In the UK, we have an inflation target of 2% and it’s the Bank of England’s job to use monetary policy, in particular interest rates, to keep inflation within 1 percentage point of its target. However, with rising commodity prices and the onset of recession back in 2008, interest rates had another objective: to prevent or at least lessen the recession. Bank Rate fell to 0.5% and there it has remained in a bid to encourage investment, discourage saving and increase consumption, as a means of stimulating the economy.
However, at such a low rate, interest rates are not acting as a brake on inflation, which is now well above target. This rise in inflation, has been largely brought about by cost-push factors, such as the restoration of the 17.5% VAT (up from the temporary 15%), higher oil and commodity prices, and a fall in the exchange rate. But part of the reason might be found in the increase in money supply that resulted from quantitative easing.
There are concerns that the UK may lose its credibility on inflation if action isn’t taken. The OECD has advised the Bank of England to raise Bank Rate to 3.5% by the end of 2011. The following articles consider this issue.
Articles
Time to worry about inflation? BBC News blogs, Stephanomics, Stephanie Flanders (28/5/10)
UK must not fall for the false promise of higher inflation Telegraph, Charles Bean, Deputy Governor of the Bank of England (4/6/10)
Reports and documents
General Assessment of the Macroeconomic Situation OECD Economic Outlook, No. 87 Chapter 1 (see especially pages 53–4) (May 2010)
United Kingdom – Country Summary OECD Economic Outlook, No. 87 (May 2010)
Statistical Annex OECD Economic Outlook, No. 87 (available 10/6/10)
Inflation Report portal Bank of England (see May 2010)
Questions
- Explain the relationship between interest rates and inflation. Why have such low interest rates caused inflation to increase?
- In 2008, the UK moved into recession, but was also suffering from inflation. This was unusual, as AD/AS analysis suggests that when aggregate demand falls, growth will fall, but so will prices. What can explain the low growth and inflation we saw in 2008?
- What is the difference between real and nominal GDP?
- What are the causes of the current high inflation and what solutions are available and viable?
- Why are expectations of inflation so important and how might they influence the Bank of England’s plans for interest rates?
- Do you think the OECD should have advised the Bank of England? Will there be any adverse effects internationally if the UK doesn’t heed the OECD’s advice?
- Is the OECD’s assessment of the UK in the above Country Summary consistent with its view on UK interest rates contained in pages 53 and 54 in the first OECD link?
With the Conservatives and Liberal Democrats now in power in the UK and with the Labour Party, having lost the election, being now in the midst of a leadership campaign, politicians from across the political spectrum are balming Gordon Brown for the ‘mess the country’s in’. The UK has a record budget deficit and debt, and is just emerging from a deep recession, when only a few years ago, Gordon Brown was claiming the end of boom and bust. But is the condition of the UK economy Mr Brown’s fault? Would it have been any better if others had been in charge, or if there had been even greater independence for the Bank of England of if there had been an Office of Budget Responsibility (see)?
The following podcast by Martin Wolf, chief economics commentator of the Financial Times, considers this question. He argues that:
Everybody would like to blame Gordon Brown for the financial crisis. But he was only acting in line with the national consensus on economic policy.
The economic legacy of Mr Brown FT podcasts, Martin Wolf (13/5/10)
The economic legacy of Mr Brown Financial Times, Martin Wolf (13/5/10)
Questions
- Explain what is meant by ‘the great moderation’.
- Should regulation of the banks be handed back to the Bank of England?
- Why may controlling inflation not necessarily result in stable economic growth? Is this a case of Goodhart’s Law?
- Why was the UK economy especially fragile during the banking crisis and its aftermath?
- What, according to Martin Wolf, was Mr Brown’s biggest mistake?
- Could a mistake be now being made by following the conventional wisdom that cutting the deficit is the solution to achieving sustained recovery?
