The Bank of England was granted independence to set interest rates back in 1997. This is known as instrument independence. However, the remit is set by the government and so it does not have goal independence. Amongst the policy announcements on Budget day (Wed 20 March), the government detailed amendments to the Bank’s remit. In particular, the remit now more explicitly acknowledges that, in exceptional circumstances, the Bank might need to pay more attention to output variability.
Despite the amendments to its remit, the Bank of England continues to have a forward-looking operational inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point). The MPC therefore sets the Bank Rate, i.e. the rate at which it engages in short-term lending to financial institutions, to affect general interest rates in the economy. In turn, the level of interest rates is assumed to affect the level of aggregate demand and, hence, the rate of demand-pull inflation as well as inflation rate expectations.
A key economic benefit of delegating interest rate decisions to the Monetary Policy Committee (MPC) is thought to be lower inflation rate expectations. By granting the Bank of England operational or instrument independence, inflation announcements have a credibility that they would not if monetary policy was under the control of elected politicians. So why change the inflation rate remit?
The government remains of the view that inflation rate targeting has served the UK well, despite inflation being persistently above target for the past three years (see chart: click here for a PowerPoint). However, it has sought to clarify how the Bank of England might be expected to behave in exceptional circumstances when the economy is buffeted by shocks and disturbances, such as those that it has faced following the financial crisis of the late 2000s. The government argues that in such circumstances the output volatility that could result by ensuring that inflation remains on target could be undesirable. Therefore, the MPC should give consideration to the volatility of output that targeting inflation would cause in such exceptional circumstances.
The amended remit says that in setting monetary policy the MPC should communicate to the public the trade-offs that are inherent in meeting its forward-looking inflation rate target. Therefore, during exceptional times, the Bank may communicate that the volatility of output resulting from returning inflation to target would be so large that it is prepared to keep monetary policy looser than it otherwise would. This could mean indicating a time-frame over which it would be expected to keep interest rates lower than otherwise. By communicating this, it would in effect be looking to affect peoples’ expectations and, importantly, their behaviour. The prospect of prolonged low interest rates, such as those currently being experienced, might encourage greater expenditure, especially as a result of lower borrowing costs – though of course this is not guaranteed!
The Governor will continue to write an open letter to the Chancellor of the Exchequer if inflation moves away from the target by more than 1 percentage point in either direction. However, in a change to the previous remit, this will be done in conjunction with the minutes of the MPC meeting that follow the publication of the official inflation figures by the Office for National Statistics. By publishing the letter alongside the minutes, it gives the MPC more time to consider its strategy and to give due consideration to the trade-offs in returning inflation to the target. If inflation remains more than 1 percentage point above or below the target the Governor will need to write a further letter after three months. This letter would be alongside the minutes of the third subsequent meeting of the MPC.
Some commentators argue that the amended remit is merely a reflection of the current reality. In other words, the remit is being rewritten in a way which reflects how the MPC is currently making its interest rate decisions. Others are concerned that what was a simple and clear objective is now not the case and that this may have implications for the credibility of monetary policy. Whatever the rights and wrongs, Wednesday’s announcement was an important development in the history of central bank independence in the UK.
Documents
Remit for the Monetary Policy Committee Bank of England, March 2013
Governor Response to the remit for the Monetary Policy Committee Bank of England , March 2013
Articles
Bank of England handed new remit in Osbourne’s budget Guardian, Josephine Moulds (20/3/13)
Budget: Changing the Bank of England Remit Sky News, Ed Conway (20/3/13)
Budget 2013: Bank of England’s monetary policy remit changed Telegraph, Angela Monaghan (20/3/13)
King warns against ‘major change’ to Bank’s remit ITV News (15/3/13)
Chancellor adjusts Bank of England inflation remit Financial Times, Nick Reeve (20/3/13)
Budget 2013: Bank of England gets new orders BBC News (20/3/13)
Questions
- Why would monetary policy be expected to be more credible under an independent central bank?
- How might a lack of credibility over monetary policy affect the economy’s rate of inflation?
- Outline the advantages and disadvantages of the changes to the Bank of England’s remit.
- Central bank independence constrains discretion over monetary policy. Should governments constrain their discretion over fiscal policy? What are the advantages and disadvantages?
- Explain how the MPC tries to affect the rate of inflation through changes in the Bank Rate?
