On 14 December, the US Federal Reserve announced that its 10-person Federal Open Market Committee (FOMC) had unanimously decided to raise the Fed’s benchmark interest rate by 25 basis points to a range of between 0.5% and 0.75%. This is the first rise since this time last year, which was the first rise for nearly 10 years.
The reasons for the rise are two-fold. The first is that the US economy continues to grow quite strongly, with unemployment edging downwards and confidence edging upwards. Although the rate of inflation is currently still below the 2% target, the FOMC expects inflation to rise to the target by 2018, even with the rate rise. As the Fed’s press release states:
Inflation is expected to rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.
The second reason for the rate rise is the possible fiscal policy stance of the new Trump administration. 
If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
However, just how much and when the Fed will raise interest rates again is highly uncertain. Future monetary policy measures will only become more predictable when Trump’s policies and their likely effects become clearer.
Articles
US Federal Reserve raises interest rates and flags quicker pace of tightening in 2017 Independent, Ben Chu (14/12/16)
US Federal Reserve raises interest rates: what happens next? The Telegraph, Szu Ping Chan (15/12/16)
Holiday traditions: The Fed finally manages to lift rates in 2016 The Economist (14/12/16)
US raises key interest rate by 0.25% on strengthening economy BBC News (14/12/16)
Fed Raises Key Interest Rate, Citing Strengthening Economy The New York Times, Binyamin Appelbaum (14/12/16)
US dollar surges to 14-year high as Fed hints at three rate hikes in 2017 The Guardian, Martin Farrer and agencies (15/12/16)
Questions
- What determines the stance of US monetary policy?
- How does fiscal policy impact on market interest rates and monetary policy?
- What effect does a rise in interest rates have on exchange rates and the various parts of the balance of payments?
- What effect is a rise in US interest rates likely to have on other countries?
- What is meant by ‘forward guidance’ in the context of monetary policy? What are the benefits of providing forward guidance?
- What were the likely effects on the US stock market of the announcement by the FOMC?
- Following the FOMC announcement, two-year US Treasury bond yields rose to 1.231%, the highest since August 2009. Explain why.
- For what reason does the FOMC believe that the US economy is already expanding at roughly the maximum sustainable pace?
The IMF has just published its six-monthly World Economic Outlook. It expects world aggregate demand and growth to remain subdued. A combination of worries about the effects of Brexit and slower-than-expected growth in the USA has led the IMF to revise its forecasts for growth for both 2016 and 2017 downward by 0.1 percentage points compared with its April 2016 forecast. To quote the summary of the report:
Global growth is projected to slow to 3.1 percent in 2016 before recovering to 3.4 percent in 2017. The forecast, revised down by 0.1 percentage point for 2016 and 2017 relative to April, reflects a more subdued outlook for advanced economies following the June UK vote in favour of leaving the European Union (Brexit) and weaker-than-expected growth in the United States. These developments have put further downward pressure on global interest rates, as monetary policy is now expected to remain accommodative for longer.
Although the market reaction to the Brexit shock was reassuringly orderly, the ultimate impact remains very unclear, as the fate of institutional and trade arrangements between the United Kingdom and the European Union is uncertain.
The IMF is pessimistic about the outlook for advanced countries. 
It identifies political uncertainty and concerns about immigration and integration resulting in a rise in demands for populist, inward-looking policies as the major risk factors.
It is more optimistic about growth prospect for some emerging market economies, especially in Asia, but sees a sharp slowdown in other developing countries, especially in sub-Saharan Africa and in countries generally which rely on commodity exports during a period of lower commodity prices.
With little scope for further easing of monetary policy, the IMF recommends the increased use of fiscal policies:
Accommodative monetary policy alone cannot lift demand sufficiently, and fiscal support — calibrated to the amount of space available and oriented toward policies that protect the vulnerable and lift medium-term growth prospects — therefore remains essential for generating momentum and avoiding a lasting downshift in medium-term inflation expectations.
These fiscal policies should be accompanied by supply-side policies focused on structural reforms that can offset waning potential economic growth. These should include efforts to “boost labour force participation, improve the matching process in labour markets, and promote investment in research and development and innovation.”