It was the 12th May 2010 and George Osborne’s first day as the UK’s new Chancellor of the Exchequer. His arrival at HM Treasury coincided with the latest ONS labour market release. Just in case you were rather distracted by political events, we take the opportunity here to trawl through some of the latest labour market numbers, focusing, in particular, on those that may pose real challenges for George Osborne and the new coalition government.
From the ONS release we observe that in the three months to March the total number of economically active individuals in the UK was 31.340 million. Of these, 28.829 million were employed while 2.510 million were unemployed (but actively seeking work). The number of people employed fell by 76,000 over the quarter (and by 341,000 over the year) while the number unemployed rose by 53,000 (279,000 over the year).
Now we consider the rate of unemployment. The unemployment rate expresses the total number unemployed as a percentage of those economically active. Over the first quarter of 2010 the unemployment rate rose to 8.0%, a rise of 0.2 percentage points on the previous quarter and a rise of 0.9 percentage points from a year earlier. It is the highest quarterly unemployment rate since the 8.1% recorded in Q3 1996.
Next, consider unemployment and gender. Of those unemployed in the first quarter of the year, 61.6% were male and 38.4% were female. The increase in the male unemployment rate during the economic slowdown has been especially marked. The male unemployment rate in Q1 2010 rose to 9.2%, up from 7.9% a year ago and 5.6% two years ago. The female unemployment rate has increased to 6.7% in Q1 2010 from 6.1% in Q1 2009 and 4.8% in Q1 2008. Therefore, over the past two years the male unemployment rate has risen by 3.6 percentage points while the female rate has increased by 2.1 percentage points.
Another troubling issue is unemployment amongst the young. The unemployment rate amongst those aged 18-24 is considerably higher than the overall rate. In the three months to March the unemployment rate for this age group was 17.9% compared with the overall rate of 8%. But, more than this, the current rate of unemployment amongst those aged 18-24 is actually higher than during the early 1990s when it peaked at 17.8% in Q1 1993. The male unemployment rate amongst this age group is especially high having risen to 20.7% in the first quarter of the year, up 2 percentage points on the year and up from 14.2% in Q1 2008. The female rate amongst this age group is 14.6%, up 1.3 percentage points on the year and up from 9.8% in Q1 2008.
Another issue that emerges out of the statistics is the rise in long-term unemployment. The number of people unemployed for more than one year rose to 757,000 in the first quarter, up from 509,000 a year ago and 397,000 two years ago. Perhaps, it is easier to see the magnitude of this problem when we note that 30.2% of those unemployed have been unemployed for at least one year – this is up from 24.5% in Q1 2008. Amongst females, 25% of those unemployed have been without work for at least one year, but amongst males this rises to 33.4%. In other words, one-quarter of unemployed females and one-third of unemployed males are now regarded as being long-term unemployed.
As troubling as these numbers are, the issue of long-term unemployment is one that, over the past two decades, has never really gone away. On average since 1992, 29.4% of those unemployed have been without work for at least one year (34.2% amongst men and 21.6% amongst women).
And now to our final observation: the historically high number of economically inactive individuals of working age. In the first quarter of 2010, 8.166 million of those of working age were economically inactive, up by 86,000 over the year. As a proportion of the working population, this equates to 21.5%, which is not in itself a record high – during 1983 it reached 23.2% – but it is, nonetheless, up from 20.7% a year ago. The inactivity rate amongst those of working age is highest amongst females at 25.9% (up from 25.7% a year ago) compared with 17.4% amongst men (up from 16.1% a year ago).
One factor that helps to explain the overall rise in inactivity is the 43,000 increase in the number of students who have become economically inactive over the past year. But, we also note upward pressures on inactivity over the past year from the increase of 37,000 in the number of people who are ‘long-term sick’ and from the 13,000 increase in the number who feel ‘discouraged’ from seeking work. These pressures highlight some of the many costs that arise from unemployment and potentially raise some tricky policy challenges for the new government.
