taking any further action with regards to QE. The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target. Paul Dales, chief UK economist at Capital Economics, suggested that the central bank is signalling that ‘more QE is coming, if not in June, then in August’.
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Questions
- How could the BoE use monetary policy to boost the economy?
- Explain how changes in interest rates affect aggregate demand.
- Define and explain quantitative easing (QE).
- How might QE help to stimulate economic growth?
- How is the pursuit of QE likely to affect the price of government bonds? Explain.
- Evaluate the extent to which monetary policy is able to stimulate the economy and achieve price stability.
The recent pandemic has, and will have, serious implications for our economy with some estimating the largest drop in GDP ‘in living memory’. Expenditure from disposable income fell by 60% as social distancing policies were introduced and consumers started reducing their spending.
However, despite the impact being widespread across all sectors of the economy, workers in the gig economy are at a particular financial disadvantage. A report by Fintech firm, Portify, has found that income for self-employed gig workers fell 30% in the first two weeks of April, compared to the pre-crisis average. It is estimated that there will be a loss of £1.5bn through earnings and £6.9bn in economic contributions from gig economy workers.
Chancellor Rishi Sunak announced increased benefits for the self-employed at the daily briefing on March 20th but did not guarantee their wages. This has understandably left those people who are self-employed, e.g. freelancers, with greater uncertainty. According to the Office for National Statistics, there are 5 million self-employed people in the UK, who make up 15% of the labour market.
The government has been cautious over the financial support for the self-employed, because it is more difficult to confirm how much they are earning each month. However, many of the 5 million workers would have been among the first to be impacted by the closures and restrictions caused by the outbreak.
What is the ‘gig economy’?
The gig economy has grown significantly since the last global recession of 2008/9. After a substantial number of people lost their jobs, they turned towards self-employment. A boom in digital platforms, such as Uber and Deliveroo, has sparked a revolution in the world of work, with as many as one in 10 working-age adults now working in the gig economy, up from one in 20 in 2016. According to the Association of Independent Professionals and the Self-Employed (IPSE), prior to the coronavirus outbreak, self-employed people contributed £305bn to the British economy.
A gig economy is where workers are paid for the ‘gigs’ they do, e.g. a parcel delivery or taxi ride. They receive the money for the completed job instead of a regular wage. In the UK it is estimated that 5 million people are employed in this type of capacity. Flexible hours and controlling the amount you work is appealing for many people wanting to manage their home life and other priorities.
In the gig economy, workers are classed as independent contractors. This is also beneficial for employers as they only need to pay their workers when there is work available. Therefore, when demand drops, they don’t have to get rid of staff or have to incur unnecessary staff costs. However, this also has its drawbacks for the worker. They have no protection against unfair dismissal, no right to redundancy payments, and no right to receive the national minimum wage, paid holiday or sickness pay.
Impact of the coronavirus on the gig economy
Anybody experiencing symptoms of the virus have been told to self-isolate. Employees who are then self-isolating can access statutory sick pay from the first day they are off. However, it is unclear if this applies to gig-economy workers. Unions that represent such workers have raised their concerns over the uncertainty and have demanded that urgent action is needed on working practices, including on sick pay. The United Private Hire Drivers (UPHD) union said:
Without access to worker rights such as minimum wage and sick pay, drivers who are infected may simply not be able to afford to stop working.
Work and Pensions Minister, Justin Tomlinson, has said that gig economy workers can apply for universal credit (which can take five weeks to come through) if they need to self-isolate. However, this is not an option for those who live hand-to-mouth. The government has indicated it wanted to do more for the self-employed but it is operationally difficult. Robert Jenrick, the Communities Secretary, said:
The purpose of our employment mechanism is to help continue the connection between employees and their business so once this is over – and it will be over – those individuals can return to their usual work and that link isn’t broken.
However, six days after the Chancellor’s initial support package was announced, he announced a new self-employed income support scheme, which will cover up to 80% of self-employed workers’ average taxable monthly profits. This taxable grant is to be paid in a lump sum in June and will no doubt provide a vital lifeline for those workers who have seen their income disappear almost overnight.
Those who are eligible will receive a taxable grant amounting to 80% of the average profits from the last three tax years. HMRC will use the total trading profit for the last three tax years and use this to calculate a monthly amount. However, annual profits are taken after expenses and capital allowances, but before pension contributions and charitable donations. Therefore, workers who have made significant investments into their businesses are likely to lose out.
