Category: Essentials of Economics: Ch 11

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Monetary policy: too much, too late?

In this third blog about inflation, we focus on monetary policy to deal with the problem and bring inflation back to the target rate, which is typically 2 per cent around the world (including the eurozone, the USA and the UK). We ask the questions: was the response of central banks too timid initially, meaning that harsher measures had to be taken later; and will these harsher measures turn out to be excessive? In other words, has the eventual response been ‘too much, too late’, given that the initial measures were too little?

Inflation rates began rising in the second half of 2021 as economies began to open up as the pandemic subsided. Supply-chain problems drove the initial rise in prices. Then, following the Russian invasion of Ukraine in February 2022 and the adverse effects on oil, gas and grain prices, inflation rose further. In the UK, CPI inflation peaked at 11.1% in October 2022 (see chart 1 in the first of these three blogs). Across the whole EU-27, it peaked at 11.5% in October 2022; US inflation peaked at 9.1% in June 2022; Japanese inflation peaked at 4.3% in January 2023.

This raises the questions of why interest rates were not raised by a greater amount earlier (was it too little, too late?) and why they have continued to be raised once inflation rates have peaked (is it too much, too late?).

The problem of time lags

Both inflation and monetary policy involve time lags. Rising costs take a time to work their way through the supply chain. Firms may use old stocks for a time which are at the original price. If it is anticipated that costs will rise, central banks will need to take action early and not wait until all cost increases have worked their way through to retail prices.

In terms of monetary policy, the lags tend to be long.

If central bank interest rates are raised, it may take some time for banks to raise savings rates – a common complaint by savers.

As far as borrowing rates are concerned, as we saw in the previous blog, loans secured on dwellings (mortgages) account for the majority of households’ financial liabilities (76.4% in 2021) and here the time lags between central bank interest rate changes and changes in people’s mortgage interest rates can be very long. Only around 14 of UK mortgages are at variable rates; the rest are fixed, typically for between 2 to 5 years. So, when Bank Rate changes, people on fixed rates will be unaffected until their mortgage comes up for renewal, when they can be faced with a huge increase in payments.

Only around 21% of mortgages in England were/are due for renewal in 2023, and with 57% of these the old fixed rates were below 2%. Currently (July 2023), the average two-year fixed-rate mortgage rate in the UK is 6.81% (based on 75% loan to value (LTV)); the average five-year rate is 6.31% (based on 75% LTV). This represents a massive increase in interest rates, but for a relatively small proportion of homeowners and an even smaller proportion of total households.

But as more and more fixed-rate mortgages come up for renewal, so the number of people affected will grow, as will the dampening effect on aggregate demand as such people are forced to cut back on spending. This dampening effect will build up for many months.

And there is another time lag – that between prices and wages. Wages are negotiated periodically, normally annually or sometimes less frequently. Employees will typically seek a cost-of-living element in wage rises that covers price rises over the past 12 months, not inflation in the past month. If inflation is rising (or falling), such negotiations will not reflect the current situation. There is thus a time lag built in to such negotiations. Even if higher interest rates reduce inflation, the full effect can take some time because of this wages time lag.

Other time lags include those involving ongoing capital projects. If construction is taking place, it will take some time to complete and in the meantime is unlikely to be stopped. Higher interest rates will affect capital investment decisions now, but existing projects are likely to continue to completion. As more projects are completed over time, so the effect of higher interest rates is likely to accumulate.

Then there is the question of savings. During the pandemic, many people increased their savings as their opportunities for spending were more limited. Since then, many people have drawn on these savings to fund holidays, eating out and other leisure activities. Such spending is likely to taper off as savings are reduced. Again, the interest rises may prove to have been excessive as a means of reducing aggregate demand.

These time lags suggest that after some months the economy will have been excessively dampened and that the policy will have ‘overshot’ the mark. Had interest rates been raised more rapidly earlier and by larger amounts, the peak level of rates may not have needed to be so high.

Perhaps one of the biggest worries about raising interest rates excessively because of time lags is the effect on corporate and government debt. Highly indebted companies and countries will find that a large increase in interest rates makes servicing their debt much harder. For example, Thames Water, the UK’s biggest water and sewerage company accumulated some £14 billion in debt during the era of low interest rates. It has now declared that it cannot service these debts and is on the brink of insolvency. In the case of governments, as increasing amounts have to be spent on servicing their debt, so they may be forced to cut expenditure elsewhere. This will have a dampening effect on the economy – but with a time lag.