The UK government has just given the go-ahead for the building of two new nuclear reactors at Hinkley Point in Somerset. The contract to build and run the power station will go to EDF, the French energy company.
The power station is estimated to cost some £14 billion to build. It would produce around 7% of the UK’s electricity. Currently the 16 nuclear reactors in the UK produce around 19%. But all except for Sizewell B in Suffolk are due to close by 2023, although the lives of some could be extended. There is thus a considerable energy gap to fill in the coming years.
Several new nuclear power stations were being considered to help fill this gap, but with rising capital costs, especially following the Fukushima disaster in Japan, potential investors pulled out of other negotiations. Hinkley Point is the only proposal left. It’s not surprising that the government wants it to go ahead.
All that remains to agree is the price that EDF can charge for the electricity generated from the power station. This price, known as the ‘strike price’, is a government-guaranteed price over the long term. EDF is seeking a 40-year deal. Some low carbon power stations, such as nuclear and offshore wind and wave power stations, have high capital costs. The idea of the strike price is to reduce the risks of the investment and make it easier for energy companies to estimate the likely return on capital.
But the strike price, which will probably be agreed at around £95 per megawatt hour (MWh), is roughly double the current wholesale price of electricity. EDF want a price of around £100 per MWh, which is estimated to give a return on capital of around 10%. The government was hoping to agree on a price nearer to £80 per MWh. Either way, this will require a huge future subsidy on the electricity generated from the plant.
There are several questions being asked about the deal. Is the strike price worth paying? Are all the costs and benefits properly accounted for, including environmental costs and benefits and safety issues? Being an extremely long-term project, are uncertainties over costs, performance of the plant, future market prices for electricity and the costs of alternative forms of power generation sufficiently accounted for? Will the strike price contravene EU competition law? Is the timescale for construction realistic and what would be the consequences of delays? The articles consider these questions and raise a number of issues in planning very long-term capital projects.
Articles
Hinkley Point: Britain’s second nuclear age given green light as planning permission is approved for first of new generation atomic power stations Independent, Michael McCarthy (19/3/13)
Will they or won’t they? New nuclear hangs in the balance ITV News, Laura Kuenssberg (19/3/13)
Hinkley Point C: deal or no deal for UK nuclear? The Telegraph, Alistair Osborne (19/3/13)
New nuclear power plant at Hinkley Point C is approved BBC News (20/3/13)
Britain’s Plans for New Nuclear Plant Approach a Decisive Point, 4 Years Late New York Times, Stanley Reed and Stephen Castle (15/3/13)
Nuclear power plans threatened by European commission investigation The Guardian (14/3/13)
New Hinkley Point nuclear power plant approved by UK government Wired, Ian Steadman (19/3/13)
Renewable energy providers to help bear cost of new UK nuclear reactors The Guardian, Damian Carrington (27/3/13)
Europe backs Hinkley nuclear plant BBC News (8/10/14)
Information/Reports/Journal Articles
Environmental permitting of Hinkley Point C Environment Agency
NNB Generation Company Limited, Radioactive Substances Regulations, Environmental Permit Application for Hinkley Point C: Chapter 7, Demonstration of Environmental Optimisation EDF
Greenhouse Gas Emission of European Pressurized Reactor (EPR) Nuclear Power Plant Technology: A Life Cycle Approach Journal of Sustainable Energy & Environment 2, J. Kunakemakorn, P. Wongsuchoto, P. Pavasant, N. Laosiripojana (2011)
Questions
- Compare the relative benefits of a construction subsidy and a subsidised high strike price from the perspectives of (a) the government (b) EDF.
- What positive and negative externalities are involved in nuclear power generation?
- What difficulties are there in valuing these externalities?
- What is meant by catastrophic risk? Why is this difficult to take account of in any cost–benefit analysis?
- What is meant by a project’s return on capital? Explain how discounted cash flow techniques are used to estimate this return.
- What should be taken into account in deciding the rate of discount to use?
- How should the extra jobs during construction of the plant and then in the running of the plant be valued when making the decisions about whether to go ahead?
Banks in Cyprus are in crisis. They have many bad debts e.g. to Greece and as mortgages in a falling property market. Private-sector debts have become unsustainable for the banks. The problem is compounded by negative economic growth and large government deficits (see chart). But, as with Icelandic banks back in 2008, this means a crisis for the whole country.