What next?
The Independent Workers Union of Great Britain (IWGB), which represents gig-economy workers, has announced that it is suing the government over its failure to protect the wages and jobs of millions of workers during the pandemic. It has also accused the government of failing to ensure the health and safety of those still employed through proper sick pay. It has also argued that the lack of certainty encourages those potentially infected to continue working so they can still receive a wage.
The current scheme is only planned to cover the next three months. However, it is questionable whether this will be enough, and the government may have to extend the support.
There is also concern around how much of the gig economy (besides delivery and distribution workers) will remain once the restrictions are eased. Ryan Barnett, an IPSE economist predicts the economic impact to be far more severe than the 2008 financial crisis, pointing out that many entertainment industry workers have already had jobs cancelled until the end of 2021. Even when we can re-emerge from the current lockdown, it is likely that many workers will continue to rely on Universal Credit for a prolonged period of time.
Conclusion
There is no doubt that the current situation has had an impact on the daily lives of everyone in the economy. However, the level of uncertainty for those working in the gig economy has been concerning for many of the 5 million people.
The full impact of the crisis will not be known until some time after the lockdown. However, it is what measures are put in place in the short run that will have an impact and provide a greater level of certainty for the self-employed. It is important that the government understands the importance of supporting self-employment throughout the crisis, as the self-employed will likely play a key role in the economic activity and recovery that will follow.
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Questions
- Explain why many economies have seen an increase in the gig economy over the last decade.
- What are the advantages and disadvantages of a gig economy?
- How does the gig economy impact on the flexibility of the labour market in the UK?
With promises by the newly elected Conservative government to increase investment expenditure on health, education, innovation and infrastructure, it was expected that Rishi Sunak’s first Budget would be strongly expansionary. In fact, it turned out to be two Budgets in one – both giving a massive fiscal boost.
An emergency Budget
The first part of the Budget was a short-term emergency response to the explosive spread of the coronavirus. An extra £12 billion is to be spent on the NHS and other public services. Whether this will be anything like enough to cope with the effects of the pandemic as businesses fail and people lose their jobs remains to be seen. (See the blog A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak.)
A key issue is just how quickly the money can be spent. How quickly can you train health professionals or produce more ventilators or provide extra hospital beds?
This emergency part of the Budget was co-ordinated with the Bank of England’s decision to cut Bank Rate from 0.75% to 0.25%.
This combined fiscal and monetary response to the crisis was further enhanced by the agreement of central banks on 15 March to boost world liquidity by increasing the supply of US dollars through large-scale quantitative easing. The US central bank, the Federal Reserve, also cut its main federal funds rate by one percentage point from 1–1.25% to 0–0.25%.
The planned Budget
The second part of the Budget is to raise government investment by 9% in real terms over the next four years, bringing overall government expenditure to 41% of GDP, financed largely by extra borrowing. As the IFS observes, “That is above its pre-crisis level and bigger than at any point between the mid 1980s and the start of the financial crisis.”
But despite this rise in the proportion of government spending to GDP, in other respects the spending plans are less expansionary than they may appear. Increases in current spending on health, education and defence had already been promised. This leaves other departments, such as social security, facing cuts, or at least no increase. And when compared with 2010/11 levels, if you exclude health, government current spending per head of the population will around 14% lower, or 19% lower once you account for spending that replaces EU funding.
The Chancellor’s hope is that, by focusing on investment, there will be a supply-side effect as well as a demand-side boost. If increases in aggregate demand are balanced by increases in aggregate supply, such a policy would not be inflationary in the long run. But in the light of the considerable uncertainty of the effects of the coronavirus, the plans may well require significant adjustment in the Autumn Budget – or earlier.
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Questions
- To what extent is this Budget ‘Keynesian’?
- Is the extra government expenditure likely to crowd out private expenditure? Explain.
- Demonstrate the desired long-term economic effect of the infrastructure policy using either an AD/AS diagram or a DAD/DAS diagram.
- How is the coronavirus pandemic likely to affect potential GDP in (a) the short run (b) the long run?
- Why is public-sector debt likely to soar over the next four years while annual government debt interest payments are likely to continue their gentle decline?
- What is missing from the Budget that you feel ought to have been included? Explain why.
With many countries experiencing low growth some 12 years after the financial crisis and with new worries about the effects of the coronavirus on output in China and other countries, some are turning to a Keynesian fiscal stimulus (see Case Study 16.6 on the student website). This may be in the form of tax cuts, or increased government expenditure or a combination of the two. The stimulus would be financed by increased government borrowing (or a reduced surplus).