The distribution of pain

Those with large credit-card debt and large mortgages coming up for renewal or at variable rates will have borne the brunt of interest rate rises. These people, such as young people with families, are often those most affected by inflation, with a larger proportion of their expenditure on energy and food. Other people adversely affected are tenants where landlords raise rents to cover their higher mortgage payments.

Those with no debts will have been little affected by the hike in interest rates, unless the curbing of aggregate demand affects their chances of overtime or reduces available shifts or, worse still, leads to redundancy.

Excessive rises in interest rates exacerbate these distributional effects.

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Questions

  1. For what reasons might a central bank be unwilling to raise interest rates by more than 0.25 or 0.5 percentage points per month?
  2. What instruments other than changing interest rates does a central bank have for influencing aggregate demand?
  3. Distinguish between demand-pull and cost-push inflation.
  4. Why might using interest rates to curb inflation be problematic when inflation is caused by adverse supply shocks?
  5. How are expectations of consumers and firms relevant in determining (a) the appropriate monetary policy measures and (b) their effectiveness?
  6. How could a careful use of a combination of monetary and fiscal policies reduce the redistributive effects of monetary policy?
  7. How might the use of ‘forward guidance’ by central banks reduce the need for such large rises in interest rates?
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What does 2023 have in store for the UK economy?

Last year was far from the picture of economic stability that all governments would hope for. Instead, the overarching theme of 2022 was uncertainty, which overshadowed many economic predictions throughout the year. The Collins English Dictionary announced that their word of the year for 2022 is ‘permacrisis’, which is defined as ‘an extended period of instability and insecurity’.

For the UK, 2022 was an eventful year, seeing two changes in prime minister, economic stagnation, financial turmoil, rampant inflation and a cost of living crisis. However, the UK was not alone in its economic struggles. Many believe that it is a minor miracle that the world did not experience a systemic financial crisis in 2022.

Russia’s invasion of Ukraine has led to the biggest land war in Europe since 1945, the most serious risk of nuclear escalation since the Cuban missile crisis and the most far-reaching sanctions regime since the 1930s. Soaring food and energy costs have fuelled the highest rates of inflation since the 1980s and the biggest macroeconomic challenge in the modern era of central banking (with the possible exception of the financial crisis of 2007–8 and its aftermath). For decades we have lived with the assumptions that nuclear war was never going to happen, inflation will be kept low and rich countries will not experience an energy crisis. In 2022 all of these assumptions and more have been shaken.

With the combination of rising interest rates and a massive increase in geopolitical risk, the world economy did well to survive as robustly as it did. However, with public and private debt having risen to record levels during the now-bygone era of ultra-low interest rates and with recession risks high, the global financial system faces a huge stress test.

Government pledges

Rishi Sunak, the UK Prime Minister, started 2023 by setting out five pledges: to halve inflation, boost economic growth, cut national debt as a percentage of GDP, and to address NHS waiting lists and the issue of immigrants arriving in small boats. Whilst most would agree that meeting these pledges is desirable, a reduction in inflation is forecast to happen anyway, given the monetary policy being pursued by the Bank of England and an easing of commodity prices; and public-sector debt as a percentage of GDP is forecast to fall from 2024/25.

Success in meeting the first four pledges will partly depend on the effects of the current industrial action by workers across the UK. How soon will the various disputes be settled and on what terms? What will be the implications for service levels and for inflation?

A weak global economy

Success will also depend on the state of the global economy, which is currently very fragile. In fact, it is predicted that a third of the global economy will be hit by recession this year. The head of the IMF has warned that the world faces a ‘tougher’ year in 2023 than in the previous 12 months. Such comments suggest the IMF is likely soon to cut its economic forecasts for 2023 again. The IMF already cut its 2023 outlook for global economic growth in October, citing the continuing drag from the war in Ukraine, as well as inflationary pressures and interest rate rises by major central banks.

The World Bank has also described the global economy as being ‘on a razor’s edge’ and warns that it risks falling into recession this year. The organisation expects the world economy to grow by just 1.7% this year, which is a sharp fall from an estimated 2.9% in 2022 according to the Global Economic Prospects report (see link below). It has warned that if financial conditions tighten, then the world’s economy could easily fall into a recession. If this becomes a reality, then the current decade would become the first since the 1930s to include two global recessions. Growth forecasts have been lowered for 95% of advanced economies and for more than 70% of emerging market and developing economies compared with six months ago. Given the global outlook, it is no surprise that the UK economy is expected to face a prolonged recession with declining growth and increased unemployment.

The current state of the UK economy

Despite all the concerns, official figures show that, even though households have been squeezed by rising prices, UK real GDP unexpectedly grew in November, by 0.1%. This has been explained by a boost to bars and restaurants from the World Cup as people went out to watch the football and also by demand for services in the tech sector.