Articles
IMF Sees Subdued Global Growth, Warns Economic Stagnation Could Fuel Protectionist Calls IMF News (4/10/16)
The World Economy: Moving Sideways IMF blog, Maurice Obstfeld (4/10/16)
The biggest threats facing the global economy in eight charts The Telegraph, Szu Ping Chan (4/10/16)
IMF and World Bank launch defence of open markets and free trade The Guardian, Larry Elliott (6/10/16)
IMF warns of financial stability risks BBC News, Andrew Walker (5/10/16)
Backlash to World Economic Order Clouds Outlook at IMF Talks Bloomberg, Rich Miller, Saleha Mohsin and Malcolm Scott (4/10/16)
IMF lowers growth forecast for US and other advanced economies Financial Times, Shawn Donnan (4/10/16)
Seven key points from the IMF’s latest global health check Financial TImes, Mehreen Khan (4/10/16)
Latest IMF forecast paints a bleak picture for global growth The Conversation, Geraint Johnes (5/10/16)
IMF Report, Videos and Data
World Economic Outlook, October 2016 IMF (4/10/16)
Press Conference on the Analytical Chapters IMF (27/9/16)
IMF Chief Economist Maurice Obstfeld explains the outlook for the global economy IMF Video (4/10/16)
Fiscal Policy in the New Normal IMF Video (6/10/16)
CNN Debate on the Global Economy IMF Video (6/10/16)
World Economic Outlook Database IMF (October 2016)
Questions
- Why is the IMF forecasting lower growth than in did in its April 2016 report?
- How much credibility should be put on IMF and other forecasts of global economic growth?
- Look at IMF forecasts for 2015 made in 2013 and 2012 for at least 2 macroeconomic indicators. How accurate were they? Explain the inaccuracies.
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the main factors determining a country’s long-term rate of economic growth?
- Why is there growing mistrust of free trade in many countries? Is such mistrust justified?
Many of the arguments used by both sides in the referendum debate centre on whether there will be a net economic gain from either remaining in or leaving the EU. This involves forecasting.
Forecasting the economic impact of the decision, however, is difficult, especially in the case of a leave vote, which would involve substantial change and uncertainty.
First, the effects of either remaining or leaving may be very different in the long run from the short run, and long-run forecasts are highly unreliable, as the economy is likely to be affected by so many unpredictable events – few people, for example, predicted the financial crisis of 2007–8.
Second, the effects of leaving depend on the nature of any future trading relationships with the EU. Various possibilities have been suggested, including ‘the Norwegian model’, where Britain leaves the EU, but joins the European Economic Area, giving access to the single market, but removing regulation in some key areas, such as fisheries and home affairs. 
Another possibility is ‘the Swiss model’, where the UK would negotiate trade deals on an individual basis. Another would be ‘the Turkish model’ where the UK forms a customs union with the EU. At the extreme, the UK could make a complete break from the EU and simply use its membership of the WTO to make trade agreements.
Nevertheless, despite the uncertainty, economists have ventured to predict the effects of remaining or leaving. These are not precise predictions for the reasons given above. Rather they are based on likely assumptions.
In a poll of 100 economists for the Financial Times, ‘almost three-quarters thought leaving the EU would damage the country’s medium-term outlook, nine times more than the 8 per cent who thought the country would benefit from leaving’. Most fear damage to financial markets in the UK and to inward foreign direct investment.
Despite the barrage of pessimistic forecasts by economists about a British exit, there is a group of eight economists in favour of Brexit. They claim that leaving the EU would lead to a stronger economy, with higher GDP, a faster growth in real wages, lower unemployment and a smaller gap between imports and exports. The main argument they use to support their claims is that the UK would be more able to pursue trade creation freed from various EU rules and regulations.
Then, less than four weeks before the vote, a poll of economists who are members of the Royal Economic Society and the Society of Business Economists came out strongly in favour of continued membership of the EU. Of the 639 respondents, 72 per cent thought that the most likely impact of Brexit on UK real GDP would be negative over the next 10 to 20 years; and 88 per cent thought the impact on GDP would be negative in the next five years (see chart: click to enlarge).
Of those stating that a negative impact on GDP in the next 5 years would be most likely, a majority cited loss of access to the single market (67%) and increased uncertainty leading to reduced investment (66%).
The views of the majority of economists accord with those of various organisations. Domestic ones, such as the Bank of England, the Treasury (see the blog Brexit costs), the Institute for Fiscal Studies and the National Institute for Economic and Social Research (NIESR) all warn that Brexit would be likely to result in lower growth – possibly a recession – increased unemployment, a fall in the exchange rate and higher prices and that greater economic uncertainty would damage investment.
