Bank rate in the UK has been at the historically low level of 0.5% since March 2009 and the MPC decision on 13 January was to leave the rate unchanged (see also). But inflation has been well above the Bank of England’s target of 2% since December 2009 and it could well rise further as international commodity prices are soaring. Some economists are thus arguing that Bank rate should rise. This is crucial, they say, to dampen inflationary expectations.
Other economists, however, argue that aggregate demand is likely to remain depressed and that the economy is operating with a large negative output gap. What is more, house prices are falling, as are real wages (see Bosses gain – workers’ pain)
In the following extract from BBC Radio 4’s Today Programme, two economists, Charles Goodhart and Willem Buiter, both former members of the MPC, debate the issue.
Podcast
Should interest rates rise? BBC Today Programme (13/1/11)
Data
Economic and Labour Market Review, Office for National Statistics (For inflation data see Tables Chapter 3, Table 3.01; for interest rates see Tables Chapter 5, Table 5.08)
Monetary Policy Committee Decisions Bank of England
Questions
- What are the arguments for a rise in Bank rate at the current time?
- What are the arguments against a rise in Bank rate at the current time?
- What information would you require to decide which of the arguments was the more powerful?
- Why is it difficult to decide the size of the output gap?
- To what extent do the arguments for and against a rise in Bank rate depend on the factors determining expectations, and what expectations are important here?
- To what extent are exchange rates relevant to the effectiveness of interest rate policy?
For most people, buying a new car is a luxury and in times of hardship it is a luxury that many cannot afford. Sales of new cars did grow during 2010 by 1.8% compared to the previous year, although the end of the car scrappage scheme in March 2010 did see a fall in sales. Sales went from being 19.9 per cent up on 2009 in the first half of the year, to being 13.8 per cent down for the remainder of 2010. On top of this, they are predicted to fall by some 5% over the coming 12 months.
Part of the explanation of this trend is the VAT rise. While an extra 2.5% is hardly noticeable on many every day items (as we saw when VAT was reduced to 15%), it will have a much larger effect on more expensive items, such as cars.
It was expected that people thinking of buying a new car would try to beat the VAT rise and so car firms hoped for a surge in sales during December. However, this did not occur and with VAT at 20% during 2011, car prices will rise: a £15,000 car will cost an extra £320. Another contributing factor to the lower than expected sales in December was the snow. Retail sales in December collapsed by 37.5%, where as fleet sales, which are less likely to be affected by the adverse weather rose by 5.1%. Similar patterns were seen in Spain, Italy and France, but in Germany sales were up by 7% on the year from December 2009.
The good news for the UK car industry is that the second half of 2011 is expected to see growth, so there may be some recovery. Furthermore, UK-built cars have seen a rise in sales – up by 17%. Finally, as petrol prices continue to rise, it is hoped that this might encourage people to trade in their less efficient old cars for more fuel-efficient new cars. This will certainly be an industry to watch over the next few months.
Snow hits new car sales Telegraph, Graham Ruddick (8/1/11)
UK new car sales to fall in 2011, says industry BBC News (7/1/11)
Mixed end to the year for European car sales Independent (7/1/11)
Car sales set to stall? Daily Mirror, Clinton Manning (8/1/11)
UK new car sales rose 1.8pc in 2010 despite end of scrappage scheme Telegraph, Amy Wilson (7/1/11)
New car sales increased in 2010 Telegraph, Chris Knapman (7/1/11)
Car registrations fall 18% from year ago Financial Times, Norma Cohen (7/1/11)
Questions
- What type of tax is VAT? Illustrate the effect of such a tax on a diagram and explain why the higher the price of the good, the bigger the impact of the VAT rise. How might this impact inflation?
- Why are car sales expected to fall in the UK over the coming year? Given this expected trend, what might we expect to see in terms of car prices?
- What impact might rising petrol prices have on new car purchases? What figure would you expect to see for cross elasticity of demand?