At first sight, the UK’s cost of living crisis might look fairly mild compared to other countries. Its inflation rate was 10.7% in November 2022, compared to 12.6% in Italy, 16% in Poland and over 20% in Hungary and Estonia. But UK inflation is still way above the Bank of England’s 2% target. The Bank went on to tighten monetary policy further, by increasing interest rates to 3.5% in December. Further rate rises are expected in 2023. In fact, the markets and the Bank both expect the main rate to reach 5.2% by the end of this year. With the consequent squeeze on real incomes, the Bank of England expects a recession in the UK this year – possibly lasting until mid-2024.

The UK is also affected by global interest rates, which affect global growth. Global interest rates average 5%. A 1 percentage point increase would reduce global growth this year from 1.7% to 0.6%, with per capita output contracting by 0.3%, once changes in population are taken into account. This would then meet the technical definition of a global recession. This means that the Bank’s November economic forecast, which was based on a Bank Rate of 3%, may worsen due to an even larger contraction than previously expected. The resulting drop in spending and investment by people and businesses could then cause inflation to come down faster than the Bank had predicted when rates were at 3%.

There could be some positive news however, that may help bring down inflation in addition to rate rises. There has been some appreciation in the pound since the huge drop caused by the September mini-budget that had brought its value to a nearly 40-year low. This will help to reduce inflation by reducing the price of imports.

As far as workers are concerned, pay increases have been broadly contained, with 2022 being one of the worst years in decades for UK real wage growth. Limiting pay rises can have a deflationary effect because people have less to spend, but it also weighs on economic growth and productivity. Despite the impact on inflation, there is a lot of unrest across the UK, with strike action continuing to be at the forefront of the news. Strikes over pay and conditions continue in various sectors in 2023, including transport, health, education and the postal service. Strikes and industrial action have a negative effect on the wider economy. If wages are stagnating and the economy is not performing well, productivity will suffer as workers are less motivated and less investment in new equipment takes place.

Financial stresses

The UK economy is also under threat of a prolonged recession due to the proportion of households that lack insulation against financial setbacks. This proportion is unusually large for a wealthy economy. A survey conducted prior to the pandemic, found that 3 million people in the UK would fall into poverty if they missed one pay cheque, with the country’s high housing costs being a key source of vulnerability. Another survey recently suggested that one-third of UK adults would struggle if their costs rose by just £20 a month.

The pandemic itself meant that over 4 million households have taken on additional debt, with many now falling behind on repaying it. This, combined with recent jumps in energy and food bills, could push many over the edge, especially if heating costs remain high when the present government cap on energy prices ends in April.

However, there could be some better news for households with the easing of COVID restrictions in China. This could have a positive impact on the UK economy if it helps ease supply-chain disruptions occurring since the height of the global pandemic. It could reduce inflationary pressure in the UK and other countries that trade with China by making it easier – and therefore less costly – for people to get hold of goods.

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Questions

  1. Define the term ‘deflation’.
  2. Explain how an appreciation of the pound is good for inflation.
  3. Discuss the wider economic impacts of industrial strike action.
  4. Why is it important for the government to keep wages contained?
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Interest rates and the impending recession

On 3 November, the Bank of England announced the highest interest rate rise in 33 years. It warned that the UK is facing the longest recession since records began. With the downturn starting earlier than expected and predicted to last for longer, households, businesses and the government are braced for a challenging few years ahead.

Interest rates

The Monetary Policy Committee increased Bank Rate to 3% from the previous rate of 2.25%. This 75-basis point increase is the largest since 1989 and is the eighth rise since December. What is more, the Bank has warned that it will not stop there. These increases in interest rates are there to try to tackle inflation, which rose to 10.1% in September and is expected to be 11% for the final quarter of this year. Soaring prices are a growing concern for UK households, with the cost of living rising at the fastest rate for 40 years. It is feared that such increases in the Bank’s base rate will only worsen household circumstances.

There are various causes of the current cost-of-living crisis. These include the pandemic’s effect on production, the aftermath in terms of supply-chain problems and labour shortages, the war in Ukraine and its effect on energy and food prices, and poor harvests in many parts of the world, including many European countries. It has been reported that grocery prices in October were 4.7% higher than in October 2021. This is the highest rate of food price inflation on record and means shoppers could face paying an extra £682 per year on average.

There is real concern about the impact of the interest rates rise on the overall economy but, in particular, on peoples’ mortgages. Bank of England Governor, Andrew Bailey, warned of a ‘tough road ahead’ for UK households, but said that the MPC had to act forcefully now or things ‘will be worse later on’.