The reason is that the banking sector in Cyprus, as in Iceland and Ireland too, is large relative to the whole economy – over 8 times annual GDP (second only to Ireland in the EU). Loans to Greece alone are as much as 160% of Cyprus’ GDP and Cypriot banks were badly hit by the terms of the Greek bailout, which required creditors to take a 53% reduction (or ‘haircut’) in the value of their loans to Greece. With such a large banking sector, it is impossible for the Cypriot government alone to rescue the banks.
Cyprus thus turned to the EU for a bailout: back in June 2012. This makes Cyprus the fifth country to seek a bailout (after Greece, Ireland, Portugal and Spain). A bailout of €10 billion has just been agreed by the EU and IMF. The bailout comes with the ‘usual’ conditions of strong austerity measures of tax rises and cuts in government expenditure. But what makes this bailout different from those given to the other countries was a proposed levy on savers.
The proposal was that people with up €99,999 in their bank accounts (of any type) would face a one-off tax of 6.75%. The rate for those with €100,000 or more would be 9.9%, including on the first €99,999. This would raise around €5.8 billion of the €10 billion.
Not surprisingly, there was a public outcry in Cyprus. People had thought that their deposits were protected (at least up to €100,000). There was a run on cash machines, which, as a result were set to deliver just small amounts of cash to cope with the excessive demand. There was huge pressure on the Cypriot government not to introduce the measure.
But the ramifications of the proposed levy go well beyond the question of justice to savers. Questions are being raised about its incentive/disincentive effects. If people in other countries in future financial difficulties felt that they might face similar levies, how would they behave? Also, there is no haircut being proposed for holders of banks’ bonds. As Robert Peston states in his first article below:
The Cypriot deal sets back the cause of the new global rules for bringing order to banking systems when crisis hits. Apart from anything else, in other eurozone countries where banks are weak, it licenses runs on those banks, as and when a bailout looms.
But getting incentives right is not easy. As the Buttonwood column in The Economist points out:
The problem is tied up with the issue of moral hazard. This can be applied to both creditors and debtors; the former should be punished for reckless lending and the latter for living beyond their means. The collapse of Lehman Brothers is seen as an example of the faulty reasoning behind moral hazard; by letting the bank go bust, the crisis was spread throughout the financial system. But rescuing every creditor (or intervening to bail out the markets every time they falter) is the reason we are in this mess.
One alternative considered by the Cyprus parliament was to exempt people with less than €20,000 in their accounts from the levy. But this was rejected as being insufficient protection for savers. Another is to exempt people with less than €100,000, or to charge people with between €20,000 and €100,000 at a lower rate or rates.
But charging less, or nothing, on deposits of less than €100,000 would make it harder to to raise the €5.8 billion required by the EU. Without alternative measures it would mean charging a rate higher than 9.9% on larger deposits. The Cypriot government is afraid that this would discourage inward investment. Russia, in particular, has invested heavily in the Cyprus economy and Russia is campaigning vigorously to limit the size of the levy on large deposits. But there is little sympathy for Russian depositors, much of whose deposits are claimed to be ‘laundered money’. The Cypriot government has been seeking financial support from the Russian government.
An alternative proposal being considered is to issue government bonds in an “investment solidarity fund” and to transfer pension funds from semi-public companies to the state. Also Russia may be willing to invest more money in Cyprus’ offshore oil and gas fields.
Agreement
A deal was struck between Cyprus and the EU/IMF early in the morning of 25 March, just hours before the deadline. For details, see the News Item Cyprus: one crisis ends; another begins.
