The iPhone effect

Following the announcement of the new iPhone 5, I have read articles suggesting a beneficial stimulus (for the US) arising from the sale of this new piece of technology. Here is an article from Paul Krugman, and as a side note, he mentions and firmly believes that the problems were are facing are due to a lack of demand (see an earlier post for views otherwise.)

" ...Wednesday was iPhone 5 day, the day Apple unveiled its latest way for people to avoid actually speaking to or even looking at whoever they’re with.
 So is the new phone as insanely great as Apple says?...
What I’m interested in, instead, are suggestions that the unveiling of the iPhone 5 might provide a significant boost to the U.S. economy, adding measurably to economic growth over the next quarter or two.

Do you find this plausible? If so, I have news for you: you are, whether you know it or not, a Keynesian — and you have implicitly accepted the case that the government should spend more, not less, in a depressed economy.

Before I get there, let’s talk about where the buzz is coming from.

A recent research note from JPMorgan argued that the new iPhone might add between a quarter- and a half-percentage point to G.D.P. growth in the last quarter of 2012. How so? First, the report argued that Apple was likely to sell a lot of phones in a short period of time. Second, it noted that although iPhones are manufactured overseas, most of the price you pay when you buy one is domestic value-added — retailing and wholesaling, advertising and profits — all of which counts as part of G.D.P. Finally, it took some plausible guesses about the price of each phone and the number of phones sold, and used those guesses to make an estimate of the impact on G.D.P.

It’s all pretty straightforward. But the implications are wider than most people realize.

The crucial thing to understand here is that these likely short-run benefits from the new phone have almost nothing to do with how good it is — with how much it improves the quality of buyers’ lives or their productivity. Such effects will kick in only over the longer run. Instead, the reason JPMorgan believes that the iPhone 5 will boost the economy right away is simply that it will induce people to spend more.

And to believe that more spending will provide an economic boost, you have to believe — as you should — that demand, not supply, is what’s holding the economy back. We don’t have high unemployment because Americans don’t want to work, and we don’t have high unemployment because workers lack the right skills. Instead, willing and able workers can’t find jobs because employers can’t sell enough to justify hiring them. And the solution is to find some way to increase overall spending so that the nation can get back to work.

So where can more spending come from? Businesses are sitting on lots of cash but, for the most part, have seen little reason to do a lot of investment. Why expand your capacity when you don’t have enough sales to make full use of the capacity you already have? And because businesses aren’t spending a lot, incomes are low, so consumer demand is low, which perpetuates those low sales.

Yet depressions do end, eventually, even without government policies to get the economy out of this trap. Why? Long ago, John Maynard Keynes suggested that the answer was “use, decay, and obsolescence”: even in a depressed economy, at some point businesses will start replacing equipment, either because the stuff they have has worn out, or because much better stuff has come along; and, once they start doing that, the economy perks up. Sure enough, that’s what Apple is doing. It’s bringing on the obsolescence. Good.

But why suffer through years of depressed output and high unemployment while waiting for enough obsolescence to accumulate? Why not have the government step in and spend more, say on education and infrastructure, to help the economy through its rough patch? Don’t say that the government can’t add to total spending, or that government spending can’t create jobs. If you believe that the iPhone 5 can give the economy a lift, you’ve already conceded both that the total amount of spending in the economy isn’t a fixed number and that more spending is what we need. And there’s no reason this spending has to be private.

Yet far from using public spending to support the economy in its time of trouble, our political system — driven by a combination of ideology, exaggerated deficit fears and Republican obstructionism — has moved to make the depression worse. Yes, unemployment benefits and food stamps are up, because so many more people are in need; but government employment has plunged, as has public investment.

Now, despite all this, we will eventually recover. Over time there will be more equipment that needs replacing, more iPhone-like innovations that boost spending, and, in the long run, we will exit this economic trap. But, as Keynes famously pointed out in another context, in the long run we are all dead. To borrow a phrase from myself, why not end this depression now?"

QE has been effective

Contrary to my last post, a BoE policymaker has spoken out in favour of QE, suggesting the Bank is right to inject further stimulus into the economy. This time however, the quote is much shorter!