However, it could be argued that there was a silver lining in Thursday’s announcement. The future rises in interest rates are predicted to peak at a lower rate than previously thought. Amongst all the mini-budget chaos, there was concern that rates could surpass the 6% mark. Now the Bank of England has given the assurance that future rate rises will be limited and that Bank Rate should not increase beyond 5% by next autumn. The Bank was keen to reassure markets of this by making clear the thinking behind the decision in the published minutes of MPC meeting.

Recession

With the Bank warning of the longest recession since records began, what does this actually mean? Economies experience periods of growth and periods of slowdown or even decline in real GDP. However, a recession is defined as when a country’s economy shrinks for two three-month periods (quarters) in a row. The last time the UK experienced a recession was in 2020 during the height of the pandemic. During a recession, businesses typically make less profits, pay falls, some people may lose their jobs and unemployment rises. This means that the government receives less money in taxation to use on public services such as health and education. Graduates and school leavers could find it harder to get their first job, while others may find it harder to be promoted or to get big enough pay rises to keep pace with price increases. However, the pain of a recession is typically not felt equally across society, and inequality can increase.

The Bank had previously expected the UK to fall into recession at the end of this year but the latest data from the Office for National Statistics (ONS) show that GDP fell by 0.3% in the three months to August. The Bank is predicting that GDP will shrink by 0.5% between May and August 2023, followed by a further fall of 0.3% between September and December. The Bank then expects the UK economy to remain in recession throughout 2023 and the first half of 2024.

With the higher interest rates, borrowing costs are now at their highest since 2008, when the UK banking system faced collapse in the wake of the global financial crisis. The Bank believes that by raising interest rates it will make it more expensive to borrow and encourage people not to spend money, easing the pressure on prices in the process. It does, however, mean that savers will start to benefit from higher rates (but still negative real rates), but it will have a knock-on effect on those with mortgages, credit card debt and bank loans.

The recession in 2020 only lasted for six months, although the 20.4% reduction in the UK economy between April and June that year was the largest on record. The one before that started in 2008 with the global financial crisis and went on for five quarters. Whilst it will not be the UK’s deepest downturn, the Bank stressed that it will be the longest since records began in the 1920s.

Mortgages

Those with mortgages are rightly feeling nervous about the impact that further increases in mortgage interest rates will have on their budgets. Variable mortgage rates and new fixed rates have been rising for several months because of this year’s run of rate rises but they shot up after the mini-Budget. The Bank forecasts that if interest rates continue to rise, those whose fixed rate deals are coming to an end could see their annual payments soar by an average of £3000.

Homebuyers with tracker or variable rate mortgages will feel the pain of the rate rise immediately, while the estimated 300 000 people who must re-mortgage this month will find that two-year and five-year fixed rates remain at levels not seen since the 2008 financial crisis. However, the Bank said that the cost of fixed-rate mortgages had already come down from the levels seen at the height of the panic in the wake of Kwasi Kwarteng’s mini-Budget, which sent them soaring above 6%.

There is a fear of the devastating impact on those who simply cannot afford further increases in payments. The Joseph Rowntree Foundation (JRF) said an extra 120 000 households in the UK, the equivalent of 400 000 people, will be plunged into poverty when their current mortgage deal ends. The analysis assumes that mortgage rates remain high, with homeowners forced to move to an interest rate of around 5.5%. For people currently on fixed rates typically of around of 2% which are due to expire, this change would mean a huge increase. Such people, on average, would find the proportion of their monthly income going on housing costs rising from 38% to 54%. In cash terms this equates to an average increase of £250, from £610 a month to £860 a month.

In addition to these higher monthly home-loan costs threatening to pull another 400 000 people into poverty, such turmoil in the mortgage market would increase competition for rental properties and could result in rents for new lets rising sharply as the extra demand allows buy-to-let landlords to pass on their higher loan costs (or more).

Unemployment

Since the mini-Budget, the level of the pound and government borrowing costs have somewhat recovered. However, mortgage markets and business loans are still showing signs of stress, adding to the prolonged hit to the economy. The Bank now forecasts that the unemployment rate will rise, while household incomes will come down too. The unemployment rate is currently at its lowest for 50 years, but it is expected to rise to nearly 6.5%.

Looking to the future

It is the case that the lasting effects of the pandemic, the war in Ukraine and the energy shock have all played their part in the current economic climate. However, it could be argued that the Bank and the government are now making decisions that will inflict further pain and sacrifice for millions of households, who are already facing multi-thousand-pound increases in mortgage, energy and food bills.