Articles
UK unemployment rises in first quarter Investment Week, Hannah Smith (12/5/10)
UK unemployment climbs to a 16-year high Irish Independent, Svenja O’Donnell Brian Groom (13/5/10)
UK unemployment increases to 2.51 million BBC News (12/5/10)
Unemployment: what the experts say Guardian (12/5/10)
UK unemployment hits highest since 1994 The Times, Robert Lindsay (12/5/10)
Jobs recovery still fragile, ‘dire’ data shows Financial Times, Brian Groom (12/5/10)
Scottish unemployment rises by 10,000 in three months BBC News (12/5/10)
Unemployment rises to highest level since 1994, ONS says inthenews.co.uk, Sarah Garrod (12/5/10)
Data
Latest on employment and unemployment Office for National Statistics (12/5/10)
Labour Market Statistics, May 2010 Office for National Statistics (12/5/10)
Labour market statistics page Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission
Questions
- What is meant by somebody being economically active? Do they have to be in a job to be economically active?
- Using the figures in the commentary, calculate the number of economically active people in Q1 2009 and so the change up to Q1 2010.
- If the number of people unemployed rises does this mean the rate of unemployment rises? Explain your answer.
- What factors might explain the persistent problem of long-term unemployment? What policy prescriptions would you offer the new coalition government in attempting to tackle this problem?
- Looking back through the commentary, pick out some of the notable gender differences. What factors might help to explain these?
- Are there any factors identified in the commentary that may be affecting the economy’s potential output?
The latest inflation release from the Office for National Statistics shows the annual rate of CPI inflation for April at 3.7%, up from 3.4% in March. In other words, the average price of a basket of consumer goods – the Consumer Price Index – was 3.7% higher in April than in the same month last year. In three of the last four months, the rate of inflation has been in letter-writing territory, i.e. more than 1 percentage point away from the government’s central inflation rate target of 2%. Of course, this time it was George Osborne, the new Chancellor of the Exchequer, who was the recipient of the obligatory explanatory letter from Mervyn King, the Governor of the Bank of England.
Over the past six months the average annual rate of rate of consumer price inflation in the UK has been 3.1%. It is, therefore, no surprise that there is considerable debate amongst commentators about the need for the Bank to raise interest rates. Part of the debate concerns the extent to which the Bank is right to argue that the current inflationary pressures are essentially short term and, according to May’s letter from the Governor to the Chancellor ‘are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy’.
The Bank points to the impact on the inflation figures of what we might term ‘one-off effects’. These include, for instance, the restoration in January of the standard rate of VAT to 17½% and the raising in the Budget in March of certain excise duties (commodity taxes), such as those on alcoholic beverages and on petrol. The Bank also points to the effects from the weakening of Sterling, specifically on the prices of imports, and from the increase over the past year in the price of oil because of higher demand on the back of the global economic recovery. Again, the Bank continues to argue that these pressures should weaken over the next 12 months.
As you might expect of the economics profession, there are others who argue that the Bank is being somewhat complacent over the prospects for inflation. Of course, these are incredibly uncertain times. In effect, the Bank is having to assess, on the one hand, the significance of cost pressures, such as those emanating from oil and other commodity prices, and, on the other hand, the future strength of aggregate demand, particularly in response to the likely fiscal tightening, not only in the UK, but in many other parts of the world too.
While economists will always hold divergent views on the prospects for inflation and, more generally, the economy, we may see another debate reignited in the months ahead: the debate over the extent to which the government’s powers over both fiscal and monetary policy are constrained.
Since 1997, the Bank of England has had a clear mandate to target the rate of inflation. But, to what extent might this mandate cause tensions between fiscal and monetary policy in the months ahead given the government’s plans for fiscal consolidation? In particular, with a tightening of fiscal policy, so as to reduce the size of the government’s budget deficit, will the Bank of England be able to maintain low interest rates and thereby help to sustain aggregate demand? This will, of course, depend on the path of inflation and, importantly, the sources of inflation. Nonetheless, it will be interesting to see whether the clear, if limited, remit of the Bank of England places pressure on the UK’s macroeconomic policy framework in these difficult economic times.