"Mr Miles, who has supported additional stimulus throughout most of this year and voted for more quantitative easing against the majority of the nine-member Monetary Policy Committee on several occasions, said that a further cut in the record-low interest rate could prove counterproductive.

"Monetary policy in the UK has been set to its most expansionary setting in history; and I believe it is right that it is still being moved further in that direction," Mr Miles said, according to the text of his speech at an event in Edinburgh.

In July the Bank launched another £50bn round of government bond purchases with newly-created money to boost the recession-hit economy and most economists expect more once the current programme is completed in November.

Mr Miles reiterated that quantitative easing helped support the economy, Reuters reported.

"I believe the evidence is that it has had a significant positive effect," he said, adding that the current economic weakness was no proof that quantitative easing had ceased to work as other forces were holding the economy back.

"It is not as if it is hard to identify such forces - one of which is the clear deterioration in the funding conditions for banks across Europe that began in the autumn of last year and which was followed by falling confidence across most of Europe and stagnation in economic activity," he said.

Mr Miles stuck to the central bank's position that a further cut in the benchmark rate could be counterproductive.

"There were reasons to believe [during the financial crisis] that the benefits of cutting Bank Rate further [from the current 0.5pc] were, at best, likely to be small and that the effects could well be perverse," he said. "I see no obvious reason to think things are much different today, though this is something to keep monitoring."

While Mr Miles said a rapid return to a more normal monetary policy was not imminent, he laid out his view of an exit strategy.

"The timing and the speed of reversing the unusually accommodative monetary policy stance will be determined by the outlook for inflation," he said.

"I believe there are likely to be advantages to raising Bank Rate first [before selling back bonds], and I would expect this to be the strategy," he said."

QE Warning-'stepping into the unknown'

I have recently read a speech by Spencer Dale, who is chief economist at the Bank of England, warning that if growth continues to remain weak, we should be wary about automatically resorting to printing money. Here is my summary followed by the full speech:

Summary:
The policy actions undertaken by the MPC have undeniably played a critical role in stabilising our economy. Although those actions may bring with them potential risks and costs, the risks of monetary inaction at a time when our economy was teetering at the edge of a great depression were far greater.

Monetary policy can do more. If the economic outlook deteriorates further, policy can respond. We have not yet run out of road. But there are limits to how much we should ask of monetary policy.

We need to remember how little we know about the economy and how it works. Beware confident economists.

If output growth remains weak, we will need to assess carefully developments in potential supply as well as demand before deciding how to respond. The rates of growth enjoyed prior to the crisis may not be the correct benchmark for the next few years.
And we need to consider the potential costs as well as benefits of further policy easing. We are in uncharted – and potentially dangerous - water.

