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.
According to political business cycle theory, incoming governments tend to take harsh measures at first, when they can blame the cuts on the ‘mess they’ve inherited’ from their predecessors. And then two or three years later, as an election looms, they can start spending more and/or cutting taxes, hoping that the good will this creates will help them win the election.
So are we seeing the start of a new political business cycle with the start of the new Coalition government? The following two articles look at the issue.
Coalition will inflict cuts now and spend later to win a second term Guardian, Larry Elliott (17/5/10)
If you get all the bad news out at once, the only way left to go will be up. Or will it? Independent, Sean O’Grady (18/5/10)
Questions
- Explain what is meant by the ‘political business cycle’.
- Would the existence of a political dimension to the business cycle amplify or dampen the cycle, or could it do either depending on the circumstances? Explain.
- Does the existence of an independent central bank eliminate the political business cycle?
- Will the new Office for Budget Responsibility (see Nipping it in the Budd: Enhancing fiscal credibility?) help to eliminate the political business cycle? Explain your answer.
The incoming coalition government in the UK has been spelling out its fiscal policy. It is sticking to the Conservative pledge of cutting £6bn from government spending this fiscal year (6 April 2010 to 5 April 2011). It hopes to make most of these by ‘efficiency savings’ – in other words, providing the same level of service for less money. It has, however, said that it will take advice from the Treasury and the Bank of England as to whether the cuts need to be delayed if the economy weakens substantially.
But the Bank of England is forecasting a continuation of the recovery (see its latest Inflation Report below), even assuming no further quantitative easing beyond the £200bn of assets purchased by the Bank. The Governor, Mervyn King, feels that the economy can indeed bear the proposed £6bn cut in government spending and that this will also send an important signal to the market that the government is committed to reducing the deficit.
The new government has also said that it will honour the Liberal Democrat pledge to raise the personal tax free allowance on income tax to £10,000. It has also backtracked somewhat on the Conservative pledge not to raise national insurance. Only employers will be spared the rise; employees will have to pay it.
So has there been a major change in fiscal policy? Has the focus moved from one of maintaining aggregate demand in order to avoid falling back into recession to one of making a start on tackling the deficit straight away? Or is the change in emphasis more one of presentation than substance? The following webcasts looks at the new fiscal policy emerging from number 11 and at the latest forecasts for growth and inflation.
Webcasts
What kind of medicine is the economy going to be fed? BBC Newsnight, Paul Mason (13/5/10)
Policy breakdown for Lib Dem-Conservative coalition BBC News, James Landale (12/5/10)
Savings cuts to ‘hit middle class families’ BBC News, Keith Doyle (15/5/10)
Inflation Report, May 2010 Bank of England (click on Watch Webcast) (12/5/10)
Documents and data
Coalition Agreement published (see here for text of agreement) Conservative Party (11/5/10)
Conservative – Liberal Democrat coalition negotiations agreements Liberal Democrats (11/5/10)
Inflation Report, May 2010 (portal) Bank of England, see in particular:
Articles
Department by department, what the new Government plans to do Independent (13/5/10)
VAT rise looms as coalition deal adds estimated £10bn to debt Guardian, Katie Allen and Julia Kollewe (13/5/10)
Some initial reaction to the Tory / Lib Dem coalition agreement Institute for Fiscal Studies Press Release, Robert Chote and Mike Brewery (12/5/10)
Tax rises likely under coalition government, says Institute for Fiscal Studies Telegraph, Edmund Conway (13/5/10)
Give and take BBC News blogs, Stephanomics, Stephanie Flanders (12/5/10)
Questions
- What ground has been given by (a) the Conservatives; (b) the Liberal Democrats in terms of their proposed economic policies (see Looking at the manifestos for details of their proposed policies).
- What will be the implications of a £6bn cut in government spending on aggregate demand? What other determinants of aggregate demand need to be taken into account in order to assess the likely growth in GDP over the coming months?
- What are the distributional consequences of (a) a rise in the personal income tax allowance to £10,000; (b) a rise in VAT?
- Has there been a major change in fiscal policy?
Since March 2009, the Bank of England has engaged in a process of quantitative easing (QE). Over the period to January 2010 the Bank of England injected £200 billion of new money into the economy by purchasing assets from the private sector, mainly government bonds. The assets were purchased with new money, which enters the economy as credits to the accounts of those selling the assets to the Bank of England. This increase in narrow money (the monetary base) is then able to form the basis of credit creation, allowing broad money (M4) to increase by a multiple of the increased monetary base. In other words, injecting £200 billion allows M4 to increase by considerably more.
