Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.
According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:
CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.
It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.
Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)
Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)
Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England
Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)
Questions
- Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
- Explain the difference between the forecasts and the outturn.
- Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
- What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
- What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
- How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.
However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:
“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.
Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”
Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.
BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)
Questions
- Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
- What is the relationship between interest rates and inflation?
- What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
- How has the recent speculation affected fixed rate mortgages?
- What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
- What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
- Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?
With the UK economy borrowing 11% of GDP, it is undeniable that spending cuts are needed. Of course, the big question is should they be occurring now or delayed until the recovery is more stable. However, another question is now being asked. Should taxes be cut to help the worse off? David Cameron says that this is out of the question. While he is a ‘tax-cutting Tory’ who ‘believes in tax cuts’, any significant cuts in taxes specifically aimed at the poor would simply make matters worse, especially as the Coalition government is already helping to move thousands of families out of taxation altogether, albeit by increasing taxes on the better off.
“It’s no good saying we’re going to deal with the deficit by cutting spending, but then we’re going to make things worse again by cutting taxes. I’m afraid it doesn’t add up.”
Those in favour of cutting taxes include John Redwood, the head of the Tory’s economic affairs committee, who argues that they would help to boost the economy, by ‘encouraging the wealth creators and the private sector’. By reducing the burden on residents, disposable income will increase, helping to stimulate consumption and investment, which should in turn boost aggregate demand. This would be a much needed stimulus following the latest data which showed: a shrinking economy once again in the last quarter of 2010, consumer confidence at its lowest level in the past 20 years, the possibility of unstable markets should the government be seen to ‘twitch’ on the austerity drive and 57% in a YouGov poll saying that the cuts are ‘being imposed unfairly’. Public approval for the Coalition’s budget deficit reduction strategy has fallen from 53% in June 2010 to 38% in February 2010. Add to this rising inflation and unemployment and the last thing people want to hear is surely ‘No big tax cuts’.
However, the budget deficit must be tackled: now or later. Whenever it happens and whichever party is in power, spending must be cut and/or tax revenues must rise and everyone will have to play their part.
Cameron: ‘Tax cuts impossible right now’ Sky News (6/2/11)
David Cameron says major tax cuts not possible BBC News (6/2/11)
Cameron vows ‘No to big tax cuts’ The Press Association (6/2/11)
David Cameron: Sorry, but we can’t afford tax cuts Telegraph, Patrick Hennessy (5/2/11)
George Osborne faces Conservative pressure for tax cuts BBC News (1/2/11)
Nick Clegg’s tax cuts will cost £4.3 billion, says IFS Telegraph, James Kirkup (2/2/11)
Doubts mount over Cameron’s austerity drive Associated Press (6/2/11)
Sorry it is so complicated BBC 2, Daily Politics, Stephanie Flanders (14/6/10)
Questions
- What is government borrowing? Who does the government borrow from?
- Analyse the impact of tax cuts on the economy. Think about which groups will be affected the most and in what ways.
- Which components of aggregate demand will be affected by cuts in spending and rising taxes?
- ’Cuts in taxation would boost the economy.’ To what extent do you agree with this statement?
- What will be the impact of tas cuts on the government’s macroeconomic objectives, given your answer to question 3?
- What are the arguments (a) for cutting the budget deficit now and (b) for cutting the budget deficit later?
The recession caused a large rise in unemployment in many countries. In the USA the rise has been particularly steep, where unemployment now stands at 14.5 million, or 9.8% of the labour force. Unemployment has continued to rise despite renewed growth in the US economy, where the latest annual real GDP growth is 2.6% (measured in Q3 2010). The rise in unemployment has been blamed on ‘sticky wages’ – i.e. the reluctance of wage rates to fall.
But are wages genuinely sticky as far as the average worker is concerned? They may be in many specific jobs with specific employers, but many workers made redundant then find work in different jobs at lower rates of pay. For them, their wage has fallen, even if particular jobs are paying the same as before.
So what are the consequences of this? Does the willingness of workers to accept lower paid jobs mean that the labour market is flexible and that people will thus price themselves into work? If so, why is employment still rising? Or does a reduction in real wages for many people dampen spending and hence aggregate demand, thereby reducing the demand for labour? If so, why is GDP rising?
The following articles look at the apparent stickiness of wages and the implications for the labour market and the macroeconomy.
Articles
Downturn’s Ugly Trademark: Steep, Lasting Drop in Wages Wall Street Journal, Sudeep Reddy (11/1/11)
The Causes of Unemployment Seeking Alpha, Brad DeLong (13/1/11)
Sticky, sticky wages The Economist blogs: Free Exchange, R.A. (11/1/11)
The Causes of Unemployment New York Times blogs: Wonkish, Paul Krugman (16/1/11)
America’s union-bashing backlash Guardian, Paul Harris (5/1/11)
Data
Federal Reserve Economic Data: FRED Federal Reserve Bank of St. Louis (US macroeconomic datasets)
United States GDP Growth Rate Trading Economics
US unemployment statistics Bureau of Labor Statistics
Questions
- Why might nominal wages be sticky downwards in specific jobs in specific companies?