International organisations, such as the OECD, the IMF and the WTO, also argue that leaving the EU would create great uncertainty over future trade relations and access to the Single Market and would reduce inward foreign direct investment and the flow of skills.
But the forecasts of all these organisations depend on their assumptions about trade relations and that, in the event of the UK leaving the EU, would depend on the outcome of trade negotiations. The Leave campaign argues that other countries would want to trade with the UK and that therefore leaving would not damage trade. The Remain campaign argues that the EU would not wish to be generous to the UK for fear of encouraging other countries to leave the EU and that, anyway, the process of decoupling from the EU and negotiating new trade deals would take many years and, in the meantime, the uncertainty would be damaging to investment and growth.
The articles linked below looks at the economic arguments about Brexit and reflect the range of views of economists. Several are from ‘The Conversation’ as these are by academic economists. Although some economists are in favour of Brexit, the vast majority support the Remain side in the debate.
Articles
EU referendum: Pros and cons of Britain voting to leave Europe The Week (4/5/16)
The fatal contradictions in the Remain and Leave camps The Economist (3/6/16)
Four reasons a post-Brexit UK can’t copy Norway or Switzerland The Telegraph, Andrew Sentance (10/6/16)
What will Brexit do to UK trade? Independent, Ben Chu (2/6/16)
Leavers may not like economists but we are right about Brexit Institute for Fiscal Studies, Paul Johnson (9/6/15)
Why Brexit supporters should take an EU-turn – just like I did The Conversation, Wilfred Dolfsma (8/6/16)
The economic case for Brexit The Conversation, Philip B. Whyman (28/4/16)
Fact Check: do the Treasury’s Brexit numbers add up? The Conversation, Nauro Campos (20/4/16)
Which Brexit forecast should you trust the most? An economist explains The Conversation, Nauro Campos (25/4/16)
Why is the academic consensus on the cost of Brexit being ignored? The Conversation, Simon Wren-Lewis (17/5/16)
How Brexit would reduce foreign investment in the UK – and why that matters The Conversation, John Van Reenen (15/4/16)
The consensus on modelling Brexit NIESR, Jack Meaning, Oriol Carreras, Simon Kirby and Rebecca Piggott (23/5/16)
Reports, Press Conferences, etc.
Economists’ forecasts: Brexit would damage growth Financial Times, Chris Giles and Emily Cadman (3/1/16)
The Economy After Brexit, Economists for Brexit
Economists’ Views on Brexit Ipsos MORI (28/5/16)
Inflation Report Bank of England (May 2016)
EU referendum: HM Treasury analysis key facts HM Treasury (18/4/16)
Brexit and the UK’s public finances Institute for Fiscal Studies, Carl Emmerson , Paul Johnson , Ian Mitchell and David Phillips (25/5/16)
The Long and the Short of it: What price UK Exit from the EU? NIESR, Oriol Carreras, Monique Ebell, Simon Kirby, Jack Meaning, Rebecca Piggott and James Warren (12/5/16)
The Economic Consequences of Brexit: A Taxing Decision OECD (27/4/16)
Transcript of the Press Conference on the Release of the April 2016 World Economic Outlook IMF (12/4/16)
Macroeconomic implications of the United Kingdom leaving the Euroepan Union IMF Country Report 16/169 (1/6/16)
WTO warns on tortuous Brexit trade talks Financial Times, Shawn Donnan (25/5/16)
Questions
- Summarise the main economic arguments of the Remain side.
- What assumptions are made by the Remain side about Brexit?
- Summarise the main economic arguments of the Leave side.
- What assumptions are made by the Leave side about Brexit?
- Assess the realism of the assumptions of the two sides.
- If the UK exited the EU, would it be possible to continue gaining the benefits of the single market while restricting the free movement of labour?
- Would it be beneficial to go for a ‘free trade’ option of abolishing all import tariffs if the UK left the EU? Would it mean that UK exports would face no tariffs from other countries?
- If forecasting is unreliable, does this mean that nothing can be said about the costs and benefits of Brexit? Explain.
The Treasury has published a paper analysing the costs of Britain leaving the EU. Its central assumption is that the UK would negotiate a bilateral trade deal with the EU similar to that between Canada and the EU. Under this assumption the Treasury estimates that, by 2030, GDP would be 6.2% lower than if the UK had remained in the EU, meaning that the average household would be £4300 per year worse off than it would otherwise have been. The analysis also finds that there would be a total reduction in tax receipts of £36 billion per year – far greater than any savings from lower contributions to the EU budget.