But just how much more will M4 rise? How big is the money multiplier? This depends on the demand for loans from banks, which in turn depends on the confidence of business and households. With the recovery only just beginning, demand is still very dampened. Credit creation also depends on the willingess of banks to lend. But this too has been dampened by banks’ desire to increase liquidity and expand their capital base in the wake of the credit crunch.
Not surprisingly, the growth in M4 has been sluggish. Between March and Decmber 2009, narrow money (notes, coin and banks’ reserve balances in the Bank of England) grew from £91bn to £203bn (an increase of 123%). M4, however, grew from £2011bn to £2048bn: an increase of only 1.8%. In fact, in December it fell back from £2069bn in November.
Despite the continued sluggishness of the economy, at its February meeting the Bank of England announced an end to further quantitiative easing – at least for the time being. Although Bank Rate would be kept on hold at 0.5%, there would be no further injections of money. Part of the reason for this is that there is still considerable scope for a growth in broad money on the basis of the narrow money already created. If QE were to continue, there could be excessive broad money in a few months’ time and that could push inflation well above target. As it is, rising costs have already pushed inflation above the 2% target (see Too much of a push from costs but no pull from demand).
So will this be an end to quantitative easing? The following articles explore the question.
Bank of England halts quantitative easing Guardian, Ashley Seager (4/2/10)
Bank calls time on quantitative easing (including video) Telegraph, Edmund Conway (5/2/10)
Bank of England’s time-out for quantitative easing plan BBC News (4/2/10)
Shifting goalposts keep final score in question Financial Times, Chris Giles and Jessica Winch (5/2/10)
Bank halts QE at £200bn despite ‘sluggish’ recovery Independent, Sean O’Grady (5/2/10)
Easy does it: No further QE BBC News blogs, Stephanomics, Stephanie Flanders (4/2/10)
Leading article: Easing off – but only for now Independent (5/2/10)
Not easy Times Online (5/2/10)
Quantitative easing: What the economists say Guardian (4/2/10)
Questions
- Explain how quantitative easing works?
- What determines the rate of growth of M4?
- Why has the Bank of England decided to call a halt to quantiative easing – at least for the time being?
- What is the transmission mechanism whereby an increase in the monetary base affects real GDP?
- What role does the exchange rate play in the transmission mechanism?
- Why is it difficult to predict the effect of an increase in the monetary base on real GDP?
- What will determine whether or not the Bank of England will raise interest rates in a few months’ time?
It’s not just the roads in the UK that were frozen, as the Bank of England unsurprisingly decided to keep interest rates frozen at 0.5%. Furthermore, many economists do not expect to see interest rates increase for some time. Roger Bootle has predicted that rates could stay low for up to 5 years and this will contribute to a continuing weak pound and spell further trouble for importers and their customers.
The Bank of England also left its money-creation programme of ‘quantitative easing’ unchanged, but next month it will have to decide whether to extend quantitative easing beyond the limits of £200 billion that it set back in November.
Whilst we are supposedly beginning our economic recovery – with 2009 quarter 4 figures showing the first rise in output since the first quarter of 2008 – its strength remains questionable. Indeed, the rise in output in the last three months of 2009 was a mere 0.1%. So how important are interest rates in helping to sustain the recovery? Can they really pull us out of the recession by remaining at just 0.5%? Read the articles below which look at freezing interest rates and quantitative easing.
FTSE unaffected by interest rate decision In the News (7/1/10)
Freeze on UK interest rates BBC News (7/1/10)
Bank of England may raise interest rates as soon as March, leading economist predicts Telegraph (7/1/10)
Interest rates and quantitative easing on hold Guardian, Larry Elliott (7/1/10)
Bank of England extends quantitative easing by £25bn – but is it enough? Guardian, Larry Elliott (5/11/10)
Questions for QE BBC News blogs, Stephanomics, Stephanie Flanders (7/1/10)
Interest rates could stay low for 5 years, says Bootle BBC News (7/1/10)
Questions
- How do low interest rates contribute to a weak pound? How does this affect exporters and importers?
- What is quantitative easing? Should the QE programme be extended? What are the arguments for and against this in terms of economic recovery and public debt?
- How much of an impact do you think the recession will have on government policy over the next few months?
- Explain the transmission mechanisms by which changes in interest rates affect the goods market.
- If the Bank of England were not independent, what do you think would be happening to interest rates?