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’?
The quarter 2 UK GDP growth figures were published at the end of July. They show that real GDP grew by a mere 0.2% over the quarter, or 0.7% over 12 months. These low growth figures follow 2010Q4 and 2011Q1 growth rates of –0.5 and 0.5 respectively, giving an approximately zero growth over those six months. The recovery that seemed to be gathering pace in early 2010, now seems to have petered out, or at best slowed right down. According to an average of 27 forecasts, collated by the Treasury, GDP is expected to grow by just 1.3% in 2011 – below the potential rate of economic growth and thus resulting in a widening of the output gap.
With such a slow pace of recovery, current forecasts suggest that it will be 2013 before the economy returns to the pre-recession level of output: just over five years after the start of the recession in 2008. This chart from the National Institute of Economic and Social Research compares the current recession with previous ones and shows how the recovery is likely to be the slowest of the five recessions since the 1930s.
The Confederation of British Industry (CBI) in its latest Economic Forecast says that the economic outlook has become more challenging.
The intensification of euro area sovereign debt pressures has added to the downside risks facing the UK economy – although the agreement reached at the recent summit appears to represent an initial step towards resolving the issues.
Meanwhile the global economy is going through a soft patch, partly as a result of the previous surge in commodity prices, which has put pressure on household budgets and raised costs for businesses.
Against this backdrop confidence appears to have wilted somewhat.
The opposition blames the slow pace of recovery on the austerity measures imposed by the government. The depressing of aggregate demand by cutting government expenditure and raising taxes has depressed output growth. The problem has been compounded by a lack of consumer spending as real household incomes have been squeezed by inflation and as consumers fear impending tax rises and cuts in benefits. And export growth, which was hoped to lead the country’s recovery, has been hit by weak demand in Europe and elsewhere.
With weak growth, the danger is that automatic fiscal stabilisers (i.e. more people claiming benefits and lack of growth in tax revenues) will mean that the government deficit is not cut. This may then force the Chancellor into further austerity, which would compound the problem of low demand. The opposition has thus been calling for a (temporary) cut in VAT to stimulate the economy.
The government argues that rebalancing the budget is absolutely crucial to maintaining international confidence and Britain’s AAA rating by the credit rating agencies, Moody’s, Fitch and Standard and Poor’s (S&P). Any sign that the government is slacking in its resolve, could undermine this confidence. According to George Osborne, while other countries (including the USA and many eurozone countries) are facing a lot of instability, “Britain is a safe haven. We have convinced the world that we can deal with our debts, bring our deficit down, and that’s meant that interest rates, for British families, for British businesses, are lower than they would otherwise be; it means that our country’s credit rating has been affirmed … and it means that we have that crucial ingredient of any recovery – economic stability.”
What is more, the government claims that the essence of the UK’s problem of low growth lies on the supply side. The focus of growth policy, it maintains, should be on cutting red tape, improving efficiency and, ultimately, in reducing taxes.
What we are witnessing is a debate that echoes the Keynesian/new classical debates of the 1980s and earlier: a debate between those who blame the current problem on lack of aggregate demand and those who blame it on supply-side weaknesses, including weaknesses of the banking sector.
So what should be done? Is it time for a (modest) fiscal expansion, or at least a reining in of the fiscal tightening? Should the Bank of England embark on another round of quantitative easing (QE2)? Or does the solution lie on the supply side? Or should policy combine elements of both?
