Tag: expectations

14 December 201012 January 2011

Unexpected inflation rise

It is the Bank of England’s responsibility to ensure that inflation remains on target. They use interest rates and the money supply to keep inflation within a 1% band of the inflation target set by the government = 2%. However, for the past 12 months, we have had an inflation rate above the 3% maximum and this looks set to continue. Official figures show that the CPI inflation rate has risen to 3.3% in November, up from 3.2% in October 2010 – above the inflation target. There was also movement on the RPI from 4.5% to 4.7% during the same months. The ONS suggests that this increase is largely down to record increases in food, clothing and furniture prices: not the best news as Christmas approaches. It is not just consumers that are facing rising prices, as factories are also experiencing increasing costs of production, especially with the rising cost of crude oil (see A crude story). Interest rates have not changed, as policymakers believe prices will be ‘reined in’ before too long.

However, the government expects inflation to remain above target over the next year, especially with the approaching increase in VAT from 17.5% to 20%. As this tax is increased, retail prices will also rise and hence inflation is likely to remain high. There is also concern that retailers will use the increase in VAT to push through further price rises. A report by KPMG suggests that 60% of retailers intend not only to increase prices to cover the rise in VAT, but to increase prices over and above the VAT rise.

Despite the planned VAT rise spelling bad news for inflation, it could be the spending cuts that offset this. As next year brings a year of austerity through a decrease in public spending, this could deflate the economy and hence bring inflation back within target. However, there are suggestions that more quantitative easing may be on the cards in order to stimulate growth, if it appears to be slowing next year. The Bank of England’s Deputy Governor, Charles Bean said:

“It is certainly possible that we may well want to undertake a second round of quantitative easing if there is a clear sign that UK output growth and with it inflation prospects are slowing,” Bean told a business audience in London.”

The following articles consider the rising costs experienced by firms, the factors behind the inflation and some of the likely effects we may see over the coming months.

Articles

UK inflation rises to a surprise six-month high The Telegraph, Emma Rowley (14/12/10)
UK inflation rate rises to 3.3% in November BBC News (14/12/10)
Inflation unexpectedly hits 6-month high in November Reuters, David Milliken and Christina Fincher (14/12/10)
Food and clothing push up inflation Associated Press (14/12/10)
Retailers ‘to increase prices by more than VAT rise’ BBC News (14/12/10)
VAT increase ‘will hide price rises’ Guardian, Phillip Inman (14/12/10)
Slower growth may warrant more QE Reuters, Peter Griffiths and David Milliken (13/12/10)
Factories feel squeeze of inflation The Telegraph, Emma Rowley (13/12/10)
Figures show rise in input prices The Press Association (13/12/10)
November producer input prices up more than expected Reuters (13/12/10)

Data

Inflation ONS
Inflation Report Bank of England

Questions

What is the difference between the RPI and CPI? How are each calculated?
Why are interest rates the main tool for keeping inflation on target at 2%? How do they work?
Is the inflation we are experiencing due to demand-pull or cost-push factors? Illustrate this on diagram. How are expectations relevant here?
Explain why the rise in VAT next year may make inflation worse – use a diagram to help your explanation.
Explain the process by which rising prices of crude oil affect manufacturers, retailers and hence the retail prices we see in shops.
How are the inflation rate, the interest rate and the exchange rate linked? What could explain the pound jumping by ‘as much as 0.2pc against the dollar after the report’ was released?
Explain why the public spending cuts next year may reduce inflation. Why might more quantitative easing be needed and how could this affect inflation in the coming months?

20 October 201026 October 2010

Cutting edge

Now the details of the Comprehensive Spending Review (CSR) are known, the comments are coming thick and fast. As we saw in the last news blog, Taking sides in the war of the cuts, economists are divided over whether the cuts will be compensated by a rise in private expenditure or whether overall aggregate demand will fall, driving the economy back into recession. As you will see in the articles below, they are still as divided as ever.

At least we know the details of the cuts. The plan is for an average cut across government departments of some 19 per cent over four years, although the size will vary enormously from department to department. The government is predicting that the effect will be about 490,000 fewer jobs in the public sector. In addition to the cuts, the retirement age is to rise to 66 for both men and women by 2020 and regulated rail fares will rise by 3% above RPI inflation for three years from 2012.

Examine the details of the measures in the articles below and consider what the effects are likely to be, both on the macro economy and on income distribution.

