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.
Articles
The Bank of England is moving closer to killing the most boring chart in UK finance right now Business Insider, Will Martin (16/6/17)
UK inflation hits four-year high of 2.9% Financial Times, Gavin Jackson and Chloe Cornish (13/6/17)
Surprise for markets as trio of Bank of England gurus call for interest rates to rise The Telegraph, Szu Ping Chan Tim Wallace (15/6/17)
Bank of England rate setters show worries over rising inflation Financial TImes, Chris Giles (15/6/17)
Three Bank of England policymakers in shock vote for interest rate rise Independent, Ben Chu (15/6/17)
Bank of England edges closer to increasing UK interest rates The Guardian, Katie Allen (15/6/17)
Bank of England doves right to thwart hawks seeking interest rate rise The Guardian, Larry Elliott (15/6/17)
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)
Questions
- 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?
The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.
But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.
This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.
As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”
A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.
The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.
Articles
Fed’s asset shift to pose new test of economy’s recovery, resilience Reuters, Howard Schneider and Richard Leong (6/4/17)
Federal Reserve likely to begin cutting back $4.5 trillion balance sheet this year Washington Post, Ana Swanson (5/4/17)
Why the Fed’s debate about shrinking its balance sheet really, really matters Money Observer, Russ Mould (7/4/17)
The Fed and ECB keep a cautious eye on the exit Financial Times (7/4/17)
Get ready for the Fed’s next scary policy change CBS Money Watch, Anthony Mirhaydari (5/4/17)
The Fed wants to start shrinking its $4.5 trillion balance sheet later this year Business Insider, Akin Oyedele (5/4/17)
Inside the Fed’s March Meeting: The Annotated Minutes Bloomberg, Luke Kawa, Matthew Boesler and Alex Harris (5/4/17)
QE was great for asset prices – will ‘QT’ smash them? The Financial Review (Australia), Patrick Commins (7/4/17)
Shrinking the Fed’s balance sheet Brookings, Ben Bernanke (26/1/17)
Data
Selected data Board of Governors of the Federal Reserve System
Questions
- Distinguish between active and passive QT.
- If QE is a form of expansionary monetary policy, is QT a form of contractionary monetary policy?
- Could QT take place alongside an expansion of broad money?
- What dangers lie in the Fed scaling back its holdings of government (Treasury) bonds and mortgage-backed securities?
- Why is it unlikely that the Fed will reduce its holdings of securities to pre-crisis levels?
- Why are the Bank of England, the ECB and the Bank of Japan still pursuing a policy of QE?
- What are the implications for exchange rates of QT in the USA and QE elsewhere?
- Find out data for the monetary base, for narrow money (M1) and broader money (M2) in the USA. Are narrow and/or broad money correlated with Federal Reserve asset holdings?
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.
Videos
UK inflation shoots above two percent, adding to Bank of England conundrum Reuters, William Schomberg, David Milliken and Richard Hunter (21/3/17)
Bank target exceeded as inflation rate rises to 2.3% ITV News, Chris Choi (21/3/17)
Steep rise in inflation Channel 4 News, Siobhan Kennedy (21/3/17)
U.K. Inflation Gains More Than Forecast, Breaching BOE Goal Bloomberg, Dan Hanson and Fergal O’Brien (21/3/17)
Articles
Inflation leaps in February raising prospect of interest rate rise The Telegraph, Julia Bradshaw (21/3/17)
Brexit latest: Inflation jumps to 2.3 per cent in February Independent, Ben Chu (21/3/17)
UK inflation rate leaps to 2.3% BBC News (21/3/17)
UK inflation: does it matter for your income, debts and savings? Financial Times, Chris Giles (21/3/17)
Rising food and fuel prices hoist UK inflation rate to 2.3% The Guardian, Katie Allen (21/3/17)
Reality Check: What’s this new measure of inflation? BBC News (21/3/17)
Data
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
Questions
- 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?
Interest rates have been at record lows across the developed world since 2009. Interest rates were reduced to such levels in order to stimulate recovery from the financial crisis of 2007–8 and the resulting recession. The low interest rates were accompanied by extraordinary increases in money supply under various rounds of quantitative easing in the USA, UK, Japan and eventually the eurozone. But have such policies done harm?
This is the contention of Brian Sturgess in a new paper, published by the Centre for Policy Studies. He maintains that the policy has had a number of adverse effects:
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There will be nothing left in the monetary policy armoury when the next downturn occurs other than even more QE, which will compound the following problems. |
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It has had little effect in stimulating aggregate demand and economic growth. Instead the extra money has been used to repair balance sheets and support unprofitable businesses. |
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It has inflated asset prices, especially shares and property, which has encouraged funds to flow to the secondary market rather than to funding new investment. |
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The inflation of asset prices has benefited the already wealthy. |
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By keeping interest rates down to virtually zero on savings accounts, it has punished small savers. |
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By rewarding the rich and penalising small savers, it has contributed to greater inequality. |
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By keeping interest rates down to borrowers, it has encouraged households to take on excessive amounts of debt, which will be hard to service if interest rates rise. |
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It has lowered the price of risk, thereby encouraging more risky types of investment and the general misallocation of capital. |
Sturgess argues that it is time to end the policy of low interest rates. Currently, in all the major developed economies, central bank rates are below the rate of inflation, making the real central bank interest rates negative.