Articles
UK economy grows by 0.2% BBC News (26/7/11)
Economic growth stalls – and slump will carry on until 2013 Independent, Sean O’Grady (27/7/11)
GDP figures mean Britain will miss its economic growth targets Guardian, Julia Kollewe (26/7/11)
UK GDP figures show slower growth of 0.2% BBC News (26/7/11)
UK growth forecast looks unrealistic after GDP fall Independent, Sean O’Grady (27/7/11)
UK set for low growth as the mood ‘darkens’ Independent, Sean O’Grady (1/8/11)
No sign of a U-turn – but there may be a minor course change Scotsman, John McLaren (27/7/11)
George Osborne vows to stick with ‘plan A’ despite UK GDP growth slowdown The Telegraph, John McLaren (27/7/11)
Weak growth may force Chancellor into further austerity The Telegraph, Jeremy Warner (26/7/11)
UK households squeezed harder than US or Europe The Telegraph, Philip Aldrick, and Emma Rowley (30/7/11)
UK Government will have to act if growth remains weak, warns CBI The Telegraph, Philip Aldrick (1/8/11)
UK economy GDP figures: what the experts say Guardian, Claire French (26/7/11)
My plan B for the economy Guardian, Ed Balls, Ruth Lea, Jonathan Portes, Digby Jones and Stephanie Blankenburg (27/7/11)
Not much of a squeeze The Economist, Buttonwood’s notebook (26/7/11)
Some safe haven The Economist (30/7/11)
UK growth – anything to be done? BBC News, Stephanie Flanders (26/7/11)
IMF report on UK: main points The Telegraph, Sarah Rainey (2/8/11)
Families to be £1,500 a year worse off, IMF warns The Telegraph, Philip Aldrick (2/8/11)
IMF casts doubt on UK deficit plan, Financial Times, Chris Giles (1/8/11)
Data and reports
GDP Growth (reliminary estimate) ONS
Gross domestic product preliminary estimate: 2nd Quarter 2011 ONS (26/7/11)
World Economic Outlook Update IMF
OECD Economic Outlook No. 89 Annex Tables OECD (see Table 1)
United Kingdom: IMF Country Report No. 11/220 IMF (2/8/11)
Prospects for the UK economy National Institute of Economic and Social Research (3/8/11)
Questions
- What special ‘one-off’ factors help to explain why the underlying growth in 2011Q2 may have been higher than 0.2%?
- Why is the output gap rising? How may supply-side changes affect the size of the output gap?
- Why is the recovery from recession in the UK slower than in most other countries? Why is it slower than the recovery from previous recessions?
- How may automatic fiscal stabilisers affect (a) economic growth and (b) the size of the public-sector deficit if the output gap widens?
- Distinguish between demand-side and supply-side causes of the slow rate of economic growth in the UK.
- Compare the likely effectiveness of demand-side and supply-side policy measures to stimulate economic growth, referring to both magnitude and timing.
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?
Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.
According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:
CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.
It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.
Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)
Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)
Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England
Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)
Questions
- Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
- Explain the difference between the forecasts and the outturn.
- Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
- What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
- What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
- How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
Business leaders and politicians pay a great deal of attention to economic forecasts. And yet these forecasts often turn out to be quite wrong. Very few economists predicted the banking crisis of 2008 and the subsequent credit crunch and recession. And the recently released 2010 Q4 growth figures for the UK economy, which showed a decline in real GDP of 0.5%, took most people by surprise.
What is more, forecasters often disagree. If, for example, you look at the forecasts made by various panel members for Consensus Forecasts, you can see the divergence between their various predictions.
So why is economic forecasting so unreliable? Is it the fault of economic models? Or are there too many unpredictable factors that can impact on economies – factors such as business and consumer confidence, or political events, or natural disasters, such as the recent floods in Australia, South Africa and Brazil? Will economic forecasting always be a very inexact science?
Articles
Davos 2011: Why do economists get it so wrong? BBC News, Tim Weber (27/1/11)
Popular Semi-Science Slate, Robert J. Shiller (24/1/11)
Fed Often Gets It Wrong In Its Forecasts on US Economy American Public Media, Justin Wolfers (26/1/11)
Don’t bet on economic forecasting CNBC, Jeff Cox (21/9/10)
Forecasts
Forecasts for the UK economy HM Treasury
Econ Stats: The Economic Statistics and Indicators Database Economy Watch (large database of worldwide annual statistics, including forecasts to 2015)
World Economic Outlook IMF (follow link in right-hand panel)
OECD Economic Outlook: Statistical Annex OECD
European Economic Forecasts European Commission, Economic and Financial Affairs DG
Questions
- For what reasons may economic forecasts turn out to be wrong?.
- To what extent is economic forecasting like weather forecasting? Which is harder and why?
- Wo what extent can the poor accuracy of economic forecasts be blamed on the application of the ‘wrong type of economics’?
- How much variation is there in the independent forecasts of the UK economy reported by the Treasury (see HM Treasury link above)?
- Using the HM Treasury link, compare the forecasts made of 2010 in January 2010 with those made of 2010 in January 2011. Attempt an explanation of the differences.