There have been further concerns raised about the possible tax rises planned by the Chancellor Jeremy Hunt. If large tax rises and spending cuts are set out in the Autumn Statement of 17 November, the Bank of England’s chief economist has warned that Britain risks a deeper than expected economic slowdown. This could weigh on the British economy by more than the central bank currently anticipates, in a development that would force it to rethink its approach to setting interest rates.

There is no doubt that the future economic picture looks painful, with the UK performing worse than the USA and the eurozone. The Bank Governor, Andrew Bailey, believes that the mini-Budget had damaged the UK’s reputation internationally, stating, ‘it was very apparent to me that the UK’s position and the UK’s standing had been damaged’. However, both the Governor and the Chancellor or the Exchequer agree that action needs to be taken now in order for the economy to stabilise long term.

Jeremey Hunt, the Chancellor, explained that the most important thing the British government can do right now is to restore stability, sort out the public finances and get debt falling so that interest rate rises are kept as low as possible. This echoes the Bank’s belief in the importance of acting forcefully now in order to prevent things being much worse later on. With the recession predicted to last into 2024, the same year as a possible general election, the Conservatives face campaigning to remain in government at the tail end of a prolonged slump.

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Questions

  1. Define the term ‘recession’ and how is it measured.
  2. Explain what happens to the key macroeconomic indicators during this period of the business cycle.
  3. Which policies would governments normally implement to get a economy into the
  4. expansionary/recovery phase of the business cycle and how do they work?
  5. What is the issue of raising interest rates during a downturn or recession?
  6. With unemployment expected to rise, explain what type of unemployment this is. What policies could be introduced to reduce this type of unemployment?
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The Pound Sterling – A week of Turmoil

On 23 September, the new Chancellor of the Exchequer, Kwasi Kwarteng, announced his mini-Budget. It revealed big tax-cutting plans with the aim of stimulating economic growth. See the blog From Reaganomics to Trussonomics for details. However, the announcement triggered a crisis of confidence in the markets. The government says the measures will kickstart economic growth, but with the tax cuts funded through extra government borrowing, markets have raised alarm over the plans, sending the pound plunging.

On Monday 26 September, traders in the UK awoke to see that the pound had fallen to the new lowest level on record against the dollar of $1.03. Although it came at a time when the markets expected the pound to weaken, the announcement pushed a fall in the pound beyond previous expectations. Concerns about where the extra money would come from to pay for the tax cuts were reflected in market movements. A weaker currency suggests investors’ faith in a country’s economic prospects is wavering.

What does a falling pound mean?

The pound’s value affects everyone – from shoppers to business owners and investors. The main impacts of the falling pound include:

  • Higher prices. A fall in the value of the pound will increase the price of goods and services imported into the UK from overseas. When the pound is weak against the dollar, it costs more for companies in the UK to buy things such as food, raw materials or parts from abroad. Firms are likely then to pass on some or all those higher costs to their customers.
  • Higher mortgage repayments. By increasing inflation, a falling pound is likely to push the Bank of England to raise interest rates to counter this. With two million people in the UK on a tracker or variable rate mortgage, monthly costs could increase substantially. Lenders are also likely to increase the rates charged on credit cards, bank loans or car loans.
  • Further pressure on energy costs. The price of all of the gas that the UK uses is based on the dollar – even if the gas is produced in the UK. As oil prices are based on the dollar, petrol and diesel could also be more expensive for UK drivers as it costs more to be imported by fuel companies. Although the dollar price of oil has been falling in recent weeks, consumers are not likely to see the benefit at the pump due to the slide in the value of the pound.
  • Stronger sales for UK firms who sell goods abroad. Some businesses in the UK could get a boost from a fall in the value of the pound. A cheaper pound makes it less expensive for people from around the globe to buy goods and services from British firms, making them more competitive.
  • More expensive trips abroad. The plunge in the pound means that people’s holiday money won’t stretch as far, particularly for anyone planning a trip to the USA. The depreciation of the pound could also see airlines face sharply increased costs, with fuel and aircraft leases often denominated in dollars.

Threat to confidence

The Bank of England said a weaker outlook for the UK economy as well as a stronger dollar were putting pressure on sterling. However, market responses were clear that Kwarteng’s mini-Budget was threatening to undermine confidence in the UK. The pound plunged to its lowest since Britain went decimal in 1971, as belief in the UK’s economic management and assets evaporated.

