Senior Bank of England officials appeared before the House of Commons’ Treasury Select Committee on 21 February to report on the state of the economy and the future path for inflation and interest rates. One topic considered was the role of depreciation.
The pound has depreciated since the referendum on EU membership in June 2016. The exchange rate index today is some 9% below that before the referendum and 15% below the peak a year before the referendum.
It had fallen as much as 14% by October 2016 below the level before the referendum and 20% below its peak, pushed down partly by the cut in Bank Rate from 0.5% to 0.25% following the referendum. In November 2017, the Bank’s Monetary Policy Committee raised Bank Rate back to 0.5%. Two or three more rises of 25 basis points are expected over the next couple of years. This has helped to strengthen sterling somewhat. (Click here for a PowerPoint of the chart below.)
But has the depreciation been advantageous or disadvantageous to the economy? Here the Governor (Mark Carney) and the Chief Economist (Andy Haldane) appeared to differ. Andy Haldane said:
A combination of the weaker pound and a stronger global economy has worked its magic. That has meant that net trade has been a significant contributor, and we expect those effects to continue over the next two or three years. … Depreciations work, and that’s how they work.
By contrast, Mark Carney said:
Depreciations don’t work. They have an economic effect, but they’re not a good economic strategy. They may be an outcome of various things … but it’s how you make yourself poorer.
Are these statements contradictory or are they simply emphasising different effects of depreciation?
Both Andy Haldane and Mark Carney would accept that a depreciation makes imports more expensive and thus reduces real incomes (at least in the short run). They would also accept that a depreciation makes exports priced in pounds cheaper in foreign currency terms and thus can boost the demand for exports.
There is disagreement over two things, however. The first is the effect on people’s real incomes in the long run. Will any fall in real incomes from higher-priced imports in the short run be offset in the long run by higher economic growth?
This relates to a second area of disagreement. This is whether a depreciation can act as a significant driver for exports over the longer term. The increased incentive on the demand side (from consumers abroad to buy UK exports) could be offset by a disincentive for exporters to become more efficient and/or to compete in terms of quality. In other words, although it can give exporters a price advantage, the crucial question is the extent to which they take advantage of this, or merely take higher profits.
The disagreements thus relate primarily to the incentive effects over the longer term.
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Treasury Committee: Wednesday 21 February 2018 Parliamentlive.tv (21/2/18) (see from 16:08:00)
Bank of England documents
Treasury Select Committee hearing on the February 2018 Inflation Report Bank of England (21/2/18)
Inflation Report – February 2018 Bank of England (8/2/18)
Interest & exchange rates data Bank of England
- How does a depreciation affect the demand for and supply of imports and exports?
- What determines the size of the effect on inflation of a depreciation?
- What is the significance of the price elasticity of demand for and supply of sterling in determining the size of depreciation resulting from a change in confidence or a change in interest rates?
- How does productivity growth impact on the effectiveness of a depreciation in leading to higher economic growth?
- In what ways might a depreciation affect productivity growth?
On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.
A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.
These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.
The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.
But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.
The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).
Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.
Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.
Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.
It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.
For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.
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- Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
- Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
- What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
- Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables
On the 15th June, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate on hold at its record low of 0.25%. This was not a surprise – it was what commentators had expected. What was surprising, however, was the split in the MPC. Three of its current eight members voted to raise the rate.
At first sight, raising the rate might seem the obvious thing to do. CPI inflation is currently 2.9% – up from 2.7% in April and well above the target of 2% – and is forecast to go higher later this year. According to the Bank of England’s own forecasts, even at the 24-month horizon inflation is still likely to be a little above the 2% target.
Those who voted for an increase of 0.25 percentage points to 0.5% saw it as modest, signalling only a very gradual return to more ‘normal’ interest rates. However, the five who voted to keep the rate at 0.25% felt that it could dampen demand too much.
The key argument is that inflation is not of the demand-pull variety. Aggregate demand is subdued. Real wages are falling and hence consumer demand is likely to fall too. Thus many firms are cautious about investing, especially given the considerable uncertainties surrounding the nature of Brexit. The prime cause of the rise in inflation is the fall in sterling since the Brexit vote and the effect of higher import costs feeding through into retail prices. In other words, the inflation is of the cost-push variety. In such cirsumstances dampening demand further by raising interest rates would be seen by most economists as the wrong response. As the minutes of the MPC meeting state:
Attempting to offset fully the effect of weaker sterling on inflation would be achievable only at the cost of higher unemployment and, in all likelihood, even weaker income growth. For this reason, the MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.