- How might the expected decline in car sales affect the UK economy over the next 12 months?
- What type of market structure is the car industry? (Think about the characteristics of monopolistic competition and oligopoly.)
- How did the car scrappage scheme help car sales?
- What might explain the different trend seen in the German car industry?
One of the key economic issues in 2010 has been the state of countries’ public finances. We take one final look this year at the latest state of the UK public finances in light of the latest release of Public Sector Finances from the Office for National Statistics. In doing so we will be updating our blog of 20th November – What’s £81.6 billion and still rising?.
Well, a good place to start is to up-date you on the amount of net borrowing. This is the amount by which public sector expenditure exceeds current receipts, almost entirely taxation revenues. After adjusting for the impact of temporary ‘financial interventions’ or policies to provide stability for the financial system, the amount of net borrowing in November was a record high £23.3 billion. Therefore, the amount of net borrowing since April and so the start of the financial year rose from over £81 billion in October – and the reason for the title of the earlier blog – to £104.4 billion in November. This is roughly the same as in the first eight months of financial year 2009/10 when we had amassed net borrowing of £105.1 billion.
In the first eight months of the last two financial years monthly net borrowing has averaged close on £13 billion. The government’s independent economic forecaster the Office for Budget Responsibility (OBR) released its Economic and Fiscal Outlook at the end of November. The OBR is forecasting that over the entire financial year the amount of net borrowing will be £148.5 billion or the equivalent of 10% of GDP.
The public-sector current budget balance measures whether the public sector is able to afford its current expenditures. This balance was an important indicator under the previous Labour government of whether it was meeting its Golden Rule whereby over the economic cycle it should be able to its afford current expenditures and any borrowing would be for net investment, i.e. capital expenditures giving rise to a stream of benefits over time. Therefore, the current budget balance compares revenues with current expenditures, including the wages of public sector staff, welfare payments and expenditures on inputs consumed in the current financial year. The public sector’s current budget (excluding financial interventions) was in deficit in November by £20.0 billion.
In the financial year to date, the current budget deficit has reached £83.2 billion almost identical to the total in the previous financial year. This means that the average monthly current budget deficit over the first eight months of the last two financial years has been £10.4 billion. The OBR is forecasting that there will be a deficit on the current budget in 2010-11 of £106.2 billion, the equivalent of 7.2% of GDP
Finally, we update the public-sector net debt total. The public sector’s net debt is its stock of debt less its liquid financial assets (largely foreign exchange reserves and bank deposits). As of the end of November, the stock of net debt (excluding the impact of the financial interventions) stood at £863 billion, equivalent to 58% of GDP. The stock of debt at the end of the last financial year stood at £772 billion, equivalent to 54% of GDP. The OBR expects it to increase to £922.9 or 60.8% by the end of this financial year.
The extent of the increase in the stock of public sector net debt is very clearly illustrated illustrated if we compare the latest numbers with those at the end of 2006/7 and so before the financial crisis really took hold. Back then, the stock of debt stood at £498 billion or 36% of GDP and so the last government was meeting it sustainable investment rule by keeping net debt below 40% of GDP. Both the sustainable investment rule and the golden rule were to be abandoned during 2008 as the financial crisis took grip.
If we add back the impact of the financial interventions, most notably the balance sheet effects of public sector banks, including Northern Rock, then the stock of public sector net debt at the end of November was £971 billion or 65.1% of GDP. This means that the actual stock has almost doubled since March 2007. It is perhaps little surprise that the government is introducing the Bank Levy in 2011 which, in large part, is being designed to acknowledge the external costs that the banking system can cause to the wider economy and, of course, to the public finances.