Full Speech:
"Monetary policy has been pushed into situations and actions that were previously unimaginable.
These challenges – and the strains they have placed on monetary policy – provide the focus for my remarks today.
What role is it realistic to expect monetary policy to play – what role can it play - as we try to recover from the financial crisis?
What are the limits of monetary policy?
I want to consider two dimensions of these potential limits.
First, and most broadly, the role monetary policy can play in trying to support a recovery in aggregate demand.
The financial crisis and subsequent recession has increased the focus on using monetary policy to stabilise the economy. In part, this was driven by the well justified fears that the deep recession could lead to deflation. But over and above that, it was a response to the widespread presumption that monetary policy could – and indeed should – play an active stabilisation role. For better or worse, we have come to expect more of monetary policy than simply maintaining price stability.
But the greater the ambition of monetary policy, the greater is the required understanding of the economy: of the shocks driving it; and of the key relationships underpinning its behaviour. Surely one lesson we have learnt from the financial crisis – perhaps the most important lesson - is that economists and policymakers know far less about the economy and its behaviour than many might have liked to believe.
What are the practical limits to stabilisation policy when there is so much about the economy we do not, and cannot, know?
The second limitation I want to explore concerns the more specific issue of the potential costs and side effects of running extremely loose monetary policy for a sustained period.
Policy rates in the major advanced economies have been close to zero for over three years. Central bank balance sheets have expanded beyond recognition as policy committees have pumped increasing amounts of money into the economy. And, more recently, a number of central banks – including my own – have provided liquidity and funding support to the banking system on a scale and in a manner that would, in more normal times, have been pretty unpalatable.
Make no mistake, there are strong arguments for all of these actions. Although our economy remains weak, I have no doubt that, had these actions not been taken, it would be in a far worse state today. But prolonged and aggressive monetary accommodation comes with potential costs and risks: to the long-run health and functioning of the economy; and potentially to the role and credibility of central banks. How much further can monetary policy be pushed until the potential costs and risks outweigh the benefits?
Recognition of this uncertainty has long been a key feature of the Bank’s approach to monetary policy. For example, with the use of fan charts in our Inflation Reports which explicitly depict the considerable uncertainty surrounding economic forecasts.
Limits to stabilising the economy using monetary policy
Let me start with the broader issue of the potential limits to using monetary policy to stabilise the economy when our knowledge of how it works is clouded by uncertainty and ignorance.
An awareness of the limits to our understanding of monetary policy has long been recognised, dating back at least 60 years or so to Milton Friedman (1948).
Taken to its extreme, this viewpoint argues that there is little or no scope for monetary policy to smooth economic cycles. Sticky wages and prices may very well imply the existence of short-run trade-offs between output and inflation. But the complexity of the economy means it is beyond the wit of policymakers to exploit those trade-offs successfully. Trying to do so is prone to amplify business cycle fluctuations rather than smooth them. Friedman’s ‘long and variable lags’ pose a constraint on what policymakers should aspire to achieve.
Under this view, the best that monetary policy can do is to maintain the nominal standard. In modern parlance: decide on your inflation target and dedicate monetary policy to achieving it – on average – over long sweeps of time. Hence Friedman’s k% rule for money growth.
Compared with modern perceptions of the active role monetary policy should play, sentiments such as those underpinning the k% rule seem rather antiquated. Central bankers today are at pains to stress that they don’t focus simply on inflation.
Such sentiments also appear defeatist. Surely we know enough to do better than simply achieve a target for trend inflation?
That may well be right. But you don’t have to look back very far to see what can happen when monetary policy fails to achieve even this seemingly modest objective. In the UK, we saw firsthand in the high and
variable inflation rates of the 1970s and 80s, the cost of monetary policy taking its eye off the ball.
The belief that we do know more – that we can do better than simply behaving as inflation nutters – is embodied in modern-day flexible inflation targeting. This gives primacy to monetary policy maintaining low and stable inflation, but posits that policymakers also know enough to have some scope to smooth short-run fluctuations in output.
This seems eminently reasonable and entirely consistent with the broad consensus within the economics profession.
But remember, we don’t fully understand the structure of the economy or the behaviour of households and companies within it. Not even close. And we don’t know the nature of the shocks affecting the economy, even long after they have occurred.
Is there a danger that we might do more harm than good?
I fear that this may sound too cautious, even wimpy. Surely it can’t be that difficult?
Or can it?
One way to illustrate the practical difficulty of making the judgements required to set monetary policy to conform to this modern day consensus is to consider the policy prescriptions implied by a simple feedback rule, in this case the most basic form of Taylor rule
The green line in Chart 1 shows the interest rate implied by a simple “plain vanilla” Taylor rule applied to the UK economy. This suggests that – were it not for the zero lower bound – Bank Rate should have been set close to -2% or so in the first quarter of 2012.

