As we saw in Part 1, households are seeing a rise in the cost of living, which is set to accelerate. Inflation in the year to January 2022, as measured by the Consumer Prices Index (CPI), was 5.5%, the highest rate for over 30 years, and it is expected to reach more than 7 per cent by April. This has put great pressure on household budgets, with wage rises for most people being below the rate of price inflation. The poor especially have been hard hit, with many struggling to meet soaring energy, food and transport prices and higher rents.
In Part 2 we look at the UK government’s response to the situation, a similar response to that in many other countries.
Effects on government finances
The Chancellor, Rishi Sunak, has stated that the government understands the pressures families are facing with the cost of living. However, rising interest rates mean that it will cost the Treasury considerably more to service the UK’s national debt of more than £2tn.
Interest payments on index-linked debt are calculated using an alternative measure of inflation, the retail prices index (RPI), which is running at 7.8%, considerably higher than anticipated in last October’s Budget. It is now projected that central government spending on debt interest this financial year will come in at around £69bn, some £11bn higher than the £58bn forecast in the October 2021 Budget and £27bn above the £42bn forecast in the March 2021 Budget.
In addition, it is expected that the latest rise in CPI will increase the chances of the Bank of England raising interest rates and thereby further increasing the costs of servicing national debt. If this is the outcome when its Monetary Policy Committee meets next month, then it would be the third successive time interest rates have been raised.
There is also concern that this, in addition to the direct effects of higher costs, will push more firms towards insolvency. It is argued that if government wanted to prevent this, it would need to cut business taxes in order to boost investment and productivity and to allow businesses to provide annual wage rises that are affordable.
Monetary policy
The Bank of England’s traditional response to rising inflation is to raise interest rates, which it has done this twice in the past few months. This means that people who have borrowed money could see their monthly payments go up, especially on mortgages tied to Bank Rate.
An aim of this policy is to make borrowing more expensive resulting in people spending less. As a result, they will buy fewer things, and prices will stop rising as fast. However, when inflation is caused by external forces, this might have a limited effect on prices and would put a further squeeze on household budgets.
Fiscal policy
Alternatively, the government might choose to cut taxes for consumers on items whose prices are rising quickly. It is taking some measures to reduce the impact of energy price rises. For example, the Treasury has announced that it would provide millions of households with up to £350 to help with their rising energy bills and in April the lowest-paid will see the National Living Wage rise by 6.6%, which is higher than the current inflation rate.
The chief economist of the British Chambers of Commerce has said that tightening monetary policy too quickly risks undermining confidence and the wider recovery, arguing that more needs to be done to limit the unprecedented rise in costs facing businesses, including financial support for those struggling with soaring energy bills and delaying April’s national insurance rise.
Conclusion
Rising inflation affects all our living standards. It a global issue with causes beyond government control.
Rising prices together with planned tax increases mean that real average take-home pay is likely to fall over the coming year. The extra energy costs and tax rises will force families to make savings elsewhere, meaning business revenues may fall, and the economic recovery could be negatively impacted.
However, it is those on low incomes that tend to find it hardest to cope with the rising cost of living. Those impacted the most will be faced with difficult decisions over the coming months as they try to cope with falling real incomes. With food price inflation expected to rise further, a likely rise in interest rates and a further increase in the energy price cap in October, these tough decisions are set to get harder for poorest households in the economy.
Articles
See articles in Part 1
Podcast
Questions
These questions are based on the podcast.
- What elements are there in household energy prices? Which element has gone up most?
- What are the arguments for and against the government delaying the rise in the rate of national insurance by 1.25 percentage points?
- What can be done to help people on modest earnings who earn just too much to receive benefits?
- Are government loans to help people with higher bills a good idea?
- What are the advantages and disadvantages of removing VAT on domestic energy?
With the onset of the pandemic in early 2020, stock markets around the world fell dramatically, with many indices falling by 30% or more. In the USA, the Dow Jones fell by 37% and the Nasdaq fell by 30%. In the UK, the FTSE 100 fell by 33% and the FTSE 250 by 41%.
