Between December 2007 and March 2009, the Bank of England reduced Bank Rate on several occasions in order to stimulate the economy and combat recession. By March 2009, the rate stood at a record low of 0.5%. Each month the Monetary Policy Committee meets to decide on interest rates and since March 2009, the members’ decision has consistently been that Bank Rate needs to remain at 0.5%.
Although the UK economy has been making tentative steps towards recovery, it is still in a very vulnerable state. Last month, the Bank of England extended its programme of quantitative easing to a total £325bn stimulus. This, together with the decision to keep interest rates down and with the shock fall in manufacturing output contributing towards first quarter growth of just 0.1%, is a key indication that the UK economy is still struggling, even though the central bank thinks it unlikely that the UK will re-enter recession this year.
Monetary policy in the UK has been very much geared towards stimulating economic growth, despite interest rates typically being the main tool to keep inflation on target at 2%. The problem facing the central bank is that economic growth and inflation are in something of a conflict. Low interest rates to stimulate economic growth also create a higher inflation environment and that is the trade-off the economy has faced. Inflation has been well above its target for some months (a high of 5.2% in September 2011), and the low interest rate environment has done little to deflate the figure. After all, low interest rates are a monetary instrument that can be used to boost aggregate demand, which can then create demand-pull inflation. However, inflation is now slowly beginning to fall, but this downward trend could be reversed with the sky high oil prices we are recently experiencing. If inflation does begin to creep back up, the Monetary Policy Committee will once again face a decision: keep Bank Rate low and continue with quantitative easing to stimulate the economy or increase Bank Rate to counter the higher rate of inflation.
The data over recent months has been truly inconsistent. Some indicators suggest improvements in the economy and the financial environment, whereas others indicate an economic situation that is moving very quickly in the wrong direction. A key factor is that the direction the UK economy takes is very much dependent on the world economy and, in particular, on how events in the eurozone unfold. The following articles consider some of the latest economic developments.
UK economy grew 0.1% to avoid recession, says NIESR Guardian, Katie Allen (5/4/12)
UK interest rates held at 0.5% BBC News (5/4/12)
UK just about avoided recession in Q1, NIESR says Telegraph, Angela Monaghan (5/4/12)
Bank of England keeps interest rates on hold at 0.5pc Telegraph (5/4/12)
UK economy ‘weak but showing signs of improvement’ BBC News (3/4/12)
Bank of England holds on quantitative easing and interest rates Guardian, Katie Allen (5/4/12)
Faith on Tories on economy hits new low Financial Times, Helen Warrell (6/4/12)
Questions
- Which factors will the Monetary Policy Committee consider when setting interest rates?
- Using a diagram to help your answer, illustrate and explain the trade-off that the MPC faces when choosing to keep interest rates low or raise them.
- What is quantitative easing? How is it expected to boost economic growth in the UK?
- Which factors are likely to have contributed towards the low growth rate the UK economy experienced in the first quarter of 2012?
- Explain the trends that we have seen in UK inflation over the past year. What factors have caused the figure to increase to a high in September and then fall back down?
- What do you expect to happen to inflation over the next few months? To what extent is your answer dependent on the MPC’s interest rate decisions?
- Although the official figures suggest that the UK avoided a double-dip recession, do you agree with this assessment? Explain your answer.
The rate of inflation in the UK is measured using the Consumer Prices Index (CPI). This is made up of a basket of goods and the ONS updates this ‘basket’ each year to ensure it is representative of what the average UK household buys. The basket contains 700 items, with 180,000 individual prices collected each month.
In recent years, items such as lip gloss have been added to the basket of goods and in the latest adjustment, the ONS has added tablet computers, amongst other things. This is a market that has seen enormous growth. It has been added to the basket as a means of giving a more accurate representation of the price changes faced by the average consumer. The ONS has made it clear that items are not added simply because they are new or removed simply because spending on them has fallen.
‘In each of these cases, the item has not been added because spending has increased or because the product is new on the market … It is purely as part of the rebalancing of the basket to improve its representation of overall price change.’
It is essential that these changes are made each year, as consumer buying habits do fluctuate considerably. One area in particular has been consumer responses to changes in technology. For example, developing and printing colour film has been removed as, with the development of digital cameras, this is no longer reflective of what a representative household spends its money on. Further to this, some items that have previously been used in calculating the RPI have now been added to the CPI, again to give a clearer picture of household spending in the UK. The following articles consider what’s in and what’s out.
Teenage fiction and iPads now in official UK shopping basket Guardian, Julia Kollewe (13/3/12)
Tablet computers added to UK inflation basket BBC News (13/3/12)
New items used to calculate inflation BBC News, Emma Simpson (23/3/12)
Tablet Computers Enter ‘Inflation Basket’ Sky News, Darren Morgan (ONS) (13/3/12)
Inflation basket of goods 2012: full list of what’s out and what’s in Guardian, Simon Rogers (13/3/12)
Tablet computers added to inflation basket of goods Telegraph (13/3/12)
How has the UK’s ‘inflation’ basket has changed? Metro, Ross McGuinness (27/3/12)
iPad and Galaxy added to inflation index Financial Times, Norma Cohen (13/3/12)
Questions
- What is the difference between the CPI and RPI? Which is usually higher? Explain your answer.