But this policy prescription depends critically on the judgements that are fed into this calibration.
For example, the basic Taylor Rule implies that policy should respond to the current level of inflation. But over much of the past five years, the UK has been hit by a series of price level shocks, which should affect inflation only temporarily and which the MPC has chosen to look through. That might suggest that policy should feedback from a forecast of medium-term inflation, once such price level effects have dropped out of the inflation calculation. If instead we allowed policy to feed back from the MPC’s forecast for inflation two-years ahead, this would move the implied policy path even lower, to the yellow line.
As you well know, the policy path implied by the Taylor rule also depends critically on the assumed size of the output gap.
The output gap used in the plain vanilla rule has been calculated – as in Taylor’s original paper – by taking deviations of output from its historical trend. Output in the UK is around 15% or so below where it would have been had the economy continued to grow in line with its pre-crisis trend. Hence, the prescription for extremely loose policy.
But a striking feature of the financial crisis and ensuing recession is that it appears to have affected the growth of the supply capacity of our economy as well as demand. Despite the apparent deficiency of demand, business surveys suggest that spare capacity within companies is relatively limited. Unemployment has risen, but by far less than might have been feared given the severity of the recession. The counterpart is that private sector productivity fell sharply and has essentially flat lined over the past couple of years.
If we use an alternative measure of the output gap, constructed by combining a simple measure of labour market disequilibrium with a measure of capacity utilisation within companies, the implied policy path shifts dramatically upwards to the blue line.
The Taylor rule also requires a judgement about the equilibrium level of real interest rates. This embodies all the uncertainty about what is happening on the supply side of economy. It also requires us to make a judgement about the extent to which the crisis has affected the functioning of financial markets. As an illustration, if we used the increase in financial spreads as a proxy for the extent to which policy has had to ease to offset the tightening in credit conditions, we get the brown line.
By way of comparison, Chart 2 compares the range of policy paths implied by these different versions of the Taylor rule with a very crude estimate of the shadow policy rate set by the MPC, in which I have used a rough rule-of-thumb to convert the estimated impact of the MPC’s asset purchases into an equivalent cut in Bank Rate.