The hope is that there will also be a longer-term supply-side effect which will boost potential national income. This could be through tax reductions creating incentives to invest or work more efficiently; or it could be through increased capacity from infrastructure spending, whether on transport, energy, telecommunications, health or education.
In the UK, the former Chancellor, Sajid Javid, had adopted a fiscal rule similar to the Golden Rule adopted by the Labour government from 1997 to 2008. This stated that, over the course of the business cycle, the government should borrow only to invest and not to fund current expenditure. Javid’s rule was that the government would balance its current budget by the middle of this Parliament (i.e. in 2 to 3 years) but that it could borrow to invest, provided that this did not exceed 3% of GDP. Previously this limit had been set at 2% of GDP by the former Chancellor, Philip Hammond. Using his new rule, it was expected that Sajid Javid would increase infrastructure spending by some £20 billion per year. This would still be well below the extra promised by the Labour Party if they had won the election and below what many believe Boris Johnson Would like.
Sajid Javid resigned at the time of the recent Cabinet reshuffle, citing the reason that he would have been required to sack all his advisors and use the advisors from the Prime Minister’s office. His successor, the former Chief Secretary to the Treasury, Rishi Sunak, is expected to adopt a looser fiscal rule in his Budget on March 11. This would result in bigger infrastructure spending and possibly some significant tax cuts, such as a large increase in the threshold for the 40% income tax rate.
A Keynesian stimulus would almost certainly increase the short-term economic growth rate as inflation is low. However, unemployment is also low, meaning that there is little slack in the labour market, and also the output gap is estimated to be positive (albeit only around 0.2%), meaning that national income is already slightly above the potential level.
Whether a fiscal stimulus can increase long-term growth depends on whether it can increase capacity. The government hopes that infrastructure expenditure will do just that. However, there is a long time lag between committing the expenditure and the extra capacity coming on stream. For example, planning for HS2 began in 2009. Phase 1 from London to Birmingham is currently expected to be operation not until 2033 and Phase 2, to Leeds and Manchester, not until 2040, assuming no further delays.
Crossrail (the new Elizabeth line in London) has been delayed several times. Approved in 2007, with construction beginning in 2009, it was originally scheduled to open in December 2018. It is now expected to be towards the end of 2021 before it does finally open. Its cost has increased from £14.8 billion to £18.25 billion.
Of course, some infrastructure projects are much quicker, such as opening new bus routes, but most do take several years.
The first five articles look at UK policy. The rest look at Keynesian fiscal policies in other countries, including the EU, Russia, Malaysia, Singapore and the USA. Governments seem to be looking for a short-term boost to aggregate demand that will increase short-term GDP, but also have longer-term supply-side effects that will increase the growth in potential GDP.
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Questions
- Illustrate the effect of an expansionary fiscal policy with a Keynesian Cross (income and expenditure) diagram or an injections and withdrawals diagram.
- What is meant by the term ‘output gap’? What are the implications of a positive output gap for expansionary Keynesian policy?
- Assess the benefits of having a fiscal rule that requires governments to balance the current budget but allows borrowing to invest.
- Would there be a problem following such a rule if there is currently quite a large positive output gap?
- To what extent are the policies being proposed in Russia, the EU, Malaysia and Singapore short-term demand management policies or long-term supply-side policies?
The monetary policy mandates of central banks have an impact on all our lives. While the terminology might not be familiar to many outside economics, their impact is, however, undeniably important. This is because they set out the objectives for the operation of monetary policy. Adjustments to interest rates or the growth of the money supply, which affect us all, reflect the mandate given to the central bank.
Since 1977 the mandate given to the Federal Reserve (the US central bank) by Congress has been to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. This mandate has become known as the dual mandate because it emphasises both employment and stable prices. Since 2012, the Federal Reserve’s Open Market Committee has issued an annual statemenent of its long-run goals. The latest was published in January 2019. Since this time, the Federal Reserve has explicitly set the ‘longer-run goal for inflation’ at 2 per cent. It has also emphasised that it would be ‘concerned’ if the inflation rate was persistently above or below this level.
