With an election approaching in the UK, uncertainty is a term we will hear frequently over the next few weeks. Until we know which party or parties will be in power and hence which policies will be implemented, planning anything is difficult. This is just one of the factors that has caused the British pound sterling to fall last week by 2% to an almost five year low against the dollar.
In the last election, uncertainty also prevailed and continued even after the election before the Coalition was formed. Given how close this election appears to be at present, another Coalition may have to be formed and this is adding to the current election uncertainty. A currency strategist at Standard Bank said:
“A $1.40 level for sterling/dollar is certainly not out of reach if the election aftermath turns ugly”
With such uncertainty, investors are refraining from putting their money into the UK and this has contributed towards the deprecation of the British pound against the dollar.
Another factor adding to this downward pressure on the pound is the latest data on industrial output. Although economic growth figures for the UK in 2014 were very positive, there are some suggestions that 2015 will not be as good as expected, though still a strong performance. The first quarter data will not be available until just before the election, but data from the ONS on industrial output shows very minimal growth at just 0.1% from January to February. Chris Williams at Markit said:
“Clearly this all bodes ill for economic growth in the opening quarter of the year. It’s now looking like the economy slowed, and possibly quite markedly, compared to the 0.6% expansion seen in the closing quarter of 2014 … The trend should improve in March, however, according to survey data.”
These two factors have combined to push the pound down, with investors preferring to hold their money in dollars, despite the weak US unemployment data. However, it is not only against the dollar that we must consider sterling’s performance. Against the euro, it has performed better, rising by 1.5%. Whether this is positive for the UK or very negative for the Eurozone is another question. The following articles consider the performance of the British pound.
Sterling falls to five-year low Financial Times, Neil Dennis (10/4/15)
Sterling plummets to five year low as economic slowdown looms The Telegraph, Mehreen Khan (10/4/15)
Pound at five-year low against dollar on weak output BBC News (10/4/15)
Sterling falls after Bank of England’s Haldane says even chances of rate cut or rise Reuters (10/4/15)
Pound falls to five-year low as volatility jumps before election Bloomberg, Anooja Debnath and David Goodman (11/4/15)
Pound falls to a five-year low against the dollar as polls suggest election will create economic uncertainty Mail Online, Matt Chorley (10/4/15)
Questions
- Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
- Explain why the election is causing economic uncertainty in the UK.
- How would uncertainty affect the demand and supply of sterling and hence the exchange rate?
- US job data is worse than expected. Shouldn’t this have caused the dollar to depreciate against the pound and not appreciate?
- Industrial output data for the UK economy is lower than expected. What has caused this?
- Why does slower growth in industrial output cause the exchange rate to depreciate?
- In order to keep the UK’s inflation rate on target, Haldane has said that we could expect a cut or rise in interest rates and policy should be prepared for both. How has this affected the exchange rate?
- Are there any advantages of having a lower pound?
The UK general election is on May 7. In the campaign during the run-up to the election the economy will be a major issue. All parties will use economic data to claim that the economy has performed well or badly and that the prospects are good or bad. As economics students you will, no doubt, be asked to comment on these claims by your friends. So where can you get analysis of the data that is not biased towards one party or another?
One source is the Institute for Fiscal Studies. It is respected by politicians of all parties as an impartial presenter and analyser of economic data. In fact, it is fiercely independent. But at election time, when often quite dramatic claims are made by politicians, the IFS often comments on whether the data support such claims.
An example occurred when David Cameron claimed that if Labour were elected, working families would face a £3028 tax rise to fund the party’s spending commitments. The IFS said that the claim was misleading as, even on the Conservatives’ assumptions, it was was based on the cumulative increase over five years, not the annual increase, and was not per household but only per working household. The IFS also said that the Conservatives’ assumptions were wrong and not in accordance with the Charter for Budget Responsibility, with which the Labour party agreed.
Expect the IFS to criticise more claims as the election campaign progresses: not just by the Conservative party but by the other parties too. After all, the IFS is not partisan and is prepared to challenge false economic claims from whatever party. Expect also that the political parties will cherry pick whatever statements by the IFS seen to favour them or criticise their opponents.
You can also expect political bias in the newspapers that report the campaigns. Even when they present facts, how they present them and which facts they choose to include and which to ignore will be a reflection of their political bias. So even newspaper reporting of what the IFS says is likely to be selective and nuanced!
