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
- What data would you need to have in order to identify the degree of economic slack in the economy?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why might the issuing of the forward guidance last July have itself contributed to the fall in unemployment?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why is credibility an important requirement for policy?
- Why may LFS unemployment be a poor guide to the degree of slack in the economy?
- 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
- 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?
- In the Japanese context, is inflation wholly desirable or are there any undesirable consequences?
- Consider whether a two-year time frame is realistic for the the Bank of Japan to achieve its 2% inflation target.
- 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.
- 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 AffairsAnnual 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
- What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
- Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
- How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
- Why may capacity have been lost since the financial crisis of 2008?
- Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
- What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
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.
Bank rate in the UK has been at the historically low level of 0.5% since March 2009 and the MPC decision on 13 January was to leave the rate unchanged (see also). But inflation has been well above the Bank of England’s target of 2% since December 2009 and it could well rise further as international commodity prices are soaring. Some economists are thus arguing that Bank rate should rise. This is crucial, they say, to dampen inflationary expectations.
Other economists, however, argue that aggregate demand is likely to remain depressed and that the economy is operating with a large negative output gap. What is more, house prices are falling, as are real wages (see Bosses gain – workers’ pain)
In the following extract from BBC Radio 4’s Today Programme, two economists, Charles Goodhart and Willem Buiter, both former members of the MPC, debate the issue.
Podcast
Should interest rates rise? BBC Today Programme (13/1/11)
Data
Economic and Labour Market Review, Office for National Statistics (For inflation data see Tables Chapter 3, Table 3.01; for interest rates see Tables Chapter 5, Table 5.08)
Monetary Policy Committee Decisions Bank of England
Questions
- What are the arguments for a rise in Bank rate at the current time?
- What are the arguments against a rise in Bank rate at the current time?
- What information would you require to decide which of the arguments was the more powerful?
- Why is it difficult to decide the size of the output gap?
- To what extent do the arguments for and against a rise in Bank rate depend on the factors determining expectations, and what expectations are important here?
- To what extent are exchange rates relevant to the effectiveness of interest rate policy?
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.
