Rising inflation: not normally a cause for celebration, but that’s not the case for Japan. Having been subject to the spectre of deflation for many years, the 22-year high for the CPI at 2.7% is a welcome figure, even it is slightly lower than expected. This surge in prices is partly the result of a growth in domestic demand and a sign, therefore, that output will expand in response to the rise in demand.
The Japanese economy has experienced largely stagnant growth for two decades and a key cause has been falling prices. Although consumers like bargains, this has been problematic for this large economy. Deflation creates continuously falling prices and this means consumers hold back from purchasing durable goods, preferring to wait until prices have fallen further.
In the blog, Japan’s recovery, we looked at inflation data showing Japanese consumer prices growing at a faster rate than expected. This ‘positive’ trend has continued.
When it comes to inflation, expectations are crucial. If people think prices will rise in the future, they are more likely to buy now to get the lower price. This can therefore help to stimulate aggregate demand and it is this that has been the target for Japan. Part of the growth in the CPI is down to the sales tax rise from 5% to 8%. This was the first time in 17 years that the sales tax had increased. Further increases in it are expected in 2015. There were concerns about the impact of this rise, based on the depression that followed the last rise back in 1997, but so far the signs seem good.
Monetary easing was a key component in ending the downward trajectory of the Japanese economy and, following the sales tax rise, many believe that another round of monetary easing may be needed to counter the effects and create further growth in the economy and in the CPI. As the Bank of Japan Governor said:
There are various ways to adjust policy. We will decide what among these measures is appropriate depending on economic and price developments at the time … For now, we can say Japan is making steady progress toward achieving 2 per cent inflation.
One of the ‘three arrows‘ of the government’s policy has been to boost government spending, which should directly increase aggregate demand. Furthermore, with signs of the CPI rising, consumers may be encouraged to spend more, giving a much needed boost to consumption. The economy is certainly not out of the woods, but appears to be on the right path. The following articles consider the Japanese economy.
Japan CPI rises less than expected Wall Street Journal, Takashi Nakamichi (25/4/14)
Japan inflation may beat BOJ forecast Reuters, Leika Kihara (22/4/14)
Tokyo consumer price growth at 22-year high BBC News (25/4/14)
Japan inflation quickens to over 5-year high, output rebounds Reuters, Leika Kihara and Stanley White (31/1/14)
Japan’s consumer inflation set to reach five-year high Guardian (18/4/14)
Tokyo inflation hits 22-year high, inching toward BOJ goal Reuters, Tetsushi Kajimoto and Leika Kihara (25/4/14)
Tokyo’s core CPI got 2.7% lift in April from tax hike The Japan Times (25/4/14)
Is Japan winning the war against deflation? CNBC, Ansuya Harjani (25/4/14)
Questions
- Why is deflation a problem?
- Using an AD/AS diagram, illustrate the problem of expectations and how this contributes to stagnant growth.
- Use the same diagram to explain how expectations of rising prices can help to boost AD.
- Why is the sales tax expected to reduce growth?
- Why is another round of monetary easing expected?
- What government policies would you recommend to a government faced with stagnant growth and falling prices?
Unemployment and employment are concepts that are often talked about in the media. Indeed, the 7% unemployment target referred to by the Governor of the Bank of England has been a constant feature of recent headlines. However, rather than targeting an unemployment rate of 7%, George Osborne has now called for ‘full employment’ and believes that tax and welfare changes are key to meeting this objective.
Reducing the unemployment rate is a key macroeconomic objective and the costs of unemployment are well-documented. There are obviously big costs to the individual and his/her family, including lower income, dependency, stress and potential health effects. There are also costs to the government: lower income tax revenues, potentially lower revenues from VAT through reduced consumer expenditure and the possibility of higher benefit payments. There are other more ‘economic’ costs, namely an inefficient use of resources. Unemployment represents a cost to the economy, as we are operating below full capacity and we therefore see a waste of resources. It is for this reason that ‘full employment’ is being targeted.
Traditional economic theory suggests that there is a trade-off between unemployment and inflation, illustrated by the well-known Phillips curve. In the past, governments have been willing to sacrifice unemployment for the purpose of reducing inflation. There have also been attempts to boost the economy and create jobs through increased borrowing. However, George Osborne has said:
Unemployment is never a price worth paying, but artificial jobs paid for with borrowed money doesn’t work either.
