Each month the Monetary Policy Committee of the Bank of England meets to set Bank Rate – the Bank’s repo rate, which has a direct impact on short-term interest rates and an indirect effect on other interest rates, such as mortgage rates and bond yields. Ever since March 2009, Bank Rate has been 0.5%. So each month the MPC has met and decided to do nothing! The latest meeting on 4 and 5 May was no exception.
And it is not just the Bank of England. The Fed in the USA has kept interest rates at between 0 and 0.25% ever since December 2008. The ECB had maintained its main interest rate at 1% for two years from May 2009. Then last month (April) it raised the rate to 1.25%, only to keep it unchanged at that level at its meeting on 5 May.
So is all this ‘doing nothing’ on interest rates (or very little in the case of the ECB) a sign that the economies of the UK, the USA and the eurozone are all ticking along nicely? Are they in the ‘goldilocks’ state of being neither too hot (i.e. too much demand and excessive inflation) or too cold (i.e. too little demand and low growth, or even recession)? Or does the apparent inaction on interest rates mask deep concerns and divisions within the decision-making bodies?
The three central banks’ prime concern may be inflation, but they are also concerned about the rate of economic growth. If inflation is forecast to be above target and growth to be unsustainably high, then central banks will clearly want to raise interest rates. If inflation is forecast to be below target and economic growth is forecast to be low or negative, then central banks will clearly want to reduce interest rates.
But what if inflation is above target and will probably remain so and, at the same time, growth is low and perhaps falling? What should the central bank do then? Should it raise interest rates or lower them? This is the dilemma facing central banks today. With soaring commodity prices (albeit with a temporary fall in early May) and the economic recovery stalling or proceeding painfully slowly, perhaps keeping interest rates where they are is the best option – an ‘active’ decision, but not an easy one!
Articles
Central Banks Leave Rates Unchanged News on News (8/5/11)
European Central Bank set for a bumpy ride City A.M., Guy Johnson (9/5/11)
Euro Tumbles Most Against Dollar Since January on Rate Signal; Yen Climbs Bloomberg, Allison Bennett and Catarina Saraiva (7/5/11)
Rates outlook Financial Times, Elaine Moore (6/5/11)
Interest rates on hold amid fears economy is stalling Independent, Sean Farrell (6/5/11)
The decision to hold back on increasing interest rates may turn out to be wrong Independent, Hamish McRae (6/5/11)
Bank of England: Inflation threat from fuel bills BBC News. Hugh Pym (11/5/11)
Andrew Sentance loses last battle over interest rates Guardian, Heather Stewart (5/5/11)
Interest rates: what the experts say Guardian (5/5/11)
King’s Defense of Record-Low Rates in U.K. Is Bolstered by Economic Data Bloomberg, Svenja O’Donnell (5/5/11)
BoE holds rates: reaction The Telegraph, Joost Beaumont, Abn Amro (5/5/11)
UK interest rates kept on hold at 0.5% BBC News (5/5/11)
Bank of England Signals Rate Increase This Year as Inflation Accelerates Bloomberg, Svenja O’Donnel (11/5/11)
ECB: Clearing the way for an Italian hawk? BBC News blogs: Stephanomics, Stephanie Flanders (5/5/11)
Ben and the Fed’s excellent adventure BBC News blogs: Stephanomics, Stephanie Flanders (27/4/11)
Inflation up. Growth down. Uncertainty everywhere BBC News blogs: Stephanomics, Stephanie Flanders (11/5/11)
Inflation report: analysts expecting a rate rise are wide of the mark Guardian, Larry Elliott (11/5/11)
May’s Inflation Report – three key graphs The Telegraph, Andrew Lilico (11/5/11)
The Errors Of The Inflation Hawks, Part I Business Insider, John Carney (9/5/11)
Errors of Inflation Hawks, Part II CNBC, John Carney (9/5/11)
Data and information
Inflation Report Bank of England
Inflation Report Press Conference Webcast Bank of England (11/5/11)
Monetary Policy ECB
ECB Interest Rates ECB
Monetary Policy Federal Reserve
US interest rates Federal Reserve
Questions
- Why is it exceptionally difficult at the current time for central banks to “get it right” in setting interest rates?
- What are the arguments for (a) raising interest rates; (b) keeping interest rates the same and also embarking on another round of quantitative easing?
- Should central banks respond to rapidly rising commodity prices by raising interest rates?
- Why is inflation in the UK currently around 2 percentage points above the target?
- What is likely to happen to inflation in the coming months and why?
- Explain the following comment by John Carney in the final article above: “To put it differently, the textbook money multiplier doesn’t exist anymore. This means that Fed attempts to juice the economy by raising the quantity of reserves—the basic effect of quantitative easing—are bound to fail.”.
- What has been the recent relationship in the UK between (a) growth in the monetary base and growth in broad money; (b) growth in the monetary base and inflation and economic growth?
The latest mortgage approval numbers from the Bank of England are another demonstration of the fragility of the UK housing market. March 2011 saw 47,577 mortgages approved for house purchase. This is roughly in line with levels seen since the turn of the year and, more generally, over the past year. In other words, activity in the housing market might be described as ‘flat-lining’.