Articles
Public borrowing soars to £23.3bn record high Independent, Nick Clark (22/12/10)
UK borrowing hits new record high as government spending jumps Telegraph, Emma Rowley (21/12/10)
Government borrowing hits record high Herald, Douglas Hamilton (22/12/10) )
Public borrowing: What the economists are saying Guardian (22/12/10)
Shock as govt borrowing hits record high Sky News, James Sillars (21/11/10)
Record UK borrowing raises concerns Financial Times, Daniel Pimlott (21/12/10)
UK government borrowing hits record high BBC News (21/12/10)
City shocked as government borrowing hits record high Scotsman, Natalie Thomas (22/12/10)
Data on UK Public Finances
Latest on Public Sector Finances Office for National Statistics (21/12/10)
Public Sector Finances Statistical Bulletin, November 2010 Office for National Statistics (21/12/10)
Public Sector Finances (First Release) Time Series Data Office for National Statistics
Statistics on Public Finance and Spending HM Treasury
Questions
- Give examples of variables which are stock concepts and those which are flow concepts. Is public sector net borrowing a stock or flow concept? What about public sector net debt?
- Give examples of public expenditures which are examples of current expenditures and examples of those which are capital expenditures?
- What arguments could you put forward for and against the previous Labour government’s golden rule? What about its sustainable investment rule?
- Explain the difference between the current budget balance and net borrowing. Why might governments want to measure both these budget balances?
- What arguments would you make for and against a rapid reduction of the level of net borrowing by the UK public sector?
The government’s plan for the UK economy is well known. Reduce the public-sector deficit to restore confidence and get the economy going again. The deficit will be reduced mainly by government spending cuts but also by tax increases, including a rise in VAT from 17.5% to 20% on 1 January 2011. Reductions in public-sector demand will be more than offset by a rise in private-sector demand.
But what if private-sector demand does not increase sufficiently? With a fall in government expenditure, reduced public-sector employment and higher taxes, the danger is that demand for private-sector output may actually fall. And this is not helped by a decline in both consumer and business confidence (see, for example, Nationwide Consumer Confidence Index). What is more, consumer borrowing has been falling (see Consumer borrowing falls again) as people seek to reduce their debt, fearing an uncertain future.
So does the government have a ‘Plan B’ to stimulate the economy if it seems to be moving back into recession? Or will it be ‘cuts, come what may’? The Financial Times (see link below) has revealed that senior civil servants have indeed been considering possible stimulus measures if a return to recession seems likely.
Over in Threadneedle Street, there has been a debate in the Bank of England’s Monetary Policy Committee over whether an additional round of quantitative easing may be necessary. So far, the MPC has rejected this approach, but one member, Adam Posen, has strongly advocated stimulating demand (see The UK inflation outlook if this time isn’t different, arguing that the current high inflation is the result of temporary cost-push factors and is not indicative of excessively strong demand.
So should there be a Plan B? And if so, what should it look like?
Articles
Gus O’Donnell’s economic ‘Plan B’ emerges BBC News, Nick Robinson (14/12/10)
Sir Gus O’Donnell asks ministers to consider possible stimulus measures Financial Times, Jim Pickard (14/12/10) (includes link to article by Philip Stephens)
Gus O’Donnell urges Treasury to prepare ‘Plan B’ for economy Guardian, Patrick Wintour and Nicholas Watt (14/12/10)
Unemployment, and that ‘Plan B’ BBC News blogs, Stephanomics, Stephanie Flanders (15/12/10)
Inflation wars (cont’d) BBC News blogs, Stephanomics, Stephanie Flanders (16/12/10)
Don’t overreact to UK inflation – Bank’s Posen Reuters, Patrick Graham (16/12/10)
Bank of England’s Adam Posen calls for more quantitative easing The Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Don’t overreact to above-target UK inflation rate, cautions Posen Herald Scotland, Ian McConnell (17/12/10)
Posen calls for calm as inflation fears rise Independent, Sean O’Grady (17/12/10)
Data
OECD Economic Outlook OECD (see, in particular, Tables 1, 18, 27, 28 and 32)
Forecasts for the UK economy HM Treasury
UK Economic Outlook PricewaterhouseCoopers
Employment and Unemployment ONS
Inflation Report Bank of England
Questions
- What are likely to be the most important factors in determining the level of aggregate demand in the coming months?