The Spending Review document
Spending Review 2010 HM Treasury (20/10/10)
Link to HM Treasury Spending Review site

Briefing and analysis from the Institute for Fiscal Studies
Opening remarks IFS, Carl Emmerson (21/10/10)
Link to briefing presentations (PowerPoint) IFS (21/10/10)

Analysis of fiscal consolidation by the IMF
Will It Hurt? Macroeconomic Effects of Fiscal Consolidation World Economic Outlook, Chapter 3, IMF (Oct 2010)

Questions

What is the distribution of cuts between government departments?
To what extent can it be said that there will be a real increase in health expenditure?
What will be the effect of the cuts and tax increases on the distribution of income?
What will determine whether the effect of the cuts will be to stimulate or dampen economic growth (or even drive the economy back into recession)? Which do you think is most likely and on what do you base your judgement?
Trace through the multiplier effects of the measures.
If the effect of the cuts is to drive the economy back into recession, what should the government’s ‘Plan B’ be?

29 August 20101 September 2010

Will the Fed redouble its efforts to prevent a double dip?

Recent data on the US economy suggest that it may be heading back towards recession. Confidence is waning as growth slows. US GDP growth figures for the second quarter of 2010 have just been revised downwards: from 2.4% to 1.6%. And although growth is still quite strongly positive, unemployment is not coming down.

Most economists still think that the US economy will avoid a double dip, but many think that it is nevertheless a distinct possibility. For example, economists at Goldman Sachs put the likelihood of a double-dip recession at 25% to 30%, which although less than 50% is still a substantial risk.

Ben Bernanke, Chairman of the Federal Reserve, told a gathering of bankers and economists in Wyoming on August 27 that the Fed “will do all that it can” to avoid a double dip. According to Bernanke:

In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high… Central bankers alone cannot solve the world’s economic problems. That said, monetary policy continues to play a prominent role in promoting the economic recovery and will be the focus of my remarks today.

Bernanke outlined four monetary policy options that could be pursued, the first three of which were real possibilities for the Fed if economic growth did stall.

• The first would be to sell long-term government securities on the open market – a form of open-market operation. This quantitative easing would expand the money supply and should push long-term interest rates down (short-term interest rates are already virtually zero).

• The second would be to reduce interest rates paid to banks on reserves held in the Fed. These are currently around 0.25% and hence the scope for reductions here are very limited

• The third would be to promise to keep short-term interest rates low for a longer period than markets currently expect, thereby assuring markets that borrowing would remain cheap for some considerable time.

• The fourth option, and one not currently contemplated by the Fed, would be to raise the inflation rate target above its current level of 1.5% to 2%.

The first of the following two podcasts, which includes an interview with US Managing Editor of the Financial Times, Gillian Tett, looks at what the Fed might do. Is the solution to expand aggregate demand through monetary policy or are the problems more structural in nature? The other podcasts and the articles look at Bernanke’s proposals and their scope for avoiding a double dip.

Podcasts
‘No magic wand’ for US economy BBC Today Programme, Mark Mardell and Gillian Tett (27/8/10)
Fed Offers Higher Ground In Economic Mudslide NPR, Scott Horsley (28/8/10)
Roubini Interview Excerpt Bloomberg, Nouriel Roubini (27/8/10)

Articles
Bernanke Says Fed Will Do `All It Can’ to Ensure U.S. Recovery Bloomberg, Craig Torres and Scott Lanman (27/8/10)
What ammunition does the Fed have left? Reuters (27/8/10)
Fed is prepared to keep U.S. out of recession, Bernanke vows Los Angeles Times, Jim Puzzanghera (28/8/10)
Bernanke soothes rattled markets Telegraph (28/8/10)
Ben Bernanke promises to step in as US economy veers back towards recession Guardian, Katie Allen (27/8/10)
Shoot out at Jackson Hole – the world’s central bankers take aim at deflation Independent, Sean O’Grady (27/8/10)
Treasury Two-Year Yields Increase Most Since April After Bernanke Speech Bloomberg, Cordell Eddings (28/8/10)
Bernanke speech shows effort to find Fed consensus One News Now, Jeannine Aversa (28/8/10)
Analysis: The uncomfortable mathematics of monetary policy Reuters, Pedro Nicolaci da Costa (28/8/10)
Ben Bernanke calls for help to revive the stuttering US economy Guardian, Richard Adams (28/8/10)
Fed stands by to boost US growth Financial Times, Robin Harding, Michael Mackenzie and Alan Rappeport (27/8/10)
Bernanke outlines options for Fed Financial Times, Robin Harding (27/8/10)

Speech
The Economic Outlook and Monetary Policy Ben Bernanke (27/8/10)

Data
US Bond Rates Yahoo Finance
US interest rates Federal Reserve Statistical Release

Questions

Why is growth in the US economy slowing?
Why has the recovery from recession in the USA so far not resulted in a reduction in unemployment?
What structural problems are there in the US economy?
What further scope is there for monetary policy in stimulating the US economy?
What are the arguments for the Fed introducing a new programme of quantitative easing?
How important are expectations in determining whether the US recovery will be maintained or whether there will be a double-dip recession?
What impact did Bernanke’s speech have on bond markets and why?