In November 2018 the Federal Reserve began a review of its monetary policy strategy, its tools and how it communicates monetary policy. The review is being conducted within the guidelines that its statutory mandate gives and as well as the longer-term inflation goal of 2 per cent. However, one of the issues being addressed by the review is how the operation of monetary policy can avoid the rate of inflation frequently undershooting 2 per cent, as it has done since the financial crisis of the late 2000s and the introduction of the 2 per cent inflation rate target.
Chart 1 shows the annual rate of consumer price inflation in the US since 1998. It helps to illustrate the concern that low inflation rates can become entrenched. The chart shows that, while the average inflation rate from 1998 to 2008 was 2.7 per cent, from 2009 the average has been only 1.6 per cent. Interestingly, the average since 2012, when the explicit 2 per cent goal was introduced, to the present day is also 1.6 per cent. (Click here to download the PowerPoint chart.)
The concern going forward is that the natural or neutral rate of interest, which is the policy rate at which the rate of inflation is close to its target level and the level of output is close to its potential level, is now lower than in the recent past. Hence, when the next downturn occurs there is likely to be less room for cutting interest rates. Hence, the review is looking, in essence, to future-proof the conduct of monetary policy.
Chart 2 shows the Federal Fund rate since 1998. This is the rate at which commercial banks lend to each other the reserve balances they hold at the Federal Reserve in order to meet their reserve requirements. The Federal Reserve can affect this rate through buying or selling government securities. If it wants to drive up rates, it can sell holdings of government securities and reduce the money supply. If it wants to drive rates down, it can buy government securities and increase the money supply. The effects then ripple through to other interest rates and, in turn, aggregate demand and inflation. (Click here to download a copy of the PowerPoint chart.)
We can see from Chart 2 the dramatic cuts made by the Federal Reserve to interest rates as the financial crisis unfolded. The subsequent ‘normalisation’ of the Federal Funds rate in the 2010s saw the Federal Funds Rate rise to no higher than between 2.25 and 2.5 per cent. Then in 2019 the Federal Reserve began to cut rates again. This was despite historically-low unemployment rates. In November 2019 the unemployment rate fell to 3.5 per cent, its lowest since 1969. This has helped fuel the argument among some economists and financiers, which we saw earlier, that that the natural (or neutral) interest rate is now lower.
If the natural rate is lower, then this raises concerns about the effectiveness of monetary policy in future economic downturns. In this context, the review is considering ways in which the operation of monetary policy would be able to prevent the rate of inflation consistently undershooting its target. This includes a discussion of how the Fed can prevent inflationary expectations becoming anchored below 2 per cent. This is important because, should they do so, they help to anchor the actual rate of inflation below 2 per cent. One possibility being considered is an inflation make-up strategy. In other words, a period of below-target inflation rates would need to be matched by a period where inflation rates could exceed the 2 per cent target in order that the long-term average of 2 per cent is met.
An inflation make-up policy would work like forward guidance in that people and markets would know know that short-term interest rates would be kept lower for longer. This would then help to force longer-term interest rates lower as well as providing people and businesses with greater certainty that interest rates will be lower for longer. This could help to encourage spending, raise economic growth and prevent inflation from overshooting its target for any extensive period of time.
An inflation make-up strategy would, in part, help to cement the idea that the inflation target is effectively symmetrical and that 2 per cent is not an upper limit for the inflation rate. But, it would do more than that: it would allow the Fed to deliberately exceed the 2 per cent target.
An inflation make-up strategy does raise issues. For example, how would the Fed determine the magnitude of any inflation make-up and for how long would a looser monetary stance be allowed to operate? In other words, would an inflation make-up strategy be determined by a specific rule or formula? Or, would the principle be applied flexibly? Finally, could a simpler alternative be to raise the target rate itself, given the tendency to undershoot the 2 per cent target rate? If so, what should that the rate be?
We should know by the end of 2020 whether the Federal Reserve will adopt, when necessary, an inflation make-up monetary policy.
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Questions
- What do you understand by the monetary policy mandate of a central bank?
- Explain the ways in which the monetary policy mandate of the central bank affects our everyday lives.
- Why are inflation-rate expectations important in determining actual inflation rates?
- Why is the Federal Reserve concerned about its ability to use monetary policy effectively during future economic downturns?
- Discuss the economic arguments for and against central banks operating strict inflation-rate targets.
- Does the case for adopting an inflation make-up monetary policy mandate show that the argument for inflation-rate targeting has been lost?
- What do you understand by the idea of a natural or neutral policy interest rate? Would the actual rate be expected to be above or below this if the rate of inflation was below its target level?