But with a combination of large-scale government support for their economies, quantitative easing by central banks and returning confidence of investors, stock markets then made a sustained recovery and have continued to grow strongly since – until recently, that is.
With inflation well above target levels, central banks have ended quantitative easing (QE) or have indicated that they soon will. Interest rates are set to rise, if only slowly. The Bank of England raised Bank Rate from its historic low of 0.1% to 0.25% on 16 December 2021 and ceased QE, having reached its target of £895 billion of asset purchases. On 4 February 2022, it raised Bank Rate to 0.5%. The Fed has announced that it will gradually raise interest rates and will end QE in March 2022, and later in the year could begin selling some of the assets it has purchased (quantitative tightening). The ECB is not ending QE or raising interest rates for the time being, but is likely to do so later in the year.
At the same time economic growth is slowing, leading to fears of stagflation. Governments are likely to dampen growth further by tightening fiscal policy. In the UK, national insurance is set to rise by 1.25 percentage points in April.
The slowdown in growth may discourage central banks from tightening monetary policy more than very slightly. Indeed, in the light of its slowing economy, the Chinese central bank cut interest rates on 20 January 2022. Nevertheless, it is likely that the global trend will be towards tighter monetary policy.
The fears of slowing growth and tighter monetary and fiscal policy have led many stock market investors to predict an end to the rise in stock market prices – an end to the ‘bull run’. This belief was reinforced by growing tensions between Russia and NATO countries and fears (later proved right) that Russia might invade Ukraine with all the turmoil in the global economy that this would entail. Stock market prices have thus fallen.
The key question is what will investors believe. If they believe that share prices will continue to fall they are likely to sell. This has happened since early January, especially in the USA and especially with stocks in the high-tech sector – such stocks being heavily represented in the Nasdaq composite, a broad-based index that includes over 2500 of the equities listed on the Nasdaq stock exchange. From 3 January to 18 February the index fell from 15 833 to 13 548, a fall of 14.4%. But will this fall be seen as enough to reflect the current economic and financial climate. If so, it could fluctuate around this sort of level.
However, some may speculate that the fall has further to go – that indices are still too high to reflect the earning potential of companies – that the price–earnings ratio is still too high for most shares. If this is the majority view, share prices will indeed fall.
Others may feel that 14.4% is an overcorrection and that the economic climate is not as bleak as first thought and that the Omicron coronavirus variant, being relatively mild for most people, especially if ‘triple jabbed’, may do less economic damage than first feared. In this scenario, especially if the tensions over Ukraine are diffused, people are likely to buy shares while they are temporarily low.
But a lot of this is second-guessing what other people will do – known as a Keynesian beauty contest situation. If people believe others will buy, they will too and this will push share prices up. If they think others will sell, they will too and this will push share prices down. They will all desperately wish they had a crystal ball as they speculate how people will interpret what central banks, governments and other investors will do.
Articles
Questions
- What changes in real-world factors would drive investors to (a) buy (b) sell shares at the current time?
- How does quantitative easing affect share prices?
- What is meant by the price-earnings ratio of a share? Is it a good indicator as to the likely movement of that share’s price? Explain.
- What is meant by a Keynesian beauty contest? How is it relevant to the stock market?
- Distinguish between stabilising and destabilising speculation and illustrate each with a demand and supply diagram. Explain the concept of overshooting in this context.
- Which is more volatile, the FTSE 100 or the FTSE 250? Explain.
- Read the final article linked above. Were the article’s predictions about the Fed meeting on 26 January borne out? Comment.
Inflation has surged worldwide as countries have come out of their COVID-19 lockdowns. The increases in prices combined with supply-chain problems has raised questions of what will happen to future prices and whether it will feed further inflation cycles.
Inflation targeting
Inflation is a key contributor to instability in an economy. It measures the rate of increases in prices over a given period of time and indicates what will happen to the cost of living for households. Because of its importance, many central banks aim to keep inflation low and steady by setting a target. The Bank of England, the Federal Reserve, and the European Central Bank all aim to keep inflation low at a target rate of 2 per cent.