A figure representing full employment hasn’t been mentioned, so it remains unclear what level of unemployment would be acceptable, as despite the name ‘full employment’, this doesn’t mean that everyone has a job. There are several definitions of full employment, in both an economic and political context. In the period of reconstruction after the Second World War, William Beveridge, architect of the welfare state, defined full employment as where 3% of people would be unemployed.
In more recent times, other definitions have been given. In the era of monetarism in the 1970s, the term ‘natural rate of unemployment’ was used to define the unemployment rate to which economies tend in the long run – after inflationary expectations have adjusted. Keynesians use the term the ‘non-accelerating-inflation rate of unemployment (NAIRU)’, where unemployment is confined to equilibrium unemployment and where there is no excess or deficiency of aggregate demand. Both the natural rate and the NAIRU relate to the rate of unemployment at which the long-run Phillips curve is vertical.
In its Economic and Fiscal Outlook of March 2013, the Office for Budget Responsibility estimated the UK’s NAIRU to be 5.4%. George Osborne has not specified a particular rate. Rather, his speech refers to creating the ‘highest employment rate of any of the world’s leading economies’. He said the ambition was to make the UK:
…the best place in the world to create a job; to get a job; to keep a job; to be helped to look for another job if you lose one…A modern approach to full employment means backing business. It means cutting the tax on jobs and reforming welfare.
Therefore, while it appears that there is no target figure for unemployment, it seems that a new Conservative objective will be to focus on sustainable job creation and eliminate disequilibrium unemployment. This represents a move very much into Labour territory. Meeting the objective will be no easy task, given the past few years and such high levels of youth unemployment, as Labour were quick to point out, but the unemployment figures are certainly moving in the right direction. The following articles consider the objective of full employment.
Articles
Britain’s Osborne changes tone on economy with “full employment” target Reuters, William James (31/3/14)
George Osborne commits to ‘fight for full employment’ BBC News (including video) (1/4/14)
What does full employment mean? The Guardian (1/4/14)
What is full employment? The Telegraph, Peter Dominiczak (31/3/14)
’Jobs matter’, says George Osborne as he aims for full employment Independent, Andrew Grice (31/3/14)
Liam Bynre: Labour would aim for ‘full employment’ BBC News (17/5/13)
Osborne pledges full employment for UK Sky News (31/3/14)
Osborne commits to full employment as election looms Bloomberg, Svenja O’Donnell (31/3/14)
Whatever happened to full employment? BBC News, Tom de Castella and Caroline McClatchey (13/10/11)
Questions
- What is meant by full employment?
- Is it a good idea to target zero unemployment?
- Using a diagram, illustrate the difference between disequilibrium and equilibrium unemployment?
- How can full employment be achieved?
- What are the costs of unemployment?
- Use a diagram to illustrate the natural rate of unemployment and explain what it means in terms of the relationship between unemployment and inflation.
The growth of China over the past decade has been quite phenomenal, with figures recorded in double-digits. However, in the aftermath of the recession, growth has declined to around 7% – much higher than Western economies are used to, but significantly below the ‘norm’ for China. (Click here for a PowerPoint of the chart.)
The growth target for this year is 7.5%, but there appear to be some concerns about China’s ability to reach this figure and this has been emphasised by a recent Chinese policy.
A mini-stimulus package has been put in place, with the objective of meeting the 7.5% growth target. Government expenditure is a key component of aggregate demand and when other components of AD are lower than expected, boosting ‘G’ can be a solution. However, it’s not something that the Chinese government has had to do in recent years and the fact that this stimulus package has been put in place has brought doubts over China’s economic performance to the forefront , but has confirmed its commitment to growth. Mizuho economist, Shen Jianguang, said:
It’s very obvious that the leaders feel the need to stabilise growth…Overall, the 7.5 per cent growth target means that the government still cares a lot about economic growth.
