Tag: output gap

The first link below is to an excellent article by Noriel Roubini, Professor of Economics at New York University’s Stern School of Business. Roubini was one of the few economists to predict the 2008 financial crisis and subsequent recession. In this article he looks at the current problem of substantial deficiency of demand: in other words, where actual output is well below potential output (a negative output gap). It is no wonder, he argues, that in these circumstances central banks around the world are using unconventional monetary policies, such as virtually zero interest rates and quantitative easing (QE).

He analyses the causes of deficiency of demand, citing banks having to repair their balance sheets, governments seeking to reduce their deficits, attempts by firms to cut costs, effects of previous investment in commodity production and rising inequality.

The second link is to an article about the prediction by the eminent fund manager, Crispin Odey, that central banks are running out of options and that the problem of over-supply will lead to a global slump and a stock market crash that will be ‘remembered in a hundred years’. Odey, like Roubini, successfully predicted the 2008 financial crisis. Today he argues that the looming ‘down cycle will cause a great deal of damage, precisely because it will happen despite the efforts of central banks to thwart it.’

I’m sorry to post this pessimistic blog and you can find other forecasters who argue that QE by the ECB will be just what is needed to stimulate economic growth in the eurozone and allow it to follow the USA and the UK into recovery. That’s the trouble with economic forecasting. Forecasts can vary enormously depending on assumptions about variables, such as future policy measures, consumer and business confidence, and political events that themselves are extremely hard to predict.

Will central banks continue to deploy QE if the global economy does falter? Will governments heed the advice of the IMF and others to ease up on deficit reduction and engage in a substantial programme of infrastructure investment? Who knows?

An Unconventional Truth Project Syndicate, Nouriel Roubini (1/2/15)
UK fund manager predicts stock market plunge during next recession The Guardian, Julia Kollewe (30/1/15)

Questions

  1. Explain each of the types of unconventional monetary policy identified by Roubini.
  2. How has a policy of deleveraging by banks affected the impact of quantitative easing on aggregate demand?
  3. Assume you predict that global economic growth will increase over the next two years. What reasons might you give for your prediction?
  4. Why have most commodity prices fallen in recent months? (In the second half of 2014, the IMF all-commodity price index fell by 28%.)
  5. What is likely to be the impact of falling commodity prices on global demand?
  6. Some neo-liberal economists had predicted that central bank policies ‘would lead to hyperinflation, the US dollar’s collapse, sky-high gold prices, and the eventual demise of fiat currencies at the hands of digital krypto-currency counterparts’. Why, according to Roubini, did the ‘root of their error lie in their confusion of cause and effect’?

With the publication of the February 2014 Inflation Report the Bank of England has adjusted its forward guidance to the markets.

As we saw in Part 1 of this blog, the economy should soon fall below the 7% unemployment threshold adopted in the original forward guidance issued last August. But the Bank feels that there is still too much slack in the economy to raise interest rates when unemployment does fall below 7%.

The Bank has thus issued a new vaguer form of forward guidance.

The MPC’s view is that the economy currently has spare capacity equivalent to about 1%–1½% of GDP, concentrated in the labour market. Around half of that slack reflects the difference between the current unemployment rate of 7.1% and an estimate of its
medium-term equilibrium rate of 6%–6½%. The remaining slack largely reflects a judgement that employees would like to work more hours than is currently the case. Companies appear to be operating at close to normal levels of capacity, although this is subject to some uncertainty.

The existence of spare capacity in the economy is both wasteful and increases the risk that inflation will undershoot the target in the medium term. Moreover, recent developments in inflation mean that the near-term trade-off between keeping inflation close to the target and supporting output and employment is more favourable than at the time the MPC announced its guidance last August: CPI inflation has fallen back to the 2% target more quickly than anticipated and, with domestic costs well contained, is expected to remain at, or a little below, the target for the next few years. The MPC therefore judges that there remains scope to absorb spare capacity further before raising Bank Rate.