- What are the dangers of (a) not having a Plan B and (b) having and publishing a Plan B?
- Why is inflation currently above target? What is likely to happen to inflation over the coming months?
- What are the arguments for and against having another round of quantitative easing?
- What else could the Bank of England do to stimulate a flagging economy?
It is the Bank of England’s responsibility to ensure that inflation remains on target. They use interest rates and the money supply to keep inflation within a 1% band of the inflation target set by the government = 2%. However, for the past 12 months, we have had an inflation rate above the 3% maximum and this looks set to continue. Official figures show that the CPI inflation rate has risen to 3.3% in November, up from 3.2% in October 2010 – above the inflation target. There was also movement on the RPI from 4.5% to 4.7% during the same months. The ONS suggests that this increase is largely down to record increases in food, clothing and furniture prices: not the best news as Christmas approaches. It is not just consumers that are facing rising prices, as factories are also experiencing increasing costs of production, especially with the rising cost of crude oil (see A crude story). Interest rates have not changed, as policymakers believe prices will be ‘reined in’ before too long.
However, the government expects inflation to remain above target over the next year, especially with the approaching increase in VAT from 17.5% to 20%. As this tax is increased, retail prices will also rise and hence inflation is likely to remain high. There is also concern that retailers will use the increase in VAT to push through further price rises. A report by KPMG suggests that 60% of retailers intend not only to increase prices to cover the rise in VAT, but to increase prices over and above the VAT rise.
Despite the planned VAT rise spelling bad news for inflation, it could be the spending cuts that offset this. As next year brings a year of austerity through a decrease in public spending, this could deflate the economy and hence bring inflation back within target. However, there are suggestions that more quantitative easing may be on the cards in order to stimulate growth, if it appears to be slowing next year. The Bank of England’s Deputy Governor, Charles Bean said:
“It is certainly possible that we may well want to undertake a second round of quantitative easing if there is a clear sign that UK output growth and with it inflation prospects are slowing,” Bean told a business audience in London.”
The following articles consider the rising costs experienced by firms, the factors behind the inflation and some of the likely effects we may see over the coming months.
Articles
UK inflation rises to a surprise six-month high The Telegraph, Emma Rowley (14/12/10)
UK inflation rate rises to 3.3% in November BBC News (14/12/10)
Inflation unexpectedly hits 6-month high in November Reuters, David Milliken and Christina Fincher (14/12/10)
Food and clothing push up inflation Associated Press (14/12/10)
Retailers ‘to increase prices by more than VAT rise’ BBC News (14/12/10)
VAT increase ‘will hide price rises’ Guardian, Phillip Inman (14/12/10)
Slower growth may warrant more QE Reuters, Peter Griffiths and David Milliken (13/12/10)
Factories feel squeeze of inflation The Telegraph, Emma Rowley (13/12/10)
Figures show rise in input prices The Press Association (13/12/10)
November producer input prices up more than expected Reuters (13/12/10)
Data
Inflation ONS
Inflation Report Bank of England
Questions
- What is the difference between the RPI and CPI? How are each calculated?
- Why are interest rates the main tool for keeping inflation on target at 2%? How do they work?
- Is the inflation we are experiencing due to demand-pull or cost-push factors? Illustrate this on diagram. How are expectations relevant here?
- Explain why the rise in VAT next year may make inflation worse – use a diagram to help your explanation.
- Explain the process by which rising prices of crude oil affect manufacturers, retailers and hence the retail prices we see in shops.
- How are the inflation rate, the interest rate and the exchange rate linked? What could explain the pound jumping by ‘as much as 0.2pc against the dollar after the report’ was released?
- Explain why the public spending cuts next year may reduce inflation. Why might more quantitative easing be needed and how could this affect inflation in the coming months?