Data suggest that growth in China is relatively weak and there are concerns that the growth target will be missed, hence the stimulus package. In the aftermath of the 2008 financial crisis, there was a large stimulus package in place in China. This latest investment by the government is in no way comparable to the size of the 2008 package, but instead will be on a smaller and more specific scale. Mark Williams of Capital Economics said:
It’s a bit of a rerun of what we saw last year – something less than a stimulus package and more of piecemeal measures to ensure they reach their growth target.
It is the construction of public housing and railways that will be the main areas of investment this time round. A sum of $120–180bn per year will be available for railway construction and $161bn for social housing, and tax breaks are being extended for small businesses.
The 2008 stimulus package saw debt increase to some 200% of GDP, which did cause growing concerns about the reliance on debt. However, this latest package will be financed through the issue of bonds, which is much more similar to how market economies finance spending.
The fact that the government has had to intervene with such a stimulus package is, however, causing growing concerns about the level of debt and the future of this fast growing economy, though the new method of financing is certainly seen as progress.
It should be noted that a decline in growth for China is not only concerning for China itself, but is also likely to have adverse consequences other countries. In the increasingly interdependent world that we live in, Western countries rely on foreign consumers purchasing their exports, and in recent years it has been Chinese consumers that have been a key component of demand. However, a decline in growth may also create some benefits – resources may not be used up as quickly and prices of raw materials and oil in particular may remain lower.
It is certainly too early for alarm bells, but the future of China’s growth is less certain than it was a decade ago. The following articles consider this issue.
China’s new mini-stimulus offers signs of worry and progress BBC News, Linda Yueh (3/4/14)
China puts railways and houses at hear of new stimulus measures The Guardian (3/4/14)
China unveils mini stimulus to to boost slowing economy The Telegraph (3/4/14)
China stimulus puts new focus on growth target Wall Street Journal, Bob Davis and Michael Arnold (3/4/14)
China embarks on ‘mini’ stimulus programme to kick-start economy Independent, Russell Lynch (3/4/14)
China takes first step to steady economic growth Reuters (2/4/14)
China unveils fresh stimulus The Autstralian (3/4/14)
China’s reformers can triumph again, if they follow the right route The Guardian, Joseph Stiglitz (2/4/14)
Questions
- How has Chinese growth reached double-digits? Which factors are responsible for such high growth?
- The BBC News article suggests that the stimulus package is cause for concerns but also shows progress. How can it do both?
- Using a diagram, illustrate how a stimulus package can boost economic growth.
- What are the advantages and disadvantages of high rates of growth for (a) China and (b) Western economies?
- Why does the method of financing growth matter?
- Railway and housing construction have been targeted to receive additional finance. Why do you think these sectors have been targeted?
With the publication of the February 2014 Inflation Report the Bank of England has adjusted its forward guidance to the markets.
As we saw in Part 1 of this blog, the economy should soon fall below the 7% unemployment threshold adopted in the original forward guidance issued last August. But the Bank feels that there is still too much slack in the economy to raise interest rates when unemployment does fall below 7%.
The Bank has thus issued a new vaguer form of forward guidance.
The MPC’s view is that the economy currently has spare capacity equivalent to about 1%–1½% of GDP, concentrated in the labour market. Around half of that slack reflects the difference between the current unemployment rate of 7.1% and an estimate of its
medium-term equilibrium rate of 6%–6½%. The remaining slack largely reflects a judgement that employees would like to work more hours than is currently the case. Companies appear to be operating at close to normal levels of capacity, although this is subject to some uncertainty.
The existence of spare capacity in the economy is both wasteful and increases the risk that inflation will undershoot the target in the medium term. Moreover, recent developments in inflation mean that the near-term trade-off between keeping inflation close to the target and supporting output and employment is more favourable than at the time the MPC announced its guidance last August: CPI inflation has fallen back to the 2% target more quickly than anticipated and, with domestic costs well contained, is expected to remain at, or a little below, the target for the next few years. The MPC therefore judges that there remains scope to absorb spare capacity further before raising Bank Rate.
Just what will determine the timing and pace of tightening? The Bank identifies three factors: the sustainability of the recovery; the extent to which supply responds to demand; and the evolution of cost and price pressures. But there is considerable uncertainty about all of these.