By Tuesday 27 September, there were expectations that the Bank of England would have to raise interest rates to counter the extra spending in the mini-Budget. Economists from the City suggested the slump in the pound would not just force the Bank of England into raising rates at the next MPC announcement in November, but to intervene now by announcing an emergency interest rate rise to support the currency. This sent mortgage activity into a frenzy as brokers worked around the clock to help clients secure deals before lenders pulled their products or replaced them with more expensive ones. By the end of the week there were 40% fewer products available than before the mini-Budget.

The Bank of England

In August, the Bank predicted that the UK would go into recession, lasting some 15 months. It did so as it raised interest rates by the highest margin in 27 years (0.5 percentage points) in a bid to keep soaring prices under control. Higher interest rates can make borrowing more expensive, meaning people have less money to spend and prices will stop rising as quickly. The Bank of England is expected to raise interest rates by an even larger amount to combat the inflationary impact of the mini-Budget, as a weakening pound drives up costs of imports. The money markets are pricing a doubling of UK interest rates to more than 5% by next summer.

On Thursday 29 September the cost of government borrowing was rising to levels many economists thought were concerning. After the mini-Budget, the UK Debt Management Office, which borrows on behalf of the government by issuing new government bonds (‘gilts’), plans to raise an additional £72bn before next April, raising the financing remit in 2022/23 to £234bn. The investors in bonds are mainly large institutions, such as pension funds.

New bonds are issued at a fixed payment per annum based on the face value. If interest rates rise, then new bonds must pay a higher amount per annum to attract purchasers. Old bonds with a relatively low payment per year will fall in value. For example, if a £100 bond issued a while back paid £2 per annum (a nominal 2%) and interest rates on equivalent assets rose to 4%, the market price of the bond would fall to £50, as £2 per annum is 4% of £50. This percentage of the market price (as opposed to the face value) is known as the ‘yield’. With worries about the rise in government borrowing, bond prices fell and yields correspondingly rose. Investors were demanding much higher interest rates to lend to the UK government.

The Investment Director at JM Finn compared investing in government bonds to sloths, they’re low risk and typically don’t move. This is because lending to the UK is usually considered as an ultra-safe bet. However, some bonds fell in price by 20% in two days (26–28 September).

There was concern that the mini-Budget threatened the financial health of Britain’s biggest pensions and insurance companies, which together manage trillions of pounds of people’s cash. These companies hold large amounts of UK government bonds and the fall in their price was significantly reducing the value of their assets.

The Bank of England thus announced that it would step in to calm markets, warning that continued volatility would be a ‘material risk to UK financial stability’. The Bank would start buying government bonds at an ‘urgent pace’ to help push their price back up and restore orderly market conditions. It would set aside £65bn to buy bonds over 13 working days. It is hoped that the Bank’s action will now ease the pressure on pension funds and insurance companies.

But the purchase of bonds increases money supply. This was the process by which money supply was increased during periods of quantitative easing (QE). Increasing money supply, while helping to dampen the rise in interest rates and stabilise the financial markets, is likely to lead to higher inflation. The Bank of England had previously planned to do the opposite: to engage in quantitative tightening (QT), which involves selling some of the stock of (old) bonds which the Bank had accumulated during the various rounds of QE.

Despite the Bank of England’s action which helped to curb the fall in the sterling exchange rate, some analysts warned it could fall further and could even reach parity with the dollar. There are concerns that the Bank is simply firefighting, rather than being able to solve the wider problems. There is now growing pressure on the government to make clear the financial cost of its tax cuts and spending plans.

Criticism from the IMF

There has been widespread criticism of the government’s plan, with the International Monetary Fund warning on Tuesday 27 September that the measures were likely to fuel the cost-of-living crisis and increase inequality. The stinging rebuke from the IMF arrived at the worst moment for the UK government. The IMF works to stabilise the global economy and one of its key roles is to act as an early economic warning system. It said it understood the package aimed to boost growth, but it warned that the cuts could speed up the pace of price rises, which the UK’s central bank is trying to bring down. In an unusually outspoken statement, the IMF said the proposal was likely to increase inequality and add to pressures pushing up prices.

Mark Carney, the former Governor of the Bank of England also criticised the government, accusing them of ‘undercutting’ the UK’s key economic institutions. Mr Carney said that while the government was right to want to boost economic growth, ‘There is a lag between today and when that growth might come.’ He also criticised the government for undercutting various institutions that underpin the overall approach, including not having an OBR forecast.

What is next for the economy?

Before the announcement, the Bank had expected the economy to shrink in the last three months of 2022 and keep shrinking until the end of 2023. However, some economists believe the UK could already be in recession. The impacts of the mini-Budget have so far not alleviated fears of the UK diving into recession. However, the Governor of the Bank of England, Andrew Bailey, also warned that little could be done to stop the UK falling into a recession this year as the war in Ukraine continued. He added that it would ‘overwhelmingly be caused by the actions of Russia and the impact on energy prices’.