Webcasts and podcasts
Eurozone ministers agree 10bn euro Cyprus bailout Channel 4 News (16/3/13)
Bailout is ‘blackmail’ claims Cyprus president Euronews (17/3/13)
Cyprus’s president tries to calm fears over EU bailout The Guardian (18/3/13)
Cypriot bank customers reactions to savings levy BBC News (17/3/13)
Cyprus bailout: Parliament postpones debate amid anger BBC News (17/3/13)
Cyprus parliament delays debate on EU bailout Al Jazeera (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News, Gavin Hewitt (18/3/13)
Robert Peston: Cyprus bailout an ‘astonishing mess’ BBC News, Robert Peston (18/3/13)
Cyprus bailout is ‘completely unfair’ BBC Radio 4 Today Programme, Michael Fuchs and Bernadette Segol (18/3/13)
Lenders ‘doing everything you should not do’ on Cyprus BBC Radio 4 Today Programme, Alistair Darling (19/3/12)
Cyprus warned over bailout rejection BBC News (20/3/13)
Articles
Cyprus becomes fifth eurozone bailout The News International (Pakistan) (17/3/13)
Cyprus bailout deal sparks run on ATMs Irish Independent (17/3/13)
EU leaders gamble in Cyprus bank bailout BBC News, Gavin Hewitt (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News (18/3/13)
Q&A: Cyprus bailout BBC News (19/3/13)
Cyprus’ President Defends Bailout Deal The Motley Fool (16/3/13)
Sad Cyprus The Economist, Buttonwood’s Notebook (12/3/13)
The Cypriot bail-out: A fifth bitter lemon The Economist (30/6/12)
Analysis: Cyprus bank levy risks dangerous euro zone precedent Reuters, Mike Peacock (17/3/13)
The Cyprus precedent Reuters, Felix Salmon (17/3/13)
The Cyprus Bank Bailout Could Be A Disastrous Precedent: They’re Reneging On Government Deposit Insurance Forbes, Tim Worstall (16/3/13)
Cyprus rescue breaks all the rules BBC News, Robert Peston (18/3/13)
Cyprus and the eurozone’s survival BBC News, Robert Peston (20/3/13)
Eurogroup defends Cyprus bail-out The Telegraph (17/3/13)
Cyprus eurozone bailout prompts anger as savers hand over possible 10% levy The Guardian (16/3/13)
Cyprus’s wealth tax makes perfect sense – its rich won’t escape unscathed The Guardian, Phillip Inman (18/3/13)
The tragedy of Cyprus The Real Economy blog, Edmund Conway (16/3/13)
Damage limitation in Cyprus BBC News, Stephanie Flanders (19/3/13)
The fatal flaw in the eurozone’s not-so-cunning plan for Cyprus The Guardian, Larry Elliott (19/3/13)
Cyprus plans special fund in race to get EU-IMF bailout BBC News, (21/3/13)
Cyprus says ‘significant progress’ in debt crisis talks BBC News (23/3/13)
Background information
The Banking System in Cyprus: Time to Rethink the Business Model? Cyprus Economic Policy Review, Vol. 5, No. 2, pp. 123–130, Constantinos Stephanou (2011)
European sovereign-debt crisis Wikipedia
Questions
- What is the justification given by the Cypriot government and the EU for imposing a levy on bank deposits?
- What alternative measures could have been demanded by the EU? Why weren’t they?
- What is the significance of Russian deposits in Cypriot banks?
- Compare the benefits of the proposed levy rates with the alternative of imposing levies only on deposits over €100,000, but at higher rates (perhaps tiered).
- Explain the moral hazard issues in bailing out the Cypriot banks.
- How serious is the problem that imposing a tax on deposits in Cypriot banks might have adverse affects on the behaviour of depositors in other countries’ banks?
- How might Cypriots behave in future in regards to depositing money in banks? What impact could this have on the economy of Cyprus?
- Explain “the unholy trinity of options facing indebted nations (inflate, stagnate, default)”. Compare the effectiveness of each.
Since the late 1990s the European Commission (EC) has been concerned with trying to prevent Microsoft from abusing its dominant position. As described previously on this site, in the latest instalment last week Microsoft was fined for accidentally failing to adhere to an earlier commitment automatically to allow Windows users a choice of web browser.
This is the first case of fines being imposed for failure to comply with commitments required by the EC. In part because of Microsoft’s compliance, the fine imposed was well below the maximum level it could have been. However, it still means that Microsoft has now in total contributed enough to the EC’s coffers to cover the competition department’s budget for over 20 years.
Commitments appear to be increasingly the EC’s preferred solution for resolving competition disputes, especially in the rapidly changing IT sector (see for example Google and e-books). In contrast to a lengthy litigation process, in theory such commitments can quickly fix the problem and increase competition. The EC hopes that the fine imposed on Microsoft will send clear signals to firms that agreed upon commitments must be adhered to. However, this case also highlights that behavioural commitments require close monitoring by the competition authorities. As one industry consultant argues:
While it’s highly likely that it was a technical mistake that broke the browser choice facility the fact that it remained broken for 14 months raises significant questions about Microsoft’s ability and willingness to comply with the voluntary agreement with the EU.
At the same time the situation also raises concerns over the EU’s ability to actually monitor the outcomes of antitrust agreements.