Over the past year, the number of monthly mortgage approvals for house purchase has averaged 47,355. This number is almost half the 10-year monthly average of 89,258. There is little momentum in either direction in the number of mortgage approvals. Given the negative influences on both the supply of credit and on households’ demand for credit, it would be a major surprise if the monthly average for mortgage approvals was to rise much above the ‘50k-mark’ any time soon.
But, why the subdued mortgage data? Well, on the supply-side, mortgage lenders are maintaining tight lending criteria. On the demand side, households remain understandably cautious. Unless circumstances dictate a need to move, households are unlikely to be rushing in any great numbers to their local estate agent.
In conclusion, it appears that the current weak activity levels have become the new norm for the UK housing market post-credit crunch. Furthermore, the current flat-lining is likely to persist.
Articles
Mortgage approvals highest in five months Financial Times, Norma Cohen (4/5/11)
UK March mortgage approvals slightly lower than forecast Reuters (4/5/11)
Mortgage lending plummets by 60% Belfast Telegraph (5/5/11)
UK mortgage approvals little changed in March, BOE says Bloomberg, Jennifer Ryan (4/5/11)
Rise in mortgage approvals does not indicate recovery, say economists Guardian, Jill Insley (27/4/11) )
Mortgage lending from UK banks still subdued BBC News (27/4/11)
Data
Mortgage approval numbers and other lending data are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table A5.4.)
Questions
- Why do you think housing market activity might be ‘flat-lining’?
- Compile a list those variables that you think affect the demand for mortgages. Which of these do you think are particularly important at the moment?
- Compile a list of those variables that you think affect the supply of mortgages by lenders. Which of these do you think are particularly important at the moment?
- If you were advising an estate agent about future activity levels in the housing market, what would you be telling them?
- What do recent mortgage approvals numbers imply for the strength of housing demand?
In January 2011, Chinese growth accelerated to 9.8% as industrial production and retails sales picked up. As the second largest economy, this very high growth is hardly surprising, but it has caused concern for another key macroeconomic variable: inflation. Figures show that inflation climbed to 5.2% in March from a year before and the billionaire investor George Soros has said it is ‘somewhat out of control’. High property and food prices have contributed to high and rising inflation and this has led to the government implementing tightening measures within the economy.
In March, growth in property prices did finally begin to slow, according to the survey by the National Bureau of Statistics. Prices of new built homes had risen in 49 out of 70 Chinese cities in March from the previous months, but this was down from 56 cities in February. A property tax has also been implemented in cities like Shanghai and the minimum down payment required for second-home buyers has risen in a bid to prevent speculative buying. Bank reserve requirements have also been increased for the fourth time, after an increase in the interest rate at the beginning of April. The required reserve ratio for China’s biggest banks has now risen to 20.5%.
The situation in China is not the only country causing concern. Inflation in emerging markets is a growing concern, especially for the richer nations. The Singaporean finance minister, Tharman Shanmugaratnam, said:
“When inflation goes up in emerging markets, it’s not just an emerging market problem, it’s a global inflation and possibly interest rate problem … We have learned from painful experience in the past few years that nothing is isolated and that risk in one region rapidly gets transmitted to the rest of the world.”
He has said that inflation in emerging markets needs addressing to ensure that it does not begin to threaten the economic recovery of other leading economies. The following articles consider the latest Chinese developments.
New home price growth dips amid government tightening BBC News (18/4/11)
China growth may cool in boost for Wen’s inflation campaign Bloomberg Business (14/4/11)
China steps up inflation fight with bank reserves hike Independent, Nikhil Kumar (18/4/11)
China raises bank reserves again Reuters (17/4/11)
China’s economy ‘is just too hot’ says Peter Hoflich BBC News (18/4/10)
Top G20 economies face scrutiny over imbalances AFP, Paul Handley (16/4/11)
Inflation in China poses big threat to global trade Global Business, David Barboza (17/4/11)
Chinese inflation to slow to 4% by year-end: IMF AFP (17/4/11)
Chinese economic growth slows but inflation soars Guardian, Tania Branigan (15/4/11)
Questions
- What type of inflation is the Chinese economy experiencing? Explain your answer using a diagram.
- To what extent will the minimum payment on second homes and the property tax help reduce the growth in Chinese property prices?
- Why is there concern about high inflation in emerging markets and the impact it might have on other countries?
- How could the inflation in China hurt the economic recovery of countries such as the UK?
- How will the increase in the banks’ reserve requirements help inflation?
- Is high Chinese growth and high inflation the relationship you would expect to occur between these macroeconomic objectives? Explain your answer.