Despite the external pressures on the economy, it is clear that recent market activity has damaged confidence. The Bank has already said it will ‘not hesitate’ to hike interest rates to try to protect the pound and stem surging prices. Some economists have predicted the Bank of England will raise the interest rate from the current 2.25% to 5.75% by next spring.

The Bank’s action of emergency bond purchases helped provide Kwarteng with some respite from the financial markets after three days of turmoil, which included strong criticism of the mini-Budget from the International Monetary Fund, about 1000 mortgage products pulled and interest rates on UK government bonds hitting their highest level since 2008.

On 3 October, at the start of the Conservative Party annual conference, Kwarteng announced that the planned cut in the top rate of income tax from 45% to 40% would not go ahead. This showed that the government would change course if pressure was strong enough. That day, the sterling exchange rate against the dollar appreciated by around 0.5% to around $1.12.

But this was not enough. The pressure was still on the government. There were urgent calls from the House of Commons Treasury Select Committee to bring forward the government’s financial statement, which was not due until 23 November, by at least a month. The government was urged to publish growth forecasts as soon as possible to help calm the markets. In response, on 4 October the government agreed to bring the financial statement forward to late October along with the forecasts of its impacts from the OBR.

However, Truss and Kwarteng have so far resisted this pressure to bring analysis of their tax plans forward. They have refused independent analysis of their plans until more than six weeks after receiving them, despite more calls from Tory MPs for Downing Street to reassure the markets. The Prime Minister and Chancellor said they would only publish the independent forecasts on 23 November alongside a fiscal statement, despite them being ready on 7 October.

Longer term impacts

Amongst all the activity in the week following the mini-Budget, there are real concerns of the longer-term impacts the budget will have on the economy. Some experts predict that the lasting effects of the ‘mini’ Budget will be felt far beyond the trading floors. Large tax cuts the government claimed would boost growth have instead convinced markets the UK’s entire macroeconomic framework is under threat. Although this turmoil has been the short-term result, it’s important to step back and think about how the effects of this abrupt shift in economic policy will be felt far beyond the trading floors.

Sterling’s partial recovery a few days after the mini-Budget reflects an increased confidence that there will be a large interest rate rise coming on November 3. However, the bleak economic outlook has removed any fiscal headroom the government may have had. The largest tax cuts in five decades need funding, while spooking the markets means another £12.5bn a year added to the debt interest bill. However, Kwarteng remains committed to debt falling eventually.

It is estimated that there needs to be a fiscal tightening of around £37–£47bn by 2026/27. Even more could be required to ensure that tax revenues cover day-to-day spending or for even a small margin for error. Many have therefore called for a U-turn on the measures announced in the mini-Budget beyond abolishing the cut to the top rate of income tax. Performing a U-turn on some of the tax cuts would make the fiscal tightening much more achievable. However, it could be politically detrimental. Much lower taxes will mean less public spending. Some suggest that this trade-off was ignored when those tax cuts were announced, but market pressure has now put it centre stage.

The Prime Minister has since admitted that mistakes were made in the controversial ‘mini’ Budget that sparked market turmoil in the last week of September. However, a day before reversing the cut in the top rate of income tax, she said she would not retreat on her plan to deliver £45bn of unfunded tax cuts, insisting it would help deliver growth, but admitted: ‘We should have laid the ground better and I have learned from that.’

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Questions

  1. Explain how the announced tax cut will stimulate economic growth.
  2. What is the impact of the weakened pound on UK households and businesses?
  3. Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
  4. How is UK inflation likely to be affected by a depreciation of sterling?
  5. Are there any advantages of having a lower pound?
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Stopping the Game? Big traders vs. the swarm

Bubbles

Speculation in markets can lead to wild swings in prices as exuberance drives up prices and
pessimism leads to price crashes. When the rise in price exceeds underlying fundamentals, such as profit, the result is a bubble. And bubbles burst.

There have been many examples of bubbles throughout history. One of the most famous is that of tulips in the 17th century. As Box 2.4 in Essential Economics for Business (6th edition) explains:

Between November 1636 and February 1637, there was a 20-fold increase in the price of tulip bulbs, such that a skilled worker’s annual salary would not even cover the price of one bulb. Some were even worth more than a luxury home! But, only three months later, their price had fallen by 99 per cent. Some traders refused to pay the high price and others began to sell their tulips. Prices began falling. This dampened demand (as tulips were seen to be a poor investment) and encouraged more people to sell their tulips. Soon the price was in freefall, with everyone selling. The bubble had burst .

