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.
While inflation is a concern in the UK and is making the Bank of England think twice about keeping interest rates at their all time low of 0.5%, inflation in Japan is being celebrated. The Japanese economy has been plagued by deflation for over a decade and for the past 2 years inflation has never been above 0%. However, in April the consumer price index (CPI) rose to 0.6% from the previous year, fuelled by petrol prices. Strangely it might be the Japanese earthquake and tsunami that helped this situation, as Japan was unable to generate sufficient electricity and hence had to import fuel from abroad.
A typical question from non-economists is always about why deflation and hence falling prices is such a bad thing. Surely, it’s great for consumers? For those shopping for bargains, perhaps it is helpful – after all, if prices fall, a consumer’s real income will be higher. However, the problem with falling prices is that people start to hold off buying. If you want to buy a car, but expect prices to be lower next month, then it’s a rational decision to delay your purchase until next month when prices are lower. However, next month, you still expect prices to be lower in the following month and so delay purchasing again. And so the process continues. When people expect prices to fall they put off their purchases, this reduces demand and so prices do indeed fall. There are also costs for businesses: as consumers delay buying, sales begin to fall. And businesses are also consumers, and so they start delaying their purchases of inputs.
While many central banks across the world have begun to tighten monetary policy, the Japanese central bank seems inclined to keep monetary policy loose and has even considered expanding the emergency lending programme. As Azusa Kato, an economist at BNP Paribas, said:
“The bank will probably add stimulus if it sees more signs of weakening demand”. “If you strip out energy and food costs, consumer prices are basically flat now.”
Despite this inflationary pressure, many believe that it is unlikely to continue and deflationary pressures may appear once again in the near future. The following articles consider the Japanese deflationary situation.
Articles
Japan ends 25 months of deflation Bloomberg, Mayumi Otsuma (27/5/11)
Japan consumer prices log first rise in 28 months Associated Press (27/5/11)
Japan beats deflation for the first time in two years BBC News (275/11)
Japan overcomes deflation for first time in two years Guardian, Julia Kollewe (27/5/11)
Japanese consumer price rise (including video) BBC News (27/5/11)
Japan April core CPI rises 0.6 pct yr/yr Reuters (26/5/11)
Japan experiences inflation for first time in over two years Telegraph (27/5/11)
Data
Japan Inflation Rate Trading Economics
Consumer Price Index (Japan) Japanese Statistics Bureau
Inflation Rate and Consumer Price Index (CPI) (for USA, Canada, Australia, UK and Japan) Rate Inflation
Statistical Annex, Preliminary Version OECD
Questions
- What are the main costs of deflation? Think about the wider effects on consumers, businesses and the government.
- What has caused the increase in inflation to 0.6% in Japan and why was there an expectation that inflation would re-appear?
- What explanation can be given for the belief that deflation will soon re-emerge?
- Using a demand and supply diagram, explain the process by which consumers delaying their consumption will lead to prices falling continuously.
- What is the best policy for the Japanese central bank to pursue in light of the new data?
The snow the UK has seen over the past two winters created massive disruption, but that is only one reason for hoping for a milder winter to come. With the cold weather, the UK economy faced threats of gas shortages, as households turned on their heating. However, despite the freezing temperatures, many households were forced to turn off their heating regularly, due to the excessive bills they would face. This trend is expected to be even more prevalent if the 2011/12 winter is as cold, as fuel tariffs are predicted to rise. The Bank of England has said that gas and electricity prices could rise this year by 15% and 10% respectively. British Gas’s Parent company, Centrica said:
“In the UK the forward wholesale prices of gas and power for delivery in winter 2011/12 are currently around 25% higher than prices last winter, with end-user prices yet to reflect this higher wholesale market price environment.”
These predictions might see the average UK household paying an extra £148 over the next year. Although these are only estimates, we are still very likely to see many households being forced to turn off their heating. One thing which therefore is certain: a warmer winter would be much appreciated!
Articles
Switch energy tariff to help beat bill rises Guardian, Miles Brignall (14/5/11)
Quarter of households predicted to turn off heating BBC News, Brian Milligan (14/5/11)
Power bills set to soar by 50% in four years Scotsman (14/5/11)
Domestic fuel bills poised to rise by up to £200 Financial Times, Elaine Moore (13/5/11)
Data
Energy price statistics Department of Energy & Climate Change
Energy statistics publications Department of Energy & Climate Change
Questions
- Which factors have contributed to rising energy prices? Illustrate these changes on a demand and supply diagram.
- To what extent do these higher prices contribute to rising inflation?
- What impact might these price rises have on (a) poverty and (b) real income distribution in the UK?