Why IFS boss Paul Johnson counts in this tightest of general elections The Guardian, Larry Elliott (30/3/15)
David Cameron’s claim that Labour would raise taxes by £3,000 is ‘not sensible’, says the IFS Independent, Jon Stone (30/3/15)
‘tax rise’ is shot down by IFS The Guardian, Patrick Wintour (30/3/15)
We will borrow more if we win the election, Labour admits The Telegraph, Christopher Hope (29/3/15)
Chancellor accused of U-turn on austerity: Top economist says £20bn fiscal boost lurking in Budget is ‘remarkable reversal’ This is Money, Hugo Duncan (19/3/15)
Questions
- Distinguish between positive and normative statements. How might politicians blur the distinction in their claims and counter-claims?
- Identify three series of macroeconomic data from at least two independent organisations. For what reasons might the data be (a) unreliable; (b) used by political parties to mislead the electorate?
- In what ways can political parties use economic data to their own advantage without falsifying the data?
- How may public-sector deficit and debt statistics be interpreted in ways to suit (a) the current government’s case that the public finances have been well managed; (b) the opposition case that the public finances have been badly managed?
- Use data to analyse an economic claim by each of at least three political parties and the extent to which the claims are accurate.
- The above links are to articles from four UK national newspapers: The Guardian, the Independent, The Telegraph and the Daily Mail (This is Money). Identify political bias in the reporting in each of the articles.
The latest inflation figures, as detailed in February’s Consumer Price Inflation Statistical Bulletin, show that the annual rate of CPI inflation hit zero in February. This is down from 0.3 per cent in January. While inflation is now well outside the 1-3 per cent target range that the Bank of England is charged with meeting, perhaps a more pertinent question is whether the UK is teetering on the brink of deflation – and the risks that may carry.
To get a better sense of the latest inflation picture we need to delve deeper into the numbers and look at the patterns in the prices that make up the overall Consumer Price Index. Interestingly, these shows that five of the 12 principal product groups that make up the index are currently experiencing price deflation.
As explained in Consumer Price Inflation: The 2015 Basket of Goods and Services, produced by the ONS, around 180,000 prices quotations are collected each month for around 700 representative items. These goods and services fall into one of 12 broad 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. A monthly price index is calculated for these 12 broad groupings, known as divisions, and for sub-categories of these. For example meat is a category within food and non-alcoholic beverages. The overall CPI is a weighted average of the 12 broad groupings.
The annual rate of CPI inflation in February 2015 was zero. This means that the price of the representative basket of goods and services was unchanged from its level in February 2014. As Chart 1 shows (click here for a PowerPoint of the chart), the annual rate of CPI inflation series goes back to January 1989 and this is the first time it has fallen to zero. Its average over this period is in fact 2.7 per cent. The recent fall is quite stark with the rate of CPI inflation in June 2013 close to the top-end of the Bank of England’s target range at 2.9 per cent.
Of the 12 product groups, five constitute 10 per cent or more of the overall weight of the CPI index. These weights are dependent on the relative level of expenditure comprised by each division.
Chart 2 shows the annual rates of inflation for these five groups (click here for a PowerPoint of the chart). The most heavily-weighted component is transport (14.9%), which includes the price of fuel and passenger transport. Here we observe deflation with prices 2.7 per cent lower year-on-year in February. This is the fourth consecutive month where its annual rate of price inflation has been negative.
The second most heavily-weighted component within the CPI index is recreation and culture (14.7%), which includes games, toys and audio-visual equipment. Here too we see the emergence of deflation. In February 2015 prices were 0.8 per cent lower than in February 2014. Deflation is most prevalent in the fifth most heavily-weighted component (11.0%): food and non-alcoholic drinks. The price for this division of the CPI was 3.3 per cent lower in February 2015 as compared with February 2014. In nine of the last ten months the price of food and non-alcoholic drinks, helped by aggressive price competition in the grocery sector, has been lower year-on-year.
February also saw a negative annual rate of inflation emerge for the first time in the CPI division capturing furniture and household equipment and appliances (-0.3 per cent). Further, miscellaneous services, which include personal care and personal effects (e.g. jewellery) saw an annual rate of deflation for the eight consecutive month. The annual rate of inflation for miscellaneous services stood at -0.4 per cent in February. However, February did see an upturn in price inflation for clothing and footwear with prices 1.7 per cent higher than a year earlier while the price of alcohol and tobacco was 3.8 per cent higher year-on-year.
The detailed inflation numbers do reveal the extent to which many CPI divisions are already characterised by deflation. It is interesting to note that in A Comparison of Independent Forecasts published monthly by HM Treasury, the forecast for the final quarter of 2015 is for the annual rate of CPI inflation to be running at 0.8 per cent. An important reason for this is that the effect of falling fuel prices from November 2014 will begin to drop out of the year-on-year inflation rate calculations. The removal of this effect should help to prevent the specter of deflation provided that peoples’ inflationary expectations remain anchored, i.e. exhibit stickiness. If these were to be revised down, however, this would further contribute to downward pressure on prices since input price inflation – including wage inflation – would again be expected to fall.