Another example was the South Sea Bubble of 1720. Here, shares in the South Sea Company, given a monopoly by the British government to trade with South America, increased by 900% before collapsing through a lack of trade.

Another, more recent, example is that of Poseidon. This was an Australian nickel mining company which announced in September 1969 that it had discovered a large seam of nickel at Mount Windarra, WA. What followed was a bubble. The share price rose from $0.80 in mid-1969 to a peak of $280 in February 1970 and then crashed to just a few dollars.

Other examples are the Dotcom bubble of the 1990s, the US housing bubble of the mid-2000s and BitCoin, which has seen more than one bubble.

Bubbles always burst eventually. If you buy at a low price and sell at the peak, you can make a lot of money. But many will get their fingers burnt. Those who come late into the market may pay a high price and, if they are slow to sell, can then make a large loss.

GameStop shares – an unlikely candidate for a bubble

The most recent example of a bubble is GameStop. This is a chain of shops in the USA selling games, consoles and other electronic items. During the pandemic it has struggled, as games consumers have turned to online sellers of consoles and online games. It has been forced to close a number of stores. In July 2020, its share price was around $4. With the general recovery in stock markets, this drifted upwards to just under $20 by 12 January 2021.

Then the bubble began.

Hedge fund shorting

Believing that the GameStop shares were now overvalued and likely to fall, many hedge funds started shorting the shares. Shorting (or ‘short selling’) is where investors borrow shares for a fee and immediately sell them on at the current price, agreeing to return them to the lender on a specified day in the near future (the ‘expiration date’). But as the investors have sold the shares they borrowed, they must now buy them at the current price on or before the expiration date so they can return them to the lenders. If the price falls between the two dates, the investors will gain. For example, if you borrow shares and immediately sell them at a current price of £5 and then by the expiration date the price has fallen to $2 and you buy them back at that price to return them to the lender, you make a £3 profit.

But this is a risky strategy. If the price rises between the two dates, investors will lose – as events were to prove.

The swarm of small investors

Enter the ‘armchair investor’. During lockdown, small-scale amateur investing in shares has become a popular activity, with people seeking to make easy gains from the comfort of their own homes. This has been facilitated by online trading platforms such as Robinhood and Trading212. These are easy and cheap, or even free, to use.

What is more, many users of these sites were also collaborating on social media platforms, such as Reddit. They were encouraging each other to buy shares in GameStop and some other companies. In fact, many of these small investors were seeing it as a battle with large-scale institutional investors, such as hedge funds – a David vs. Goliath battle.

With swarms of small investors buying GameStop, its share price surged. From $20 on 12 January, it doubled in price within two days and had reached $77 by 25 January. The frenzy on Reddit then really gathered pace. The share price peaked at $468 early on 28 January. It then fell to $126 less than two hours later, only to rise again to $354 at the beginning of the next day.

Many large investors who had shorted GameStop shares made big losses. Analytics firm Ortex estimated that hedge funds lost a total of $12.5 billion in January. Many small investors, however, who bought early and sold at the peak made huge gains. Other small investors who got the timing wrong made large losses.

And it was not just GameStop. Social media were buzzing with suggestions about buying shares in other poorly performing companies that large-scale institutional investors were shorting. Another target was silver and silver mines. At one point, silver prices rose by more than 10% on 1 February. However, money invested in silver is huge relative to GameStop and hence small investors were unlikely to shift prices by anything like as much as GameStop shares.

Amidst this turmoil, the US Securities and Exchange Commission (SEC) issued a statement on 29 January. It warned that it was working closely with other regulators and the US stock exchange ‘to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing’. It remains to be seen, however, what it can do to curb the concerted activities of small investors. Perhaps, only the experience of bubbles bursting and the severe losses that can result will make small investors think twice about backing failing companies. Some Davids may beat Goliath; others will be defeated.

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Data

Questions

  1. Distinguish between stabilising and destabilising speculation.
  2. Use a demand and supply diagram to illustrate destabilising speculation.
  3. Explain how short selling contributed to the financial crisis of 2007/8 (see Box 2.7 in Economics (10th edition) or Box 3.4 in Essentials of Economics (8th edition)).
  4. Why won’t shares such as GameStop go on rising rapidly in price for ever? What limits the rise?
  5. Find out some other shares that have been trending among small investors. Why were these specific shares targeted?
  6. How has quantitative easing impacted on stock markets? What might be the effect of a winding down of QE or even the use of quantitative tightening?