Articles
UK inflation hits 17 month-high BBC News (18/5/10)
A tale of two zones BBC News blogs: Stephanomics, Stephanie Flanders (18/5/10)
Shock rise in inflation risks higher rates and unemployment Independent, Sean O’Grady (19/5/10)
Q&A: Unpleasant surprise for Threadneedle St Financial Times, Chris Giles (18/5/10)
Inflation rise see King rebuked Financial Times, Chris Giles (19/5/10)
UK inflation fears Financial Times (18/5/10)
Inflation: mercury rising Guardian (19/5/10)
The elephant in the room just got bigger Times Online, David Wighton (19/5/10)
Weak pound and tax rises lift inflation to a 17-month high (including video) Times Online, Grainne Gilmore (19/5/10)
Data
Latest on inflation Office for National Statistics (18/5/10)
Consumer Price Indices, Statistical Bulletin, April 2010 Office for National Statistics (18/5/10)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank
Questions
- What do you understand by cost-push and demand-pull inflation? To what extent are each of these significant in explaining the current rise in the rate of inflation?
- Outline the potential advantages and disadvantages of granting the Bank of England independence to set interest rates in meeting an inflation rate target.
- If the Bank of England’s remit were relaxed, say to include targeting output growth too, how might this affect its response to rising cost-push inflation? What about rising demand-pull inflation?
- Distinguish between a rise in the level of consumer prices and a rise in the rate of consumer price inflation.
- Describe the likely impact of an increase in the standard rate of VAT on the average consumer price level and on the annual rate of consumer price inflation both in the short term and in the longer term.
Taxpayers may actually be in profit by several billion pounds, following reports from Lloyds that their profits are up in the first three months of 2010. At current share prices, the taxpayers are in profit by approximately £2 billion and this figure is expected to rise, as share prices continue to rise. Lloyds is 41% owned by the public, after a £17 billion bail-out rescued the debt-ridden bank. These profits follow two years of losses by Lloyds TSB and HBOS of over £6 billion in 2008 and 2009.
So, what has caused this change in fortunes? First, there has been a fall in the number of loans, which have gone bad. The bank said, “In our wholesale division, the level of impairments has been significantly lower than the last quarter of 2009 and is also at a lower level than our initial expectations for 2010″. Second, there has been a widening gap between the interest charged on a loan and the interest paid to depositors. However, despite this good news, this bank (and others) are still not lending enough to stimulate economic growth. Furthermore, as Lloyds still remains heavily dependent on loans both from British and overseas taxpayers, it could be some time before taxpayers see any return on their ‘investment’.
Lloyds: Black is the colour of spring BBC News, Peston’s Picks, Robert Peston (27/4/10)
Lloyds Banking Group returns to profits Guardian, Jill Treanor (27/4/10)
Lloyds profits revive as bad debts imorive Reuters, Edward Taylor and Clara Ferreira-Marques (27/4/10)
Lloyds Bank returns to profit Telegraph (27/4/10)
Lloyds and RBS shares to rise to give taxpayer potential £9bn profit Guardian, Jill Treanor and Larry Elliott (26/4/10)
Questions
- How have fewer bad debts and different lending and saving rates contributed to rising profits for Lloyds?
- If profits are back up, why are British banks still not lending enough?
- What factors will determine when the taxpayers actually see the return on their ‘investment’?
- In the Guardian article, ‘Lloyds Banking Group returns to profit’ what does it mean by “The bank did not change its earlier guidance that it expected to achieve £2bn of synergies and other operating efficiencies from the HBOS takeover by the end of 2011”?
- To what extent is the news about profits at Lloyds Banking Group and RBS a useful tool for the government in the upcoming election?
- Why is it so important that banks begin to increase their lending? What will determine the size of the effect on GDP of any given increase in lending?