On 28 November 2010, a deal was reached between the Irish government, the ECB, the IMF and other individual governments to bail out Ireland. The deal involved an €85bn package to bail out the collapsing Irish banks. Not all of the money went directly to the banks and the Irish government did set aside some of the loan. However, some of this money will now be required by four key lenders in Ireland, after a stress test by a group of independent experts found that the Republic of Ireland’s banks need another €24bn (that’s £21.2bn) to survive the continuing financial crisis. Allied Irish Banks require €13.5bn, Bank of Ireland €5.2bn, Irish Life €4bn and EBS a meager €1.5bn. The governor of the central bank, Professor Patrick Honohan said:
‘The new requirements are needed to restore market confidence, and ensure banks have enough capital to meet even the markets’ darkest estimates.’
The stress test focused on an assumption of a ‘cumulative collapse’ in property prices by 62%, together with rising unemployment. Following this, the Irish Finance Minister announced the government’s intention to take a majority stake in all of the major lenders. The Irish banks have been told they need to reduce the net loans on their balance sheets by some €71bn (£63bn) by the end of 2013. This process of deleveraging is likely to generate further losses, as many loans and assets will be sold for less than their true value. The causes of this ongoing financial crisis can still be traced back to the weakness within the Irish economy and more specifically to mortgage accounts being in arrears following the property market bubble that burst. A key question will be whether this second bail-out is sufficient to restore much needed confidence in the economy and particularly in the banking sector. The articles below consider this ongoing crisis.
Irish hope it is second time lucky for bail-out Telegraph, Harry Wilson (1/4/11)
Irish Bank needs extra €24bn euros to survive BBC News (31/3/11)
Ireland forced into new £21bn bailout by debt crisis Guardian, Larry Elliott and Jill Treanor (31/3/11)
The hole in Ireland’s banks is £21bn BBC News Blogs: Peston’s Picks, Robert Peston (31/3/11)
ECB has given Ireland serious commitment Reuters (1/4/11)
Ireland banking crisis: is the worst really over? Guardian: Ireland Business Blog, Lisa O’Carroll (1/4/11)
Ireland: a dead cert for default Guardian, Larry Elliott (1/4/11)
Timeline: Ireland’s string of bank bailouts Reuters (31/3/11)
Questions
- What is the process of deleveraging? Why is likely to lead to more losses for Ireland’s banks?
- What are the causes of the financial crisis in Ireland? How do they differ from financial crises around the world?
- What are the arguments for and against bailing out the Irish banks?
- Will this second bailout halt the possible contagion to other Eurozone and EU members?
- If this second bailout proves insufficient, should there be further intervention in the Irish economy?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. Since then it has remained at the same level. Interest rates are used by the Bank of England, which aims to keep inflation at the 2% target within a 1% gap either side. However, inflation has been above 3% for some 15 months and the latest figures for February 2011 show that inflation is rising. In January, it was 4%, but data for February calculates an inflation rate of 4.4% – significantly above the Bank of England’s target rate of 2% and above the forecast rate for the month.
One of the causes of such high inflation is the price of fuel, food and clothing. No-one can have failed to notice that petrol prices are higher than ever and this is one of the factors contributing to an increase in the level of prices throughout the economy. Clothing and footwear costs, which rose by 3.6% after the January sales have also contributed to this rising figure and will put increasing pressure on the MPC to raise interest rates in the not so distant future.
In the February 2011 meeting of the Monetary Policy Committee, interest rates were kept at 0.5%, despite markets pricing the chance of a rate rise at 20%. The negative growth experienced in the final quarter of 2010 is likely to have influenced this decision, but will the inflation data we’re now seeing influence the next meeting of the MPC. This undoubtedly puts pressure on the central bank to increase interest rates to try to get inflation back on target. The cost? It could put the recovery in jeopardy and create the possibility of a double-dip recession. There is a conflict here and whatever happens to interest rates, some groups will say it’s the wrong decision. As David Kern said:
“The MPC must be careful before it takes action that may threaten the fragile recovery, particularly in the face of a tough austerity plan.”
Perhaps the Budget will provide us with some more information about how the government intends to cut the hole in public finances, ensure that the economy does not fall back into recession and keep inflation under control.
UK inflation revives talk of early interest rate rise Reuters, David Milliken and Christina Fincher (22/3/11)
How to inflation-proof your savings Telegraph, Emma Simon (22/3/11)
UK inflation rate rises to 4.4% in February BBC News (22/3/11)
Interest rates: What the economists say Guardian (10/2/11)
Q&A: Impact of rising inflation Guardian, Phillip Inman (22/3/11)
Inflation soars to over double target rate Sky News, Hazel Baker (22/3/11)
Inflation and public borrowing add to budget 2011 headaches Guardian, Larry Elliott (22/3/11)
Inflation cutting savers’ options BBC News, Kevin Peachey (22/3/11)
Inflation: What the economists say Guardian (22/3/11)
Questions
- Is inflation likely to continue going up? What might stop the rise?
- Why are interest rates such an important tool of monetary policy?
- What is the relationship between interest rates and inflation?
- What are the costs of high inflation? Does anyone benefit?
- Who would gain and who would lose if interest rates are increased in the next MPC meeting?
- Which factors have contributed towards rising inflation in the UK? Is it cost-push or demand-pull inflation?
- Why does this pose a dilemma for the government in terms of public finances and the recession?