Articles
U.K. on Brink of Falling Prices as Inflation Rate Drops to Zero Bloomberg, Tom Beardsworth (24/3/15)
UK inflation rate falls to zero in February BBC News (24/3/15)
Britain sees no inflation in February for first time on record Reuters, David Milliken and Andy Bruce (24/3/15)
Inflation hits a record zero boosting household incomes Independent, Clare Hutchinson (24/3/15)
Inflation Hits 0% As Food Costs Fall Further Sky News (24/3/15)
Inflation falls to zero in February as Britain heads to deflation Telegraph, Szu Ping Chan (24/3/15)
UK inflation hits zero for the first time on record Guardian, Angela Monaghan (24/3/15)
Data
Consumer Price Inflation, February 2015 Office for National Statistics
Consumer Price Indices, Time Series Data Office for National Statistics
Questions
- Explain the difference between a decrease in the level of prices and a decrease in the rate of price inflation. Can the rate of price inflation rise even if price levels are falling? Explain your answer
- Explain what is meant by deflation.
- In what ways might deflation affect the behaviour of people? What effect could this have on the macroeconomy?
- 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?
- What factors do you think lie behind the fall in the transport component of the CPI?
- Explain why the rate of inflation would be expected to rise in the late autumn, a year on from when the transport component of the CPI began falling.
- Does the possibility of deflation mean that inflation rate targeting has failed?
In March 2009, interest rates in the UK fell to a record low of 0.5%. At the time, it is unlikely that anyone expected that we would still be talking about such low interest rates 6 years later. There has been no movement in the UK rate of interest over the past 6 years and many believe that we are unlikely to see an increase before 2016 or late 2015 at the earliest. With inflation at 0.3%, there is ‘little reason to raise the cost of borrowing’.
The cut in interest rates back in 2009 was in response to the financial crisis and recession. A key instrument of monetary policy, interest rates affect many of the components of aggregate demand. Lower interest rates reduce the cost of borrowing, reduce the return on savings and hence encourage consumption. They can also reduce mortgage repayments and have a role in reducing the exchange rate. All of these factors are crucial for any economic stimulus. As the recovery in the UK took hold, discussions started to focus on when (and not if) interest rates would increase. As the 6 year anniversary occurs, with the MPC keeping rates at 0.5% for March, this question has once again been raised.
Interest rates are used to target inflation and the target in the UK is 2% +/- 1%. With inflation at 0.3% and some predicting that it will turn negative, thanks to such a large fall in oil prices, perhaps the most likely change in interest rates is that they will fall further. A senior Economic Adviser to the EY Item Club commented:
“While the risks of an earlier rate rise have probably increased lately, we still think it most likely that the Bank will wait until February 2016, by which time inflation will be back above 1% and heading towards the 2% target.”
This was echoed by the Chief Economist at the British Chambers of Commerce, who said:
“The strengthening pound against the euro is already posing challenges for many UK exporters and higher interest rates would only make matters worse…Given this background, business confidence will be strengthened if the Monetary Policy Committee (MPC) clearly states that interest rates are likely to stay on hold until at least early 2016.”
Some might question the logic of keeping interest rates so low, given that unemployment is falling and the economy is growing. In such cases, we would normally expect interest rates to increase, especially given how low they are and the fact that it has been 6 years since they went down. However, with oil prices down, inflation has fallen and wage growth does remain relatively weak. Furthermore, there are still some areas within the UK that are still in the recovery process.
The strength of the economy relative to Europe is also putting upward pressure on the pound, which will adversely affect the competitiveness of UK exports. These factors together mean that retaining interest rates at 0.5% received unanimous support amongst the MPC. The only disagreement was on the future direction of interest rates. It is this disagreement that is perhaps what is causing problems, as confirmation of what will happen to interest rates over the rest of 2015 would give greater certainty to an economy. The following articles consider this anniversary.
UK interest rates mark six-year anniversary at record low The Guardian, Angela Monaghan (5/3/15)
UK interest rates mark six years at record low of 0.5% BBC News (5/3/15)
Bank of England keeps interest rates on hold Financial Times, Emily Cadman (5/3/15)
Carney facing seven-year itch as BOE holds rates Bloomberg, Jennifer Ryan (5/3/15)
Bank of England rates have now been on hold six years. Here’s how it has affected you The Telegraph, Szu Ping Chan (5/3/15)
Bank of England keeps rates on hold, six years after crisis cut Reuters (5/3/15)
Bank of England keeps key rate at record low Wall Street Journal, Jason Douglas (5/3/15)
Questions
- By outlining the key components of aggregate demand, explain the mechanisms by which interest rates will affect each component.