Just what will determine the timing and pace of tightening? The Bank identifies three factors: the sustainability of the recovery; the extent to which supply responds to demand; and the evolution of cost and price pressures. But there is considerable uncertainty about all of these.

Thus although this updated forward guidance suggests that interest rates will not be raised for some time to come, even when unemployment falls below 7%, it is not at all clear when a rise in Bank Rate is likely to be, and then how quickly and by how much Bank Rate will be raised over subsequent months. Partly this is because of the inevitable uncertainty about future developments in the economy, but partly this is because it is not clear just how the MPC will interpret developments.

So is this new vaguer forward guidance helpful? The following articles address this question.

Articles

Bank of England Governor Carney’s statement on forward guidance Reuters (12/2/14)
Why has Mark Carney tweaked forward guidance? The Telegraph, Denise Roland (12/2/14)
Interest rates: Carney rips up ‘forward guidance’ policy Channel 4 News (12/2/14)
Forward guidance version 2: will the public believe it? The Guardian, Larry Elliott (12/2/14)
Mark Carney adjusts Bank interest rate policy BBC News (12/2/14)
Mark Carney’s almost promise on rates BBC News, Robert Peston (12/2/14)
Did the Bank of England’s Forward Guidance work? Independent, Ben Chu (2/2/14)
Forward Guidance 2.0: Is Carney just digging with a larger shovel? Market Watch, The Tell (12/2/14)
The U.K. Economy: Five Key Takeaways Wall Street Journal, Alen Mattich (12/2/14)

Bank of England pages
Inflation Report, February 2014 Bank of England (12/2/14)
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England

Questions

  1. Summarize the new forward guidance given by the Bank of England.
  2. Why is credibility an important requirement for policy?
  3. What data would you need to have in order to identify the degree of economic slack in the economy?
  4. Why is it difficult to obtain such data – at least in a reliable form?
  5. What is meant by the ‘output gap’? Would it be a good idea to target the output gap?
  6. Is it possible to target the rate of inflation and one or more other indicators at the same time? Explain.

Although the Monetary Policy Committee (MPC) of the Bank of England is independent in setting interest rates, until recently it still had to follow a precise remit set by the government. This was to target inflation of 2% (±1%), with interest rates set to meet this target in 24 months’ time. But things have changed since the new Governor, Mark Carney, took up office in July 2013. And now things are not so clear cut.

The Bank announced that it would keep Bank Rate at the current historically low level of 0.5% at least until unemployment had fallen to 7%, subject to various conditions. More generally, the Bank stated that:

The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.

This ‘forward guidance’ was designed to provide more information about future policy and thereby more certainty for businesses and households to plan.

But unemployment has fallen rapidly in recent months. It fell from a 7.7% average for the three months May to July 2013 to 7.1% for the latest available three months (September to November 2013). And yet there is still considerable slack in the economy.

It now, therefore, looks highly unlikely that the MPC will raise Bank Rate as soon as unemployment falls below 7%. This then raises the question of how useful the 7% target has been and whether, if anything, it has created further uncertainty about future MPC decisions.

The following still appears on the Bank of England website:

The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.

But this raises two questions: (a) how do you measure ‘economic slack’ and (b) what constitutes a substantial reduction?

So what should the Bank do now? What, if any, forward guidance should it offer to the markets? Will that forward guidance be credible? After all, credibility among businesses and households is an important condition for any policy stance. According to Larry Elliott in the first article below, there are five options.

Articles

Bank of England’s method of setting interest rates needs reviewing The Guardian, Larry Elliott (9/2/14)
Mark Carney set to adjust Bank interest rate policy BBC News (12/2/14)
Forward guidance: dead and alive BBC News, Robert Peston (11/2/14)
What “forward guidance” is, and how it (theoretically) works The Economist (11/2/14)
BOE’s forward guidance 2.0: Cheap talk, or big change? Market Watch (11/2/14)

Bank of England pages
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England

Questions

  1. What data would you need to have in order to identify the degree of economic slack in the economy?
  2. Why is it difficult to obtain such data – at least in a reliable form?
  3. Why might the issuing of the forward guidance last July have itself contributed to the fall in unemployment?
  4. Why is it difficult to obtain such data – at least in a reliable form?
  5. Why is credibility an important requirement for policy?
  6. Why may LFS unemployment be a poor guide to the degree of slack in the economy?
  7. Discuss the relative merits of each of the five policy options identified by Larry Elliott.