Thus although this updated forward guidance suggests that interest rates will not be raised for some time to come, even when unemployment falls below 7%, it is not at all clear when a rise in Bank Rate is likely to be, and then how quickly and by how much Bank Rate will be raised over subsequent months. Partly this is because of the inevitable uncertainty about future developments in the economy, but partly this is because it is not clear just how the MPC will interpret developments.
So is this new vaguer forward guidance helpful? The following articles address this question.
Articles
Bank of England Governor Carney’s statement on forward guidance Reuters (12/2/14)
Why has Mark Carney tweaked forward guidance? The Telegraph, Denise Roland (12/2/14)
Interest rates: Carney rips up ‘forward guidance’ policy Channel 4 News (12/2/14)
Forward guidance version 2: will the public believe it? The Guardian, Larry Elliott (12/2/14)
Mark Carney adjusts Bank interest rate policy BBC News (12/2/14)
Mark Carney’s almost promise on rates BBC News, Robert Peston (12/2/14)
Did the Bank of England’s Forward Guidance work? Independent, Ben Chu (2/2/14)
Forward Guidance 2.0: Is Carney just digging with a larger shovel? Market Watch, The Tell (12/2/14)
The U.K. Economy: Five Key Takeaways Wall Street Journal, Alen Mattich (12/2/14)
Bank of England pages
Inflation Report, February 2014 Bank of England (12/2/14)
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England
Questions
- Summarize the new forward guidance given by the Bank of England.
- Why is credibility an important requirement for policy?
- What data would you need to have in order to identify the degree of economic slack in the economy?
- Why is it difficult to obtain such data – at least in a reliable form?
- What is meant by the ‘output gap’? Would it be a good idea to target the output gap?
- Is it possible to target the rate of inflation and one or more other indicators at the same time? Explain.
Although the Monetary Policy Committee (MPC) of the Bank of England is independent in setting interest rates, until recently it still had to follow a precise remit set by the government. This was to target inflation of 2% (±1%), with interest rates set to meet this target in 24 months’ time. But things have changed since the new Governor, Mark Carney, took up office in July 2013. And now things are not so clear cut.
The Bank announced that it would keep Bank Rate at the current historically low level of 0.5% at least until unemployment had fallen to 7%, subject to various conditions. More generally, the Bank stated that:
The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.
This ‘forward guidance’ was designed to provide more information about future policy and thereby more certainty for businesses and households to plan.
But unemployment has fallen rapidly in recent months. It fell from a 7.7% average for the three months May to July 2013 to 7.1% for the latest available three months (September to November 2013). 
And yet there is still considerable slack in the economy.
It now, therefore, looks highly unlikely that the MPC will raise Bank Rate as soon as unemployment falls below 7%. This then raises the question of how useful the 7% target has been and whether, if anything, it has created further uncertainty about future MPC decisions.
The following still appears on the Bank of England website:
The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.
But this raises two questions: (a) how do you measure ‘economic slack’ and (b) what constitutes a substantial reduction?
So what should the Bank do now? What, if any, forward guidance should it offer to the markets? Will that forward guidance be credible? After all, credibility among businesses and households is an important condition for any policy stance. According to Larry Elliott in the first article below, there are five options.
Articles
Bank of England’s method of setting interest rates needs reviewing The Guardian, Larry Elliott (9/2/14)
Mark Carney set to adjust Bank interest rate policy BBC News (12/2/14)
Forward guidance: dead and alive BBC News, Robert Peston (11/2/14)
What “forward guidance” is, and how it (theoretically) works The Economist (11/2/14)
BOE’s forward guidance 2.0: Cheap talk, or big change? Market Watch (11/2/14)
Bank of England pages
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England
Questions
- What data would you need to have in order to identify the degree of economic slack in the economy?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why might the issuing of the forward guidance last July have itself contributed to the fall in unemployment?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why is credibility an important requirement for policy?
- Why may LFS unemployment be a poor guide to the degree of slack in the economy?
- Discuss the relative merits of each of the five policy options identified by Larry Elliott.
Rising inflation: not normally a cause for celebration, but that’s not the case for Japan. Having been subject to the spectre of deflation for many years, the 22-year high for the CPI at 2.7% is a welcome figure, even it is slightly lower than expected. This surge in prices is partly the result of a growth in domestic demand and a sign, therefore, that output will expand in response to the rise in demand.