He welcomes the two small increases by the Federal Reserve, but this should be followed by further rises, not just by the Fed, but by other central banks too. As Sturgess states in the paper (p.12):
In place of ever more extreme descents into the unknown, central banks should quickly renormalise monetary policy. That would involve ending QE and allowing interest rates to rise steadily so that interest rates can carry out their proper functions. Failure to do so will leave the global financial system vulnerable to potential shocks such as the failure of the euro, or the fiscal stresses in the US resulting from the unfinanced spending plans announced by Donald Trump in his presidential campaign.
Although Sturgess argues that the initial programmes of low interest rates and QE were a useful response to the financial crisis, he argues that they should have only been used as a short-term measure. However, if they were, and if interest rates had gone up within a few months, many argue that the global economy would rapidly have sunk back into recession. This has certainly been the position of central banks. Sturgess disagrees.
Articles
Damaging low interest rates and QE must end now, think thank warns The Telegraph, Julia Bradshaw (23/1/17)
QE has driven pension deficits up, think-tank argues Money Marketing, Justin Cash (23/1/17)
Hold: The ECB keeps interest rates and QE purchases steady as Mario Draghi defends loose policy from hawkish critics City A.M., Jasper Jolly (19/1/17)
Preparing for the Post-QE World Bloomberg, Jean-Michel Paul (12/10/16)
Paper
Stop Depending on the Kindness of Strangers: Low interest rates and the Global Economy Centre for Policy Studies, Brian Sturgess (23/1/17)
Questions
- Find out what the various rounds of quantitative easing have been in the USA, the UK, Japan and the eurozone.
- What are the arguments in favour of quantitative easing as it has been practised?
- How might interest rates close to zero result in the misallocation of capital?
- Sturgess claims that the existence of ‘spillover’ effects has had damaging effects on many emerging economies. What are these spillover effects and what damage have they done to such economies?
- How do low interest rates affect interest rate spreads?
- Have pensioners gained or lost from QE? Explain how the answer may vary between different pensioners.
- What is meant by a ‘natural’ or ‘neutral’ rate of interest (see section 3.2 in the paper)? Why, according to Janet Yellen (currently Federal Reserve Chair, writing in 2005), is this somewhere between 3.5% and 5.5% (in nominal terms)?
- What are the arguments for and against using created money to finance programmes of government infrastructure investment?
- Would helicopter money be more effective than QE via asset purchases in achieving faster economic growth? (See the blog posts: A flawed model of monetary policy and New UK monetary policy measures – somewhat short of the kitchen sink.)
- When QE comes to an end in various countries, what are the arguments for absorbing rather than selling the assets purchased by central banks? (See the Bloomberg article.)
Household borrowing on credit cards and through overdrafts and loans has been growing rapidly. This ‘unsecured’ borrowing is now rising at rates not seen since well before the credit crunch of 2008 (click here for a PowerPoint of the chart below). Should this be a cause for concern?
Household confidence is generally high and, as a result, people continue to take out more loans and so household debt continues to increase. Saving rates are falling and, at 5.1% of household disposable income, are the lowest rate since 2008, mirroring the high levels of spending and borrowing.
But as long as the economy keeps growing and as long as interest rates stay at record low levels, people should be able to continue servicing this rising debt. Indeed, with generous balance transfer offers between credit cards and many people paying off their full balance each month, only 56.6% are paying any interest at all on credit card debt, the lowest level on record.
But there could be trouble ahead! Secured borrowing (i.e. on mortgages) is at record highs as house prices have soared, limiting the amount people have to left to spend, even with ultra low interest rates. Student debt is growing, putting a brake on graduate spending.
With economic growth set to slow and inflation set to rise as the effects of the lower pound filter through into retail prices, this could initially boost borrowing further as people seek to maintain levels of consumption. But then, if unemployment starts to rise and consumer confidence starts to fall, real spending could decline, putting further downward pressure on the economy.
Confidence could then fall further and we could witness a repeat of 2008–9, when people became worried about their levels of borrowing and cut back on consumption in an attempt to claw down their debt. The economy was pushed into recession.
The Bank of England is well aware of this scenario and wants banks to ensure that their customers can afford loans before offering them.
Articles
Bank governor Mark Carney warns on household debt BBC News, Brian Milligan (30/11/16)
Credit crunch: Household debt is rising just as the economy’s future is uncertain The Telegraph, Tim Wallace (10/12/16)
Bank of England publication
Financial Stability Report, November 2016 Bank of England (30/11/16)
Data
Money and lending Bank of England Interactive Database
United Kingdom Households Debt To GDP Trading Economics
Household debt OECD Data
Questions
- What determines the amount people borrow?
- What would cause people to cut back on the amount of debt they have?
- Distinguish between secured and unsecured borrowing and debt.
- Why has secured borrowing risen? Does this matter?
- What is meant by the term ‘re-leveraging’? What is its significance in terms of household borrowing?
- Find out what the affordability tests are for anyone wanting to take out a mortgage.
- What are the greatest risks to UK financial stability?
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.