Japan has suffered from deflation on and off for more than 20 years. A problem with falling prices is that they discourage spending as people wait for prices to fall further. One of the three elements of the Japanese government’s macroeconomic policy (see Japan’s three arrows) has been expansionary monetary policy, including aggressive quantitative easing. A key aim of this is to achieve an inflation target of 2% and, hopefully, propel the economy out of its deflationary trap.

The latest news, therefore, from Japan would seem to be good: consumer prices rose 0.4% in June – the first rise for more than a year. But while some analysts see the rise in prices to be partly the result of a recovery in demand (i.e. demand-pull inflation), others claim that the inflation is largely of the cost-push variety as the weaker yen has increased the price of imported fuel and food.

If Japanese recovery is to be sustained and broadly based, a growth in real wages should be a core component. As it is, real wages are not growing. This could seriously constrain the recovery. For real wages to grow, employers need to be convinced that economic recovery will be sustained and that it would be profitable to take on more labour.

The success of the expansionary policy, therefore, depends in large part on its effect on expectations. Do people believe that prices will continue to rise? Do employers believe that the economy will continue to expand? And do people believe that their real wages will rise?

Articles

Japan prices turn higher, but BOJ’s goal remains tall order Reuters, Tetsushi Kajimoto and Leika Kihara (26/7/13)
How Japan Could Go from Deflation to Hyperinflation in a Heartbeat The Wall Street Journal, Michael J. Casey (24/7/13)
Japan Prices Rise Most Since ’08 in Boost for Abe Bloomberg, Toru Fujioka & Andy Sharp (26/7/13)
Japan central bank finds the pessimists come from within Reuters, Leika Kihara (26/7/13)
Japan’s Fiscal Crossroads: Will Abenomics Mean Tougher Changes? The Daily Beast, Daniel Gross (26/7/13)
Japan Economist Makes Rare Call to Tackle Debt The Wall Street Journal, Kosaku Narioka (25/7/13)
Japanese Consumer Prices Rise In Sign Of Some Success In Abe Economic Policy International Business Times, Nat Rudarakanchana (26/7/13)

Data

Bank of Japan Statistics Bank of Japan
Statistics Statistics Bureau of Japan
International sites for data Economics Network

Questions

  1. Distinguish between cost-push and demand-pull inflation? Do higher prices resulting from a depreciation of the currency always imply that the resulting inflation is of the cost-push variety?
  2. In the Japanese context, is inflation wholly desirable or are there any undesirable consequences?
  3. Consider whether a two-year time frame is realistic for the the Bank of Japan to achieve its 2% inflation target.
  4. What is meant by the output gap? Using sources such as the European Commission’s European Economy, AMECO database and the OECD’s Economic Outlook: Statistical Annex Tables (see sites 6 and 7 in the Economics Network’s links to Economic Data freely available online) trace the Japanese output gap over the past 10 years and comment on your findings.
  5. What supply-side constraints are likely to limit the rate and extent of recovery in Japan? What is the Japanese government doing about this (see the third arrow of Japan’s three arrows)?

This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.

The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.

In the introduction to the report, the Governor, Mervyn King, writes:

Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.

And at the news conference launching the report, he said:

We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.

The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.

The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:

Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.

We look in more detail at the question of lost capacity in Part 2.

Articles
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)

Inflation Report
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)

Additional Data
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial Affairs
Annual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury

Questions

  1. What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
  2. Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
  3. How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
  4. Why may capacity have been lost since the financial crisis of 2008?
  5. Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
  6. What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?