- Why are energy prices currently being investigated by Ofgem? What powers does the regulator have and what actions could be taken?
Just as the Bank of England has an inflation target of 2%, so does the ECB. UK inflation has been significantly above its target rate for many months and so has the eurozone’s inflation rate, which is up to 2.8% in April from its previous level of 2.7% the previous month. The increase in the general price level has been fuelled by rising costs of raw materials and high energy prices. Whilst interest rates in the UK have remained at 0.5% in a bid to stimulate economic growth, the ECB has increased interest rates by a quarter point to 1.25% and the latest inflation data may be further pressure for further rises. However, any increase in rates will put more pressure on countries such as Greece, Ireland and Portugal who are facing tough austerity measures and may put their recoveries in jeopardy.
The ECB has been optimistic about growth and it may need to be with this and possibly subsequent interest rate hikes, as they are likely to depress aggregate demand. Furthermore, European Commission’s ‘economic sentiment’ indicator has fallen to 106.2, which is the weakest since November. Eurozone unemployment remains at just under 10%, oil prices remain high and this has depressed optimism across the eurozone countries. The euro, meanwhile, continues to strengthen (up 12% against the dollar over the past year) and this has enhanced the fragile state of affairs in those countries suffering from tough austerity measures. An economist at ING has said:
“The combination of high oil prices, a strong euro, and fiscal and monetary tightening has started to dent the economic mood in the euro zone.”
Eurozone inflation rises again Telegraph, Emma Rowley (29/4/11)
Eurozone inflation rate rises to 2.8% BBC News (29/4/11)
Eurozone inflation jumps to 2.8% Financial Times, Ralph Atkins (29/4/11)
Euro zone inflation rises, points to higher ECB rates Reuters, Jan Strupczewski (29/4/11)
Eurozone inflation further above target at 2.8pct The Associated Press (29/4/11)
Questions
- What is the relationship between interest rates and inflation. Why have the ECB and the Bank of England reacted differently to rising inflation?
- Is the inflation currently being experienced in the Eurozone cost-push or demand-pull? Illustrate your answer with the help of a diagram.
- What is the relationship between interest rates and the exchange rate?
- Why is there some concern about the ‘economic sentiment’ indicator in the Eurozone?
- What is the relationship between interest rates and economic growth? Explain the process by which a change in interest rates could affect AD and then economic growth and employment.
- Why is this interest rate rise (and possible further rises) likely to hurt countries, such as Ireland and Greece more than other countries within the Eurozone?
In the past few weeks, the prices of gold and silver have been soaring and have hit all-time (nominal) highs. Over the past 12 months, gold has risen by 31%, while silver has risen by 149% and 64% since the start of February. Part of this reflects the general rise in commodity prices (see also). Oil is trading at around $125 per barrel, up 43% on a year ago; wheat is up 66%, maize by 114%, coffee (Arabica) by 118% and cotton by 122%.
Part of the reason for the rise in the price of precious metals, however, has been the weakness of the dollar. In such times, gold and silver are often seen as a ‘safe haven’ for investors.
So why have commodity prices been rising and why has the dollar been falling? What is likely to happen to the prices of gold and silver in the coming weeks and months? Is their meteoric rise set to continue? Will the ratio of the gold price to the silver price continue to fall? The following articles investigate.
Articles
Gold and silver prices jump to new record highs BBC News (25/4/11)
Gold rises 7% in April as US dollar continues to weaken BBC News (29/4/11)
Gold and silver set new highs after S&P move Financial Times, Jack Farchy (22/4/11)
Real Interest Rates Explain the Gold Price Perfectly…Too Perfectly? The Market Oracle, Andrew Butter (25/4/11)
Silver, platinum to outshine gold Toronto Sun, Sharon Singleton (25/4/11)
Gold Bugs Beware Of Fed Extermination Forbes blogs: Great Speculations, Mark Sunshine (25/4/11)
Shock and Au: Hedging Against Fear EconomyWatch, Alice Briggs (26/4/11)
Keeping an Eye on the Gold/Silver Ratio Seeking Alpha, Evariste Lefeuvre (25/4/11)
Data
Commodity Prices Index Mundi
Commodities Financial Times
Commodities BBC Market Data
Questions
- Why have the prices of gold and silver risen so much recently?
- Why has silver risen more than gold?
- Why may higher rates of world inflation make investors turn to precious metals for investment?
- How are future decisions by the Fed likely to affect the price of gold?
- According to the efficient capital markets theory (strong version), the current price of a commodity should already reflect all knowable factors that are likely to affect the price? Does this mean that speculative buying (or selling) is pointless?
- How is the price elasticity of supply of silver and gold relevant in explaining the magnitude of their price movements?
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%.