Not surprisingly the ‘Vote Remain’ campaign for the UK to stay in the EU has welcomed the analysis, seeing it as strong evidence in support of their case. Also, not surprisingly, the Vote Leave campaign has questioned both the analysis and the assumptions on which it is based.
The Treasury analysis looks at three possible scenarios: (a) a Canada-style bilateral arrangement (the central estimate); (b) the UK becoming a member or the European Economic Area – the ‘Norwegian model’ (according to the Treasury, this would reduce GDP by 3.8%); (c) no specific deal with the EU, with the UK simply having the same access to the EU as any other country that is a mamber of the WTO (this would reduce GDP by 7.5%). Thus the Norwegian model would probably result in a smaller reduction in growth, but the UK would still continue to make contributions to the EU budget and have to allow free movement of labour. Only in option (c) would it have total control over migration. Each of the estimates has a margin of error, giving a range for the reduction in GDP across the three scenarios from 3.4% to 9.5%.
The Treasury used a three-stage process to arrive at its conclusions, as explained in the FT article below:
First, it uses gravity models to estimate the effect of different trade relationships on the quantity of trade and foreign direct investment. Gravity models take into account how close countries are to each other geographically, as well as their historical links, rather than assuming that trade flows to wherever the lowest tariffs are.
Second, it uses external academic results to estimate the consequences for productivity – the efficiency of the UK economy – from different levels of trade and foreign direct investment.
Third, it plugs the productivity numbers unto a global economic model run by the National Institute of Economic and Social Research to estimate the long-run differences in national income and prosperity.
Clearly there is large-scale uncertainty over any forecasts 14 years ahead, especially when the relationship with the EU and other countries post-EU exit can only be roughly estimated. The question is whether the assumptions are reasonable and whether there would be substantial costs from Brexit, but not necessarily of £4300 per household.
The following articles look at the analysis and its assumptions. Unlike many newspaper articles, which clearly have an agenda, these articles are relatively unbiased and try to assess the arguments. Of course, it would be difficult to be totally unbiased and it would be a good idea to try to spot any biases in each of the articles.
Articles
Treasury’s Brexit analysis: what it says — and what it doesn’t Financial Times, Chris Giles (18/4/16)
A Treasury analysis suggests the costs of Brexit would be high The Economist (18/4/16)
George Osborne says UK would lose £36bn in tax receipts if it left EU The Guardian, Anushka Asthana and Tom Clark (18/4/16)
Will each UK household be £4,300 worse off if the UK leaves the EU? The Guardian, Larry Elliott (18/4/16)
FactCheck Q&A: can we trust the Treasury on Brexit? Channel 4 News, Patrick Worrall (18/4/16)
Reality Check: Would Brexit cost your family £4,300? BBC News, Anthony Reuben (18/4/16)
Brexit sparks outbreak of agreement among economists Financial Times, Chris Giles (27/4/16)
Treasury analysis
EU referendum: HM Treasury analysis key facts HM Treasury (18/4/16)
HM Treasury analysis: the long-term economic impact of EU membership and the alternatives HM Treasury (18/4/16)
Questions
- Would households actually be poorer if the Treasury’s forecasts are correct?
- What alternative trade arrangements with the EU would be possible if the UK left the EU?
- What are the Treasury model’s main weaknesses?
- What considerations are UK voters likely to take into account in the referendum which are not included in the Treasury analysis?
- Make out the case for supporting the analysis of the Treasury.
- Make out the case for rejecting the analysis of the Treasury.
The International Monetary Fund has just published its six-monthly World Economic Outlook (WEO). The publication assesses the state of the global economy and forecasts economic growth and other indicators over the next few years. So what is this latest edition predicting?
Well, once again the IMF had to adjust its global economic growth forecasts down from those made six months ago, which in turn were lower than those made a year ago. As Larry Elliott comments in the Guardian article linked below:
Every year, economists at the fund predict that recovery is about to move up a gear, and every year they are disappointed. The IMF has over-estimated global growth by one percentage point a year on average for the past four years.
In this latest edition, the IMF is predicting that growth in 2015 will be slightly higher in developed countries than in 2014 (2.0% compared with 1.8%), but will continue to slow for the fifth year in emerging market and developing countries (4.0% in 2015 compared with 4.6% in 2014 and 7.5% in 2010).
In an environment of declining commodity prices, reduced capital flows to emerging markets and pressure on their currencies, and increasing financial market volatility, downside risks to the outlook have risen, particularly for emerging market and developing economies.