Microsoft offers web browser choice to IE users BBC News (19/02/10)
Microsoft faces hefty EU fine The Guardian (06/03/13)
Microsoft fined €561m for ‘browser choice’ error The Guardian, Charles Arthur (06/03/13)
Questions
- Why is it essential that competition disputes in the IT sector are quickly resolved?
- What are the problems with monitoring company behaviour in this sector?
- What are the pros and cons of agreeing commitments rather than litigation for competition law infringements?
- How might Microsoft respond to this latest fine from the EC?
Inflation is measured as the percentage increase in the Consumer Prices Index (CPI) over the previous 12 months. The index is constructed from a basket of goods that is supposed to represent the buying habits of an average UK household. This basket is updated each year as tastes change and as technology moves forward. The basket contains approximately 700 items, with 180,000 individual prices collected each month.
As certain goods become more popular and trends change, the ONS have the responsibility of identifying these changes and updating the basket of goods. The CPI then looks at how the weighted average price of this basket of goods changes from one month to the next. As the CPI gives us the main measure of UK inflation, it is essential that the basket of goods used does represent current consumer demands. If the basket of goods used 20 years ago was still in place, we wouldn’t see thing like mobile phones and ipads being included. This is one sector that has seen significant growth in recent years and the basket of goods has been adapted in response. A new addition to the measure is e-books, which have seen a significant growth in popularity.
However, just as new products have been added to the CPI measure, other goods have been removed. In the most recent update, we’ve seen the removal of champagne and Freeview boxes from the basket of goods. With rapid changes in technological products, such as the ipad, kindle and e-books, products that were new additions only a few years ago are now old news, being replaced by the latest gadgets. Other changes to the basket of goods are less about reflecting consumer trends and more about making certain categories more representative, such as fruits and hot drinks.
So, can the changes in the basket of goods tell us anything about the impact of the recession on buying habits? One notable exclusion from the basket of goods is champagne sold in restaurants and bars. In an economic downturn, you’d expect luxury products to see a decline in consumption and the trend in champagne consumption certainly seems to support the theory. The trends suggest that consumers have instead switched to cheaper alternatives, with things like white rum bought from shops increasing.
Many people may look at the basket of goods and think that it doesn’t reflect what you buy in your average shop. But, the purpose of the CPI is to try to reflect the average consumer and the different items in the basket are given different weightings to give some indication of the amount spent on each good. The articles below look at the changes in the CPI basket of goods and what, if anything, we can take from it.
Inflation basket: E-books added by ONS BBC News (12/3/13)
Inflation basket – what does it say about you? Channel 4 News (12/3/13)
The fizz has fallen flat – champagne cut from inflation basket Independent, Martin Hickman (13/3/13)
E-books added to inflation basket, as champagne dropped The Telegraph, Philip Aldrick (13/3/13)
UK inflation basket: e-books in, champagne out The Guardian, Marking King (13/3/13)
Champagne tipped out of inflation basket Financial Times, Hannah Kuchler (13/3/13)
Champagne out, ebooks in as inflation basket updated Reuters (13/3/13)
Questions
- What is inflation and why is it such an important variable?
- How is the CPI calculated? Is it different from the RPI?
- What impact has technological change had on the basket of goods used to calculate the CPI?
- Can you identify any other economic or business trends from the products that are in and out of the CPI basket of goods?
- Given the importance of technology and the speed of change, do you think the review of the basket of goods should become more or less frequent?
- Has the economic downturn had any effect on the basket of goods used to calculate the CPI?
The Bank of England was granted independence to set interest rates back in 1997. This is known as instrument independence. However, the remit is set by the government and so it does not have goal independence. Amongst the policy announcements on Budget day (Wed 20 March), the government detailed amendments to the Bank’s remit. In particular, the remit now more explicitly acknowledges that, in exceptional circumstances, the Bank might need to pay more attention to output variability.
The Governor will continue to write an open letter to the Chancellor of the Exchequer if inflation moves away from the target by more than 1 percentage point in either direction. However, in a change to the previous remit, this will be done in conjunction with the minutes of the MPC meeting that follow the publication of the official inflation figures by the Office for National Statistics. By publishing the letter alongside the minutes, it gives the MPC more time to consider its strategy and to give due consideration to the trade-offs in returning inflation to the target. If inflation remains more than 1 percentage point above or below the target the Governor will need to write a further letter after three months. This letter would be alongside the minutes of the third subsequent meeting of the MPC.