The MPC recognises that the outlook is uncertain. It states that it stands ready to respond to circumstances as they change. If demand proves to be more resilient that it currently expects, it will raise Bank Rate. If not, it is likely to keep it on hold to continue providing a modest stimulus to the economy. However, it is unlikely to engage in further quantitative easing unless the economic outlook deteriorates markedly.
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Haldane expects to vote for rate rise this year BBC News (21/6/17)
Bank of England documents
Monetary policy summary Bank of England (15/6/17)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 14 June 2017 Bank of England (15/6/17)
Inflation Report, May 2017 Bank of England (11/5/16)
- What is the mechanism whereby a change in Bank Rate affects other interest artes?
- Use an aggregate demand and supply diagram to illustrate the difference between demand-pull and cost-push inflation.
- If the exchange rate remains at around 10–15% below the level before the Brexit vote, will inflation continue to remain above the Bank of England’s target, or will it reach a peak relatively soon and then fall back? Explain.
- For what reason might aggregate demand prove more buoyant that the MPC predicts?
- Would a rise in Bank Rate from 0.25% to 0.5% have a significant effect on aggregate demand? What role could expectations play in determining the nature and size of the effect?
- Why are real wage rates falling at a time when unemployment is historically very low?
- What determines the amount that higher prices paid by importers of products are passed on to consumers?
With the effects of the depreciation of sterling feeding through into higher prices, so the rate of inflation has risen. The latest figures from the ONS show that in the year to April 2017, CPI inflation was 2.7% – up from 2.3% in the year to March. The largest contributors to higher prices were transport costs and housing and household services.
But wage increases are not keeping up with price increases. In 2017 Q1, the average annual growth rate in regular pay (i.e. excluding bonuses) was 2.1%. In other words, real pay is falling. And this is despite the fact that the unemployment rate, at 4.6%, is the lowest since 1975.
The fall in real wages is likely to act as a brake on consumption and the resulting dampening of aggregate demand could result in lower economic growth. On the other hand, the more buoyant world economy, plus the lower sterling exchange rate is helping to boost exports and investment and this could go some way to offsetting the effects on consumption. As Mark Carney stated in his introductory remarks to the May 2017 Bank of England Inflation Report:
The combination of the stronger global outlook and sterling’s past depreciation is likely to support UK net trade. And together with somewhat lower uncertainty, stronger global growth is also likely to encourage investment as exporters renew and increase capacity.
According to the Bank of England, the net effect will be modest economic growth, despite the fall in real wages.
In the MPC’s central forecast, quarterly growth is forecast to stabilise around its current rate, resulting in growth of 1.9% in 2017 and around 1¾% in each of the next two years.
But forecasting is dependent on a range of assumptions, not least of which are assumptions about consumer and business expectations. These, in turn, depend on a whole range of factors, such as the outcome of the UK election, the Brexit negotiations, commodity prices, world growth rates and international events, such as the actions of Donald Trump. Because of the uncertainty surrounding forecasts, the Bank of England uses fan charts. In the two fan charts illustrated below (from the May 2017 Inflation Report), the bands on constructed on the following assumptions:
If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that CPI inflation or the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions and within each pair of the lighter coloured areas on 30 occasions.
The charts and tables showing the May 2017 projections have been conditioned on the assumptions that the stock of purchased gilts remains at £435 billion and the stock of purchased corporate bonds remains at £10 billion throughout the forecast period, and on the Term Funding Scheme (TFS); all three of which are financed by the issuance of central bank reserves. They have also been conditioned on market interest rates, unless otherwise stated.
The wider the fan, the greater the degree of uncertainty. These fan charts are wide by historical standards, reflecting the particularly uncertain future for the UK economy.
But one thing is clear from the latest data: real incomes are falling. This is likely to dampen consumer spending, but just how much this will impact on aggregate demand over the coming months remains to be seen.
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Inflation Report, May 2017 Bank of England (11/5/17)
Labour Market Outlook, Sping 2017 Chartered Institute of Personnel and Development (May 2017)
Statistical Interactive Database – interest & exchange rates data Bank of England
Inflation and price indices ONS
Earnings and working hours ONS
Second estimate of GDP: Jan to Mar 2017 ONS Statistical Bulletin (25/5/17)
- Find out what has happened to the dollar/sterling and the euro/sterling exchange rate and the sterling exchange rate index over the past 24 months. Plot the data on a graph.
- Explain the changes in these exchange rates.
- Why is there negative real wage growth in the UK when the rate of unemployment is the lowest it’s been for more than 40 years?
- Find out what proportion of aggregate demand is accounted for by household consumption. Why is this significant in understanding the likely drivers of economic growth over the coming months?
- Why is uncertainty over future UK growth rates relatively high at present?
- Why is inflation likely to peak later this year and then fall?