Inflation-rate targeting has been successfully practised in a growing number of countries over the past few decades. However, measures to combat rising inflation typically contract the economy through reducing real aggregate demand (or at least its rate of growth). This is a concern when the economy is not experiencing a strong economic performance.
Current outlook
Globally, rising inflation is causing concern as a surge in demand has been confronted by supply bottlenecks and rising prices of energy and raw materials. As the world emerges from the COVID-19 lockdowns, global financial markets have been affected in recent months by concerns around inflation. They have also been affected by the prospect of major central banks around the world being forced into the early removal of pandemic support measures, such as quantitative easing, before the economic recovery from the coronavirus is complete.
The Chief Economist at the Bank of England has warned that UK inflation is likely to rise ‘close to or even slightly above 5 per cent’ early next year, as he said the central bank would have a ‘live’ decision on whether to raise interest rates at its November meeting. Although consumer price inflation dipped to 3.1 per cent in September, the Bank of England has forecast it to exceed 4 per cent by the end of the year, 2 percentage points higher than its target. UK banks and building societies have already started to increase mortgage rates in response to rising inflation, signalling an end to the era of ultra-low borrowing costs and piling further pressure on household finances.
In the USA, shortages throughout the supply chains on which corporate America depends are also causing concern. These issues are translating into widespread inflationary pressure, disrupting operations and forcing companies to raise prices for customers. Pressure on every link in the supply chain, from factory closures triggered by COVID-19 outbreaks to trouble finding enough staff to unload trucks, is rippling across sectors, intensifying questions about the threat that inflation poses to robust consumer spending and rebounding corporate earnings. Reflecting concern over weaker levels of global economic growth despite rising inflationary pressures, US figures published at the end of October showed the world’s largest economy added just 194 000 jobs in September, far fewer than expected.
There are also fears raised over high levels of corporate debt, including in China at the embattled property developer Evergrande, where worries over its ability to keep up with debt payments have rippled through global markets. There are major concerns that Evergrande could pose risks to the wider property sector, with potential spill-overs internationally. However, it is argued that the British banking system has been shown in stress tests to be resilient to a severe economic downturn in China and Hong Kong.
Central bank responses
The sharpest consumer-price increases in years have evoked different responses from central banks. Many have raised interest rates, but two that haven’t are the most prominent in the global economy: the Federal Reserve and the European Central Bank. These differences in responses reflect differing opinions as to whether current price increases will feed further inflation cycles or simply peter out. For those large central banks, they are somewhat relying on households keeping faith in their track record of keeping inflation low. There is also an expectation that there are enough underutilised workers to ensure that wage inflation is kept low.
However, other monetary authorities worry that they have not yet earned the record of keeping inflation low and are concerned about the risk of wage inflation. In addition, in poorer countries there is a larger share of spending that goes on essentials such as food and energy. These have seen some of the highest price increases, so policy makers are going to be keen to stamp down on the inflation.
The Federal Reserve is expected to announce that it will start phasing out its $120bn monthly bond-buying programme (quantitative easing) as it confronts more pronounced price pressures and predictions that interest rates will be lifted next year. However, no adjustments are expected to be made to the Fed’s main policy rate, which is tethered near zero. Whilst financial markets are betting on an rise in Bank Rate by the Bank of England as early as next month, spurred by comments from Governor Andrew Bailey in mid-October that the central bank would ‘have to act’ to keep a lid on inflation.
Outlook for the UK
The Bank of England’s Chief Economist, Huw Pill, has warned that high rates of inflation could last longer than expected, due to severe supply shortages and rising household energy bills. He said inflationary pressures were still likely to prove temporary and would fall back over time as the economy adjusted after disruption caused by COVID and Brexit. However, he warned there were growing risks that elevated levels of inflation could persist next year.
The looming rise in borrowing costs for homeowners will add further pressure to family finances already stretched by higher energy bills and surging inflation. According to the Institute for Fiscal Studies, it is expected that households will face years of stagnating living standards, with predictions showing that households would on average be paying £3000 more each year in taxes by 2024/25, with the biggest impact felt by higher earners.