So what is the cause of this sluggish growth in developed countries and lower growth in developing countries? Is lower long-term growth the new norm? Or is this a cyclical effect – albeit protracted – with the world economy set to resume its pre-financial-crisis growth rates eventually?
To achieve faster economic growth in the longer term, potential national output must grow more rapidly. This can be achieved by a combination of more rapid technological progress and higher investment in both physical and human capital. But in the short term, aggregate demand must expand sufficiently rapidly. Higher short-term growth will encourage higher investment, which in turn will encourage faster growth in potential national output.
But aggregate demand remains subdued. Many countries are battling to cut budget deficits, and lending to the private sector is being constrained by banks still seeking to repair their balance sheets. Slowing growth in China and other emerging economies is dampening demand for raw materials and this is impacting on primary exporting countries, which are faced with lower exports and lower commodity prices.
Quantitative easing and rock bottom interest rates have helped somewhat to offset these adverse effects on aggregate demand, but as the USA and UK come closer to raising interest rates, so this could dampen global demand further and cause capital to flow from developing countries to the USA in search of higher interest rates. This will put downward pressure on developing countries’ exchange rates, which, while making their exports more competitive, will make it harder for them to finance dollar-denominated debt.
As we have seen, long-term growth depends on growth in potential output, but productivity growth has been slower since the financial crisis. As the Foreword to the report states:
The ongoing experience of slow productivity growth suggests that long-run potential output growth may have fallen broadly across economies. 
Persistently low investment helps explain limited labour productivity and wage gains, although the joint productivity of all factors of production, not just labour, has also been slow. Low aggregate demand is one factor that discourages investment, as the last World Economic Outlook report showed. Slow expected potential growth itself dampens aggregate demand, further limiting investment, in a vicious circle.
But is this lower growth in potential output entirely the result of lower demand? And will the effect be permanent? Is it a form of hysteresis, with the effect persisting even when the initial causes have disappeared? Or will advances in technology, especially in the fields of robotics, nanotechnology and bioengineering, allow potential growth to resume once confidence returns?
Which brings us back to the short and medium terms. What can be done by governments to stimulate sustained recovery? The IMF proposes a focus on productive infrastructure investment, which will increase both aggregate demand and aggregate supply, and also structural reforms. At the same time, loose monetary policy should continue for some time – certainly as long as the current era of falling commodity prices, low inflation and sluggish growth in demand persists.
Articles
Uncertainty, Complex Forces Weigh on Global Growth IMF Survey Magazine (6/10/15)
A worried IMF is starting to scratch its head The Guardian, Larry Elliott (6/10/15)
Storm clouds gather over global economy as world struggles to shake off crisis The Telegraph, Szu Ping Chan (6/10/15)
Five charts that explain what’s going on in a miserable global economy right now The Telegraph, Mehreen Khan (6/10/15)
IMF warns on worst global growth since financial crisis Financial Times, Chris Giles (6/10/15)
Global economic slowdown in six steps Financial Times, Chris Giles (6/10/15)
IMF Downgrades Global Economic Outlook Again Wall Street Journal, Ian Talley (6/10/15)
WEO publications
World Economic Outlook, October 2015: Adjusting to Lower Commodity Prices IMF (6/10/15)
Global Growth Slows Further, IMF’s latest World Economic Outlook IMF Podcast, Maurice Obstfeld (6/10/15)
Transcript of the World Economic Outlook Press Conference IMF (6/10/15)
World Economic Outlook Database IMF (October 2015 edition)
Questions
- Look at the forecasts made in the WEO October editions of 2007, 2010 and 2012 for economic growth two years ahead and compare them with the actual growth experienced. How do you explain the differences?
- Why is forecasting even two years ahead fraught with difficulties?
- What factors would cause a rise in (a) potential output; (b) potential growth?
- What is the relationship between actual and potential economic growth?
- Explain what is meant by hysteresis. Why may recessions have a permanent negative effect, not only on trend productivity levels, but on trend productivity growth?
- What are the current downside risks to the global economy?
- Why have commodity prices fallen? Who gains and who loses from lower commodity prices? Does it matter if falling commodity prices in commodity importing countries result in negative inflation?
- To what extent can exchange rate depreciation help commodity exporting countries?
- What is meant by the output gap? How have IMF estimates of the size of the output gap changed and what is the implication of this for actual and potential economic growth?
If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