- What determines the size and shape of the fan in a fan chart?
The latest figures from the ONS show that UK inflation rose to 2.3% for the 12 months to February 2017 – up from 1.9% for the 12 months to January. The rate is the highest since September 2013 and has steadily increased since late 2015.
The main price index used to measure inflation is now CPIH, as opposed to CPI. CPIH is the consumer prices index (CPI) adjusted for housing costs and is thus a more realsitic measure of the cost pressures facing households. As the ONS states:
CPIH extends the consumer prices index (CPI) to include a measure of the costs associated with owning, maintaining and living in one’s own home, known as owner occupiers’ housing costs (OOH), along with Council Tax. Both of these are significant expenses for many households and are not included in the CPI.
But why has inflation risen so significantly? There are a number of reasons.
The first is a rise in transport costs (contributing 0.15 percentage points to the overall inflation rate increase of 0.4 percentage points). Fuel prices rose especially rapidly, reflecting both the rise in the dollar price of oil and the depreciation of the pound. In February 2016 the oil price was $32.18; in February 2017 it was $54.87 – a rise of 70.5%. In February 2016 the exchange rate was £1 = $1.43; in February 2017 it was £1 = $1.25 – a depreciation of 12.6%.
The second biggest contributor to the rise in inflation was recreation and culture (contributing 0.08 percentage points). A wide range of items in this sector, including both goods and services, rose in price. ‘Notably, the price of personal computers (including laptops and tablets) increased by 2.3% between January 2017 and February 2017.’ Again, a large contributing factor has been the fall in the value of the pound. Apple, for example, raised its UK app store prices by a quarter in January, having raised prices for iPhones, iPads and Mac computers significantly last autumn. Microsoft has raised its prices by more than 20% this year for software services such as Office and Azure. Dell, HP and Tesla have also significantly raised their prices.
The third biggest was food and non-alcoholic beverages (contributing 0.06 percentage points). ‘Food prices, overall, rose by 0.8% between January 2017 and February 2017, compared with a smaller rise of 0.1% a year earlier.’ Part of the reason has been the fall in the pound, but part has been poor harvests in southern Europe putting up euro prices. This is the first time that overall food prices have risen for more than two-and-a-half years.
It is expected that inflation will continue to rise over the coming months as the effect of the weaker pound and higher raw material and food prices filter though. The current set of pressures could see inflation peaking at around 3%. If there is a futher fall in the pound or further international price increases, inflation could be pushed higher still – well above the Bank of England’s 2% target. (Click here for a PowerPoint of the chart.)
The higher inflation means that firms are facing a squeeze on their profits from two directions.
First, wage rises have been slowing and are now on a level with consumer price rises. It is likely that wage rises will soon drop below price rises, meaning that real wages will fall, putting downward pressure on spending and squeezing firms’ revenue.
Second, input prices are rising faster than consumer prices. In the 12 months to February 2017, input prices (materials and fuels) rose by 19.1%, putting a squeeze on producers. Producer prices (‘factory gate prices’), by contrast, rose by 3.7%. Even though input prices are only part of the costs of production, the much smaller rise of 3.7% reflects the fact that producer’s margins have been squeezed. Retailers too are facing upward pressure on costs from this 3.7% rise in the prices of products they buy from producers.
One of the worries about the squeeze on real wages and the squeeze on profits is that this could dampen investment and slow both actual and potential growth.
So will the Bank of England respond by raising interest rates? The answer is probably no – at least not for a few months. The reason is that the higher inflation is not the result of excess demand and the economy ‘overheating’. In other words, the higher inflation is not from demand-pull pressures. Instead, it is from higher costs, which are in themselves likely to dampen demand and contribute to a slowdown. Raising interest rates would cause the economy to slow further.
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Reality Check: What’s this new measure of inflation? BBC News (21/3/17)
UK consumer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
UK producer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
Inflation and price indices ONS datasets
Consumer Price Inflation time series dataset ONS datasets
Producer Price Index time series dataset ONS datasets
European Brent Spot Price US Energy Information Administration
Statistical Interactive Database – interest & exchange rates data Bank of England
- If pries rise by 10% and then stay at the higher level, what will happen to inflation (a) over the next 12 months; (b) in 13 months’ time?
- Distinguish between demand-pull and cost-push inflation. Why are they associated with different effects on output?
- If producers face rising costs, what determines their ability to pass them on to retailers?
- Why is the rate of real-wage increase falling, and why may it beome negative over the coming months?
- What categories of people are likely to lose the most from inflation?
- What is the Bank of England’s remit in terms of setting interest rates?
- What is likely to affect the sterling exchange rate over the coming months?