Investors are also reacting to concerns and have pulled $9.4bn out of UK-focused equity funds this year after hopes that a COVID-19 vaccination drive will fuel a vigorous economic recovery were overshadowed by questions about slow growth and high inflation. It is suggested that there is a general sense of caution about the UK when it comes to investing globally, driven by monetary, fiscal and trade uncertainties.
Given all the elements contributing to this outlook, The IMF has forecast that the UK will recover more slowly from the shocks of coronavirus than other G7 nations, with economic output in 2024 still 3 per cent below its pre-pandemic levels. Financial markets are predicting the Bank of England will lift interest rates as soon as the next MPC meeting. And while supply-chain bottlenecks and rising commodity prices are a global trend, the Bank’s hawkish stance has increased the possibility of a sharper slowdown in Britain than other developed markets, some analysts have said.
What next?
Some of the major central banks are poised to take centre stage when announcing their next monetary action, as it will reveal if they share the alarm about surging inflation that has gripped investors. Markets are betting that the Bank of England will begin raising interest rates, with Bank Rate expected to rise to around 1.25 per cent by the end of next year (from the current 0.1 per cent).
It is thought that the Fed will not raise interest rates just yet but will do so in the near future. Markets, businesses, and households globally will be waiting on the monetary decisions of all countries, as these decisions will shape the trajectory of the global economy over the next few years.
Articles
- Three Days Will Reveal Global Alert Level on Inflation: Eco Week
Bloomberg, Molly Smith and Craig Stirling (31/10/21)
- Inflation watch: Global food prices hit 10-year high
Al Jazeera (4/11/21)
- Fed sings the ‘transitory’ inflation refrain, unveils bond-buying ‘taper’
ReutersHoward Schneider and Ann Saphir (3/11/21)
- BoE chief economist warns UK inflation likely to hit 5%
Financial Times, Chris Giles (21/10/21)
- Inflation pressure now ‘brutal’ because of supply squeeze, US companies say
Financial Times, Andrew Edgecliffe-Johnson, Matthew Rocco, Obey Manayiti and Claire Bushey (23/10/21)
- Rising inflation could trigger global sell-off that would harm UK, says Bank
The Guardian, Richard Partington (8/10/21)
- Bank of England chief economist warns high inflation rates may persist in 2022
The Guardian, Richard Partington (7/10/21)
- Bank of England surprises markets by holding rates at record lows
CNBC, Elliot Smith (4/11/21)
Bank of England resists pressure to raise interest rates as inflation spike loomsSky News, Ed Conway (4/11/21)
Forecasts and commentary
Questions
- What is the definition of inflation?
- How is inflation measured?
- Using a diagram to aid your answers, discuss the difference between cost-push and demand-pull inflation.
- What are the demand-side and cost-side causes of the current rising inflation?
- Explain the impact an increase in interest rates has on the economy.
The BBC podcast linked below looks at the use of quantitative easing since 2009 and especially the most recent round since the onset of the pandemic.
Although QE was a major contributor to reducing the depth of the recession in 2009–10, it was barely used from 2013 to 2020 (except for a short period in late 2016/early 2017). The Coalition and Conservative governments were keen to get the deficit down. In justifying pay restraint and curbing government expenditure, Prime Ministers David Cameron and Theresa May both argued that there ‘was no magic money tree’.
But with the severely dampening effect of the lockdown measures from March 2020, the government embarked on a large round of expenditure, including the furlough scheme and support for businesses.
The resulting rise in the budget deficit was accompanied by a new round of QE from the beginning of April. The stock of assets purchased by the Bank of England rose from £445 billion (the approximate level it had been since March 2017) to £740 billion by December 2020 and is planned to reach £895 billion by the end of 2021.
So with the effective funding of the government’s deficits by the creation of new money, does this mean that there is indeed a ‘magic money tree’ or, indeed, a ‘magic money forest’? And if so, is it desirable? Is it simply stoking up problems for the future? Or will, as modern monetary theorists maintain, the extra money, if carefully spent, lead to faster growth and a reducing deficit, with low interest rates making it easy to service the debt?