- How can inflation rates be affected by interest rates?
- Why is there a debate amongst the MPC as to the future direction of interest rates?
- The Chief Economist at the British Chambers of Commerce has said that the strengthening pound is creating problems in the UK and higher interest rates would make matters worse. Why is this?
- Who would be helped and harmed by a rate rise?
- Consider the main macroeconomic objectives and in each case explain whether economic theory would suggest that interest rates should (a) fall , (b) remain at 0.5% or (c) rise.
The eurozone is certainly in trouble and, despite the efforts of world leaders to create confidence, it appears that most announcements are having the opposite effect. The risk of deflation has now emerged to be very true; the powerhouse of Europe ‘needs to do more’ and the euro has fallen following Mario Draghi’s recent comments. So, just how bad are things in the eurozone?
Mario Draghi suggested that as a means of stimulating the eurozone economies, a process of quantitative easing may soon need to begin. However, rather than reassuring investors that action was being taken to improve the economic performance in the region, it appears to have had the opposite effect. Following his comments, the euro fell to its lowest level since the middle of 2010.
Quantitative easing has seen much use in the aftermath of the financial crisis and the aim in the eurozone would be to put a stop to the continuing price decreases. The eurozone has now entered deflation and, while the aim of this economic area has always been low prices, deflation is not good news. The downward pressure on prices has been largely driven by oil prices falling and prices in other areas remaining relatively stable.
Quantitative easing would inject money into the eurozone, thus creating growth (or at least that’s the idea) and pushing up prices. One of Mario Draghi’s comments was:
‘We are making technical preparations to alter the size, pace and composition of our measures in early 2015.’
So, while it’s not certain that the QE policy will be used, it seems pretty likely, especially as this policy has been floating around for almost a year.
A key question is, will it work? The quantity theory of money does suggest that an increase in the money supply will lead to inflationary pressures, unless its velocity of circulation falls. But will it actually stimulate aggregate demand and economic growth? If there is more money in the banking system and hence more money available for lending then it may well stimulate investment and consumption. However, if consumers and firms are not confident about the effectiveness of the policy or about the future of the economy, then will the fact that more money is available for lending actually encourage them to borrow? In this case will there merely be a fall in the velocity of circulation?
The comments by Mario Draghi have also caused the euro to fall to its lowest level since 2010. The graph included in the CNBC article provides an interesting view of the path of the euro. Marc Chandler, from Brown Brothers Harriman said:
‘I’d say there’s a good chance it [the euro] gets there [parity with the dollar] before the election next November (2016) … We know the Fed’s going to be raising rates sooner or later, and the ECB is going to be easing sooner or later. I just see a steady grind lower.’
The outlook of the euro therefore doesn’t look too good by all accounts. It is now a waiting game to see if the policy of quantitative easing is implemented and whether or not it has the desired effect. The following articles consider this topic.
Eurozone economy slows further BBC News (6/1/15)
Eurozone falls into deflation for first time since October 2009 Financial Times, Claire Jones (7/1/15)
Eurozone officially falls into deflation, piling pressure on ECB The Telegraph, Marion Dakers (7/1/15)
Eurozone consumer prices fall for first time in five years Nasdaq, Brian Blackstone and Paul Hannon (7/1/15)
Draghi comments send euro to lowest level since 2010 BBC News (2/1/15)
Oil slump drags Eurozone into deflation The Guardian, Graeme Wearden (7/1/15)
Eurozone prices fall more than expected in December Reuters (7/1/15)
Eurozone lurches into deflation after oil price crashes Independent, Russell Lynch (7/1/15)
German inflation hits five-year low as Eurozone prepares for QE The Telegraph, Mehreen Khan (5/1/15)
Euro slide could take it to parity with dollar CNBC, Patti Domm (7/1/15)
Questions
- Why is deflation a cause for concern when normally the main problem is inflation that is too high?
- What is the quantity theory of money and how does it suggest an increase in the money supply will affect prices?
- If quantitative easing is implemented, is it likely to have the desired effect? Explain why or why not.
- Why has the euro been affected by Mario Draghi’s comments? Use a diagram to help your explanation.
- How will quantitative easing help to stimulate economic growth across the Eurozone? Are there any other policies that would be effective?
- Oil prices have had a big influence on the deflationary pressures in the Eurozone. If oil prices increased again, would this be sufficient to create inflation?
With an election approaching in the UK, uncertainty is a term we will hear frequently over the next few weeks. Until we know which party or parties will be in power and hence which policies will be implemented, planning anything is difficult. This is just one of the factors that has caused the British pound sterling to fall last week by 2% to an almost five year low against the dollar.