- How is the CPI calculated and hence how is inflation measured?
- What impact has technological progress had on the basket of goods that the representative household purchases? Do you think that technological progress make it more or less important for the basket of goods to be reviewed annually?
- Do you think products such as the iPad should be included in the CPI? Are they truly representative?
- In the second Guardian article, you can access a list of the products that are ‘in and out’. Is there anything on there that you think should be in or that should be out? Be sure to justify your answer!
Throughout the credit crunch and since then, one of the major problems in the global economy has been a lack of lending by banks. A key cause of the credit crunch and many of the debt problems countries and people face today is because of people living off borrowed money. In the past, credit was so easy to obtain – people could receive a mortgage for more than 100% of the value of their property. However, when more and more people began to struggle to make their monthly mortgage repayments, the banking crisis began and since then mortgage lenders have become increasingly wary about who they lend to and how much.
The Bank of England has said that in the coming months it will become even harder to obtain mortgages, as banks become increasingly wary about who becomes their customer and potential home buyers put off even applying for a mortgage. Although mortgage approvals are at a 2-year high, they still remain significantly below their pre-crisis level. Indeed, the Bank of England said:
“Lenders expected the proportion of total loan applications being approved to fall over the coming quarter with some lenders commenting that they had revised down expectations for households’ disposable incomes and hence the affordability of taking out new secured loans.”
As part of this new rationing of mortgages, lenders are requiring applicants to put down larger and larger deposits and so for first time buyers, getting on to the property ladder is becoming more and more of a dream. The property market has been suffering from this mortgage rationing as house sales are down below their pre-crisis level. The housing market is crucial to any economy, as so many other sectors and hence jobs depend on it. If mortgages remain scarce and the required deposit so high, the UK housing market is likely to remain stagnant and this will certainly prove damaging for the prospects of the UK economy in 2012.
Articles
Mortgage approvals hit new two-year high The Telegraph, Angela Monaghan (4/1/12)
Mortgage approvals up but overall lending weak Reuters (4/11/12)
Mortgage rationing becomes worse, Bank of England says BBC News (5/1/12)
Mortgage demand fell in Q4 2011, say lenders Mortgage Strategy, Tessa Norman (5/11/12)
Mortgage lending still stagnant, Bank figures show BBC News (4/11/12)
BoE: Lending to be tighter in Q1 2012 Mortgage Introducer, Yuan Phoon (5/11/12)
Data
Lending to Individuals Bank of England
Questions
- Why are mortgages being rationed?
- Why is the housing market so important for the UK economy?
- Which other sectors of the economy employ people whose jobs are dependent on a buoyant housing market?
- Why has the Bank of England said that in the coming months it will become harder to get a mortgage?
- Why would increased mortgage lending be a much needed stimulus for the UK economy?
- Using an aggregate demand and aggregate supply diagram, show how rationing of mortgages and other loans will affect the UK economy.
With the UK economy already struggling, the atmosphere in the financial sector has just a bit moodier, as Moody’s have downgraded the credit rating of 12 financial firms in the UK, including Lloyds Banking Group, Royal Bank of Scotland and Nationwide. The change in credit rating has emerged because of Moody’s belief that the UK government was less likely to support these firms if they fell into financial trouble. It was, however, emphasized that it did not “reflect a deterioration in the financial strength of the banking system.” The same can not be said for Portugal, who has similarly seen nine of their banks being downgraded due to ‘financial weakness’. George Osborne commented that it was down to the government no longer guaranteeing our largest banks, but he also said:
“I’m confident that British banks are well capitalised, they are liquid, they are not experiencing the kinds of problems that some of the banks in the eurozone are experiencing at the moment.”
Lloyds Banking Group and Royal Bank of Scotland both saw falls in their shares following their downgraded credit rating. Other banks, including Barclays also saw their shares fall, despite not being downgraded. Perhaps another indication of the interdependence we now see across the world. In interviews, George Osborne has continued to say that he believes UK banks are secure and wants them to become more independent to try to protect taxpayer’s money in the event of a crisis. Moody’s explained its decision saying:
“Moody’s believes that the government is likely to continue to provide some level of support to systemically important financial institutions, which continue to incorporate up to three notches of uplift…However, it is more likely now to allow smaller institutions to fail if they become financially troubled. The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”
The above comment reflects Moody’s approach to downgrading UK banks – not all have seen the same credit rating cuts. RBS and Nationwide have gone down 2 notches, whilst Lloyds and Santander have only gone down by 1 notch. Markets across the world will continue to react to this development in the UK financial sector, so it is a story worth keeping up to date with. The following articles consider the Moody environment.