The podcast explores these issues. There is then a longer list of questions than normal relating to the topics raised in the podcast.
Podcast
Questions
- Which of the following are stocks and which are flows?
(a) Money
(b) Income
(c) The total amount people save each month
(d) The money held in savings accounts
(e) Public-sector net debt
(f) Public-sector net borrowing
(g) National income
(h) Injections into the circular flow of income
(i) Aggregate demand
(j) Wealth
- How do banks create money?
- What is the role of the Debt Management Office in the sale of gilts?
- Describe the birth of QE.
- Is raising asset prices the best means of stimulating the economy? What are the disadvantages of this form of monetary expansion?
- What are the possible exit routes from QE and what problems could occur from reducing the central bank’s stock of assets?
- Is the use of QE in the current Covid-19 crisis directly related to fiscal policy? Or is this use of monetary policy simply a means of hitting the inflation target?
- What are the disadvantages of having interest rates at ultra-low levels?
- Does it matter if the stock of government debt rises substantially if the gilts are at ultra-low fixed interest rates?
- What are the intergenerational effects of substantial QE? Does it depend on how debt is financed?
- How do the policy recommendations of modern monetary theorists differ from those of more conventional macroeconomists?
- In an era of ultra-low interest rates, does fiscal policy have a greater role to play than monetary policy?
With the imposition of a new lockdown in England from 5 November to 2 December and in Wales from 3 October to 9 November, and with strong restrictions in Scotland and Northern Ireland, the UK economy is set to return to negative growth – a W-shaped GDP growth curve.
With the closure of leisure facilities and non-essential shops in England and Wales, spending is likely to fall. Without support, many businesses would fail and potential output would fall. In terms of aggregate demand and supply, both would decline, as the diagram below illustrates. (Click here for a PowerPoint.)
The aggregate demand curve shifts from AD1 to AD2 as consumption and investment fall. Exports also fall as demand is hit by the pandemic in other countries. 
The fall in aggregate supply is represented partly by a movement along the short-run aggregate supply curve (SRAS) as demand falls for businesses which remain open (such as transport services). Largely it is represented by a leftward shift in the curve from SRAS1 to SRAS2 as businesses such as non-essential shops and those in the hospitality and leisure sector are forced to close. What happens to the long-run supply curve depends on the extent to which businesses reopen when the lockdown and any other subsequent restrictions preventing their reopening are over. It also depends on the extent to which other firms spring up or existing firms grow to replace the business of those that have closed. The continuing rise in online retailing is an example.
With the prospect of falling GDP and rising unemployment, the UK government and the Bank of England have responded by giving a fiscal and monetary boost. We examine each in turn.
Fiscal policy
In March, the Chancellor introduced the furlough scheme, whereby employees temporarily laid off would receive 80% of their wages through a government grant to their employers. This scheme was due to end on 31 October, to be replaced by the less generous Job Support Scheme (see the blog, The new UK Job Support Scheme: how much will it slow the rise in unemployment?). However, the Chancellor first announced that the original furlough scheme would be extended until 2 December for England and then, on 5 November, to the end of March 2021 for the whole of the UK. He also announced that the self-employed income support grant would increase from 55% to 80% of average profits up to £7500.
In addition, the government announced cash grants of up to £3000 per month for businesses which are closed (worth more than £1 billion per month), extra money to local authorities to support businesses and an extension of existing loan schemes for business. Furthermore, the government is extending the scheme whereby people can claim a repayment ‘holiday’ for up to 6 months for mortgages, personal loans and car finance.
The government hopes that the boost to aggregate demand will help to slow, or even reverse, the predicted decline in GDP. What is more, by people being put on furlough rather than being laid off, it hopes to slow the rise in unemployment.
Monetary policy
At the meeting of the Bank of England’s Monetary Policy Committee on 4 November, further expansionary monetary policy was announced. Rather than lowering Bank Rate from its current historically low rate of 0.1%, perhaps to a negative figure, it was decided to engage in further quantitative easing.