26 August 2010

Searching for a new economic paradigm

Until the credit crunch and crash of 2008/9, there appeared to be a degree of consensus amongst economists about how economies worked. Agents were generally assumed to be rational and markets generally worked to balance demand and supply at both a micro and a macro level. Although economies were subject to fluctuations associated with the business cycle, these had become relatively mild given the role of central banks in targeting inflation and the general belief that we had seen the end of boom and bust.

True, markets were not perfect. There were problems of monopoly power and externalities. Also information was not perfect. But asymmetries of information were generally felt to be relatively unimportant in the information age with easy access to market data through the internet.

Then it all went wrong. With the exception of a few economists, people were caught unawares by the credit crunch. There was too little understanding of the complexities of securitisation and the leveraged risk in these pyramids of debt built on small foundations. And there was too little regard paid to the potentially destructive power of speculation and herd behaviour.

So how should economists model what has been happening over the past three years? Do we simply need to go back to Keynesian economics, which emphasised the importance of aggregate demand and the ability of economies to settle at a high unemployment equilibrium? Can the persistence of high unemployment in the USA and elsewhere be put down to a lack of demand or is the explanation to be found in hysteresis: the persistence of a problem after the initial cause has disappeared? Can failures of markets be incorporated into standard microeconomics?

Or do we need a new paradigm: one that emphasises the behaviour of economic agents and examines how people act when there are information asymmetries? These are the questions that are examined in the podcast below. It is an interview with Nobel Prize winning economist, Joseph Stiglitz.

Podcast
Joseph Stiglitz: ‘Building blocks’ of a new economics BBC Today Programme (25/8/10)

Articles
Needed: a new economic paradigm Financial Times, Joseph Stiglitz (19/8/10)
Obama should get rid of Geithner, Summers Market Watch, Wall Street Journal, Darrell Delamaide (25/8/10)
This rebel’s heresy is not so earth-shaking Fund Strategy, Daniel Ben-Ami (23/8/10)

Questions

What are Stiglitz’s criticisms of the economics profession in recent years?
What, according to Stiglitz, should be the features of a new economic paradigm?
Is such a paradigm new?
Provide a critique of Stiglitz’s analysis.
What do you understand by ‘behavioural economics’? Would a greater understanding of human behaviour by economists have helped avert the credit crunch and subsequent recession?

5 June 20106 June 2010

Inflationary credibility

In the UK, we have an inflation target of 2% and it’s the Bank of England’s job to use monetary policy, in particular interest rates, to keep inflation within 1 percentage point of its target. However, with rising commodity prices and the onset of recession back in 2008, interest rates had another objective: to prevent or at least lessen the recession. Bank Rate fell to 0.5% and there it has remained in a bid to encourage investment, discourage saving and increase consumption, as a means of stimulating the economy.

However, at such a low rate, interest rates are not acting as a brake on inflation, which is now well above target. This rise in inflation, has been largely brought about by cost-push factors, such as the restoration of the 17.5% VAT (up from the temporary 15%), higher oil and commodity prices, and a fall in the exchange rate. But part of the reason might be found in the increase in money supply that resulted from quantitative easing.

There are concerns that the UK may lose its credibility on inflation if action isn’t taken. The OECD has advised the Bank of England to raise Bank Rate to 3.5% by the end of 2011. The following articles consider this issue.

Articles

Time to worry about inflation? BBC News blogs, Stephanomics, Stephanie Flanders (28/5/10)
UK must not fall for the false promise of higher inflation Telegraph, Charles Bean, Deputy Governor of the Bank of England (4/6/10)

Reports and documents
General Assessment of the Macroeconomic Situation OECD Economic Outlook, No. 87 Chapter 1 (see especially pages 53–4) (May 2010)
United Kingdom – Country Summary OECD Economic Outlook, No. 87 (May 2010)
Statistical Annex OECD Economic Outlook, No. 87 (available 10/6/10)
Inflation Report portal Bank of England (see May 2010)

Questions

Explain the relationship between interest rates and inflation. Why have such low interest rates caused inflation to increase?
In 2008, the UK moved into recession, but was also suffering from inflation. This was unusual, as AD/AS analysis suggests that when aggregate demand falls, growth will fall, but so will prices. What can explain the low growth and inflation we saw in 2008?
What is the difference between real and nominal GDP?
What are the causes of the current high inflation and what solutions are available and viable?
Why are expectations of inflation so important and how might they influence the Bank of England’s plans for interest rates?
Do you think the OECD should have advised the Bank of England? Will there be any adverse effects internationally if the UK doesn’t heed the OECD’s advice?
Is the OECD’s assessment of the UK in the above Country Summary consistent with its view on UK interest rates contained in pages 53 and 54 in the first OECD link?