- Why might nominal average wages in the economy not be sticky downwards?
- Why is unemployment rising in the USA?
- Why might there be a problem of hysteresis in the USA that provides an explanation of the reluctance of unemployment to fall?
- Why might a fall in wages end up being contractionary?
- What lessons can be learned from the Great Depression about cures for unemployment?
- How might unemployment be brought down in the USA?
- Why may making wages somewhat more flexible, as opposed to perfectly flexible, not be a good thing?
One of the interesting things about the recent recession was the dilemma that it posed for governments. As aggregate demand fell, unemployment rose, incomes fell, which reduced demand further and so national output began to decline. Obviously there were many other factors contributing to this decline, in particular the housing market, but the long and the short of it is, aggregate demand was falling. With the AD curve shifting inwards, we would expect the average price level to fall at the same time: i.e. inflation doesn’t tend to be much of a problem during a recession. It is this fact that posed something of a dilemma. In the recession, not only was aggregate demand low, but inflation was rising. The explanation for this: in large part due to rising commodity prices – a supply-side shock. Governments had to deal with low national output and inflation: this combination made policy changes much more complex.
While prices for many goods and commodities did fall significantly after their peak in 2008, there has been a gradual rise again and there seems to be no end in sight. Headline food prices, in particular, have increased almost to their 2008 levels, although in real terms prices are still lower. Onions in India; cabbage, pork and mackerel in South Korea; chillies in Indonesia – the list goes on. The rapidly rising prices of these basic foodstuffs has, in many cases, led to emergency government intervention. However, there are fewer concerns this time round, as many hope that the causes of these higher prices are not just the increases in demand but crucially temporary supply shocks. Bloomberg’s Businessweek Assistant Managing Editor, Sheelah Kolhatkar, said:
There are a lot of reasons [for rising prices]. Weather is cited as a big one. There’s been sort of freak weather in different parts of the world. Russia experienced a drought. There are floods in Australia. There’s been sort of freezing weather in Florida. Our own Midwest experienced flooding earlier this year. And because the market for a lot of these food commodities is global, when something strange happens somewhere, that can affect a crop.
On the other hand, there are growing concerns at the timing of this inflation: the developed world has barely escaped from recession. How is it that inflation can already be a problem? Furthermore, with loose monetary policy in many countries, rising food and commodity prices could continue for some time.
An interesting question to consider is which countries will be affected the most? In Britain, like other developed countries, food consumption accounts for between 15 and 20 per cent of a household budget. However, in developing countries, food can take up between 50 and 75 per cent of a houshold budget, so any rise in food prices is disastrous.
What does it mean for the recovery? Well, if food (a necessity) is increasing in price, households have little choice but to pay the higher prices. This means they have less disposable income for other goods, hence aggregate demand may be adversely affected. The following articles will hopefully give you some ‘food for thought’!
Articles
Soaring food prices cast shadow over trading Financial Times, Dave Shellock (14/1/11)
Next shock will be high food prices Sydney Morning Herald (17/1/11)
Commodities can still shock BBC News blogs, Stephanomics, Stephanie Flanders (13/1/11)
Many countries face catastrophe as inflation creeps up the food chain Independent, Hamish McRae (16/1/11)
Soaring demand soaks food oil reserves Sydney Morning Herald, Luzi Ann Javier (17/1/11)
Government to subsidise essential food items Sunday Observer, Gammi Warushamana (16/1/11)
Brace for higher food prices Jamaica Observer, Julia Richardson (16/1/11)
Jordanians protest against soaring food prices Guardian, Johnny McDevitt (15/1/11)
Inflation, the old enemy, is back. But this is no time to be frightened Guardian, Larry Elliott (16/1/11)
Global effort to calm food prices Washington Post, Steve Mufson (15/1/11)
The link between commodity prices and Monetary Policy Seeking Alpha (14/1/11)
Australian floods bost commodity prices, shares and funds Telegraph, Ian Cowie (13/1/11)
Soaring cost of oil and food will result in turmoil Belfast Telegraph Hamish McRae (18/1/11)
Q&A: Why food prices and fuel costs are going up BBC News (14/1/11)
Data
Commodity Prices Index Mundi
Questions
- What is the difference between headline food prices and real prices?
- What are the demand-side factors causing food prices to increase?
- What factors have affected the supply-side of the food market? Use a diagram to illustrate both the demand and supply-side factors.
- Can you identify some of the key differences between the causes of the rising food prices in 2008 and the rising food prices we’re seeing at the moment?
- Who are the winners and losers of rising food prices?
- What methods of government intervention are available to stabilise prices? Are they likely to be efficient and equitable?
- How is the exchange rate affecting food prices?
- Why could a loose monetary policy make food price inflation even worse?
- What are the main consequences of rising food and commodity prices? Think about the impact on different groups within society.