UK banks’ credit rating downgraded The Press Association (7/10/11)
UK financial firms downgraded by Moody’s rating agency BBC News (7/10/11)
Moody’s downgrades nine Portuguese banks Financial Times, Peter Wise (7/10/11)
Bank shares fall on Moody’s downgrade Telegraph, Harry Wilson (7/10/11)
Moody’s cuts credit rating on UK banks RBS and Lloyds Reuters, Sudip Kar-Gupta (7/10/11)
Moody’s downgrade: George Osborne says British banks are sound Guardian, Andrew Sparrow (7/10/11)
Whitehall fears new bail-out for RBS Financial Times, Patrick Jenkins (7/10/11)
Questions
- Do you think that Moody’s have over-reacted? Explain your answer.
- What factors would Moody’s have considered when determining whether to downgrade the credit rating of any given bank and by how much?
- Why did share prices of the affected firms fall following the downgrading? What does this suggest about the public’s confidence in the banks?
- Do you think it is the right move for the government to encourage UK banks to become more independent in a bid to protect taxpayer’s money should a crisis develop?
- How might this downgrading affect the performance of the UK economy for the rest of 2011? Explain your answer.
- What are the differences behind the downgrading of UK banks and Portuguese banks?
As the prospects for the global recovery become more and more gloomy, so the need for a boost to aggregate demand becomes more pressing. But the scope for expansionary fiscal policy is very limited, given governments’ commitments around the world to deficit reduction.
This leaves monetary policy. In the USA, the Federal Reserve has announced a policy known as ‘Operation Twist’. This is a way of altering the funding of national debt, rather than directly altering the monetary base. It involves buying long-term government bonds in the market and selling shorter-dated ones (of less than three years) of exactly the same amount ($400bn). The idea is to drive up the price of long-term bonds and hence drive down their yield and thereby drive down long-term interest rates. The hope is to stimulate investment and longer-term borrowing generally.
Meanwhile in Britain it looks as if the Bank of England is about to turn to another round of quantitative easing (QE2). The first round saw £200bn of asset purchases by the Bank between March 2009 and February 2010. Up to now, it has resisted calls to extend the programme. However, it is now facing increased pressure to change its mind, not only from commentators, but from members of the government too.
But will expansionary monetary policy work, given the gloom engulfing the world economy? Is there a problem of a liquidity trap, whereby extra money will not actually create extra borrowing and spending? Many firms, after all, are not short of cash; they are simply unwilling to invest in a climate of falling sales and falling confidence.
Articles on Operation Twist
Fed takes new tack to avoid U.S. economic slump Reuters, Mark Felsenthal and Pedro da Costa (21/9/11)
How the Fed Can Act When Washington Cannot Associated Press on YouTube (20/9/11)
Analysis: Fed’s twist moves hurts company pension plans Reuters, Aaron Pressman (21/9/11)
What is Operation Twist? Guardian, Phillip Inman (21/9/11)
Operation Twist in the Wind Asia Times, Peter Morici (23/9/11)
Operation Twist won’t kickstart the US economy Guardian, Larry Elliott (21/9/11)
Stock markets tumble after Operation Twist … and doubt Guardian, Julia Kollewe (22/9/11)
‘Twist’ is a sign of the Fed’s resolve Financial Times, Robin Harding (22/9/11)
All twist, no shout, from the Fed Financial Times blogs, Gavyn Davies (21/9/11)
Twisting in the wind? BBC News, Stephanie Flanders (21/9/11)
Restraint or stimulus? Markets and governments swap roles BBC News, Stephanie Flanders (7/9/11)
FOMC Statement: Much Ado, Little Impact Seeking Alpha, Cullen Roche (21/9/11)
Why the Fed’s Operation Twist Will Hurt Banks International Business Times, Hao Li (21/9/11)
The Federal Reserve: Take that, Congress The Economist (21/9/11)
Articles on QE2
Bank of England’s MPC indicates QE2 is a case of if not when The Telegraph, Angela Monaghan (21/9/11)
Bank of England quantitative easing ‘boosted GDP’ BBC News (19/9/11)
Bank of England minutes indicate more quantitative easing on the cards Guardian, Julia Kollewe (21/9/11)
Fed and Bank of England publications
Press Release [on Operation Twist] Board of Governors of the Federal Reserve System (21/9/11) (Also follow links at the bottom of the Press Release for more details.)
Minutes of the Monetary Policy Committee Meeting, 7 and 8 September 2011 Bank of England (21/9/11) (See particularly paragraphs 29 to 32.)
Questions
- Explain what is meant by Operation Twist.
- What determines the extent to which it will stimulate the US economy?
- Why would quantitative easing increase the monetary base while Operation Twist would not? Would they both increase broad money? Explain.
- What is meant by the liquidity trap? Are central banks in such a trap at present?
- To what extent would a further round of quantitative easing in the UK drive up inflation?
- Why are monetary and fiscal policy as much about affecting expectations as ‘pulling the right levers’?
Between December 2007 and March 2009, the Bank of England reduced Bank Rate on several occasions in order to stimulate the economy and combat recession. By March 2009, the rate stood at a record low of 0.5%. Each month the Monetary Policy Committee meets to decide on interest rates and since March 2009, the members’ decision has consistently been that Bank Rate needs to remain at 0.5%.