An additional £150 billion of government bonds will be purchased under the asset purchase facility (APF). This will bring the total vale of bonds purchased since the start of the pandemic to £450 billion (including £20 billion of corporate bonds) and to £895 billion since 2009 when QE was first introduced in response to the recession following the financial crisis of 2007–8.
The existing programme of asset purchases should be complete by the end of December this year. The Bank of England expects the additional £150 billion of purchases to begin in January 2021 and be completed within a year.
UK quantitative easing since the first round in March 2009 is shown in the chart above. The reserve liabilities represent the newly created money for the purchase of assets under the APF programme. (There are approximately £30 billion of other reserve liabilities outside the APF programme.) The grey area shows projected reserve liabilities to the end of the newly announced programme of purchases, by which time, as stated above, the total will be £895 billion. This, of course, assumes that the Bank does not announce any further QE, which it could well do if the recovery falters.
Justifying the decision, the MPC meeting’s minutes state that:
There are signs that consumer spending has softened across a range of high-frequency indicators, while investment intentions have remained weak. …The fall in activity over 2020 has reflected a decline in both demand and supply. Overall, there is judged to be a material amount of spare capacity in the economy.
Conclusions
How effective these fiscal and monetary policy measures will be in mitigating the effects of the Covid restrictions remains to be seen. A lot will depend on how successful the lockdown and other restrictions are in slowing the virus, how quickly a vaccine is developed and deployed, whether a Brexit deal is secured, and the confidence of both consumers, businesses and financial markets that the economy will bounce back in 2021. As the MPC’s minutes state:
The outlook for the economy remains unusually uncertain. It depends on the evolution of the pandemic and measures taken to protect public health, as well as the nature of, and transition to, the new trading arrangements between the European Union and the United Kingdom. It also depends on the responses of households, businesses and financial markets to these developments.
Articles
- Covid: Rishi Sunak to extend furlough scheme to end of March
BBC News (6/11/20)
- Furlough extended until March and self-employed support boosted again
MSE News, Callum Mason (6/11/20)
- Number on furlough in UK may double during England lockdown
The Guardian, Richard Partington (3/11/20)
- ‘We wouldn’t manage without it’: business owners on the furlough extension
The Guardian, Molly Blackall and Mattha Busby (6/11/20)
- Sunak’s abrupt turn on UK furlough scheme draws criticism from sceptics
Financial Times, Delphine Strauss (6/11/20)
- Coronavirus: Bank of England unleashes further £150bn of support for economy
Sky News, James Sillars (5/11/20)
- Bank of England boss pledges to do ‘everything we can’
BBC News, Szu Ping Chan (6/11/20)
- Savers are spared negative rates but the magic money tree delivers £150bn more QE: What the Bank of England’s charts tell us about the economy
This is Money, Simon Lambert (5/11/20)
- Covid-19 and the victory of quantitative easing
The Spectator, Bruce Anderson (26/10/20)
- Will the Bank of England’s reliance on quantitative easing work for the UK economy?
The Conversation, Ghulam Sorwar (9/11/20)
- With a W-shaped recession looming and debt piling up, the government should start issuing GDP-linked bonds
LSE British Politics and Policy blogs, Costas Milas (6/11/20)
Official documents
Questions
- Illustrate the effects of expansionary fiscal and monetary policy on (a) a short-run aggregate supply and demand diagram; (b) a long-run aggregate supply and demand diagram.
- In the context of the fiscal and monetary policy measures examined in this blog, what will determine the amount that the curves shift?
- Illustrate on a Keynesian 45° line diagram the effects of (a) the lockdown and (b) the fiscal and monetary policy measures adopted by the government and Bank of England.
- If people move from full-time to part-time working, how is this reflected in the unemployment statistics? What is this type of unemployment called?
- How does quantitative easing through asset purchases work through the economy to affect output and employment? In other words, what is the transmission mechanism of the policy?
- What determines the effectiveness of quantitative easing?
- Under what circumstances will increasing the money supply affect (a) real output and (b) prices alone?
- Why might quantitative easing benefit the rich more than the poor?
- How could the government use quantitative easing to finance its budget deficit?