The estimate of the path of the shadow Bank Rate has been within the range of policy rules for much of the recent period. But that is hardly saying very much given how wide that range has been in recent years. And that is precisely the point! Even trying to calibrate the simplest Taylor rule can lead to vastly different policy recommendations depending on the judgements that are made.
Monetary policymakers face substantial uncertainty. That is not defeatist or wimpy; it is a fact of life. And it needs to be borne in mind when deciding how ambitious we should be in our monetary policy objectives.
Let me bring this closer to home and consider some of the issues currently facing the MPC when assessing the scope for monetary policy to stabilise output.
In days gone by, if one of my predecessors had observed a slowdown in output growth, a natural response might have been to assume that this was likely to increase economic slack and so lower future inflation. The obvious policy response to such a development would have been to loosen monetary policy in order to smooth output growth and keep inflation close to target.
Indeed, UK monetary policy during the Great Moderation can be mimicked quite well by a policy rule defined in terms of keeping output growth close to its historical trend rate.
But, as we’ve seen, a defining feature of the UK economy since the financial crisis is that the persistent weakness in output has been accompanied by a long-lasting period of very weak productivity growth, suggesting that the supply capacity of the economy may also have been impaired. This makes judging the appropriate policy response to a slowdown in output growth far more complicated.
Loosening policy further in response to weaker output might well be the right thing to do.
That would be the case, for example, if we judged that growth in supply capacity is not as weak as the available data might suggest. Rather, spare capacity may be exerting only a limited drag on inflation and there is some other explanation for the flat lining in productivity.
It might also be the right thing to do if we judged that the growth in supply capacity had indeed been muted, but that this was largely due to the lack of demand. For example, when demand is weak, many companies are likely to have to devote more resources to finding new customers and pitching for orders to generate the same amount of business. In this case, stimulating additional demand would bring with it stronger productivity growth, and would allow the economy to grow without generating higher inflation.
But injecting additional monetary stimulus when we observe weak output might not be the right thing to do.
In particular, if we thought weakness in both demand and supply were being driven by some other factor, perhaps related to our impaired financial system and the sustained period of tight credit conditions. In this case, further demand stimulus may run up against supply capacity relatively quickly and so largely result in higher inflation.
If the handbrake on your car is stuck, putting your foot further and further down on the accelerator won’t get you very far before the car starts to overheat.
A significant element of this thinking is reflected in the forecasts for growth and inflation that the Monetary Policy Committee published last month in its August Inflation Report. Even though GDP was expected to grow by far less than its historical trend rate over the next three years, the risks around the inflation target by the end of the forecast period were thought to be broadly balanced. This despite the Committee judging that there is currently a sizeable degree of spare capacity in the economy.
These are difficult judgements and ones that the MPC is having to confront in real time at its policy meetings.
There are no simple answers. But the Pavlovian-like response of some commentators to call for more monetary stimulus each time they observe weak growth is not sensible. The extent to which policy should be eased further depends crucially on the reasons why output is weak. Using monetary policy to stabilise the economy is challenging even in the best of times. The constraints posed by our uncertainty and ignorance should not be underestimated, particularly so when, as now, the performance of the supply side of the economy is highly uncertain. Moreover, there may be little that monetary policy can do to stimulate productivity growth. We need to be conscious of our limitations when setting policy.
Our economy remains weak. Unemployment has edged down in recent months but it remains too high. The onus on monetary policy is to continue to stimulate the economy. But ultimately, our job is to hit an inflation target not a growth target.
Limits to persistently loose monetary policy
Let me turn now to the more specific question of the limits to running extremely loose monetary policy for a sustained period of time. How much further can we push monetary policy before the potential costs risk outweighing the benefits?
It is clear that the financial crisis has taken monetary policy into uncharted waters.
In the UK, as in almost every other advanced economy, the size of the fallout from the financial crisis meant that we quickly exhausted our conventional policy tools. Bank Rate was cut from 5% to 0.5% in the space of 6 months.
We turned next to large scale asset purchases – QE – which we conducted on a massive scale. To date, the MPC’s planned asset purchases amount to 25% of nominal GDP.
There are obviously uncertainties in judging just how effective those actions have been. Some commentators have pointed to the weakness of growth over the past couple of years as evidence that their impact has been relatively limited. But this seems a silly argument. The scale of the headwinds affecting our economy over this period – in terms of the squeeze in households’ real incomes stemming from the rise in commodity and other import prices, the fiscal consolidation, the tightening in credit conditions, and the fallout from the euro zone crisis – has been huge. These headwinds have to be taken into account when assessing the effectiveness of the policy actions taken to offset them. There is a legitimate debate as to exactly how effective our policy actions to date have been. But I have little doubt that without them our economy would be in a far worse state today.
Most recently, the Bank, together with the Government, has launched the Funding for Lending Scheme (FLS), which provides banks with an alternative cheaper source of funding tied to the extent to which they expand lending to the UK real economy.
I can understand why to some households and companies who have been unable to borrow in recent years this may just sound like yet another in a long line of schemes to get the banks lending.
But the Funding for Lending Scheme is different. It is bigger and bolder than any scheme tried so far to get the banks lending. In terms of the cost at which funding is being made available, the maturity of that funding and, most importantly, the strong price incentives it provides to banks to expand their lending.
By helping to improve the availability of bank lending to companies and households who previously have been effectively starved of credit, it could have a significant effect on demand. Moreover, if some of the recent poor supply side performance of our economy does stem from the constraints on the flow of credit, it may also help to ease that friction.
Of course, the FLS is not a magic wand likely to resolve all impediments to lending growth. Despite the incentives provided by the scheme, some banks may remain focussed on reducing the size of their balance sheet. And even if loan rates do fall, some households and companies may be wary of increasing their levels of borrowing in the current economic climate. But the FLS takes off the table the constraint posed by high bank funding costs. And in my view stands a good chance of making a material difference.
But prolonged and aggressive monetary accommodation, combined with increasingly unconventional policy tools, also comes with potential costs and risks. We need to be alert to those pitfalls when assessing the strain that should be placed on monetary policy.
These costs and risks may manifest themselves in at least three different ways: unwelcome side effects; exit risks; and the impact on our credibility. Let me consider each of these in turn.
Monetary policy, by reducing short term interest rates and improving the availability of credit, encourages households and companies to bring forward their spending. To borrow more and save less. That is exactly what is needed in a period of deficient demand. But there are potential unwelcome side effects associated with a sustained period of loose monetary policy.
For example, a recent literature has highlighted the possibility of a so-called ‘risk taking channel’ of monetary policy. As policy rates are reduced and the yield on short-term safe assets fall, investors may shift their portfolios towards increasingly risky assets. This is perhaps particularly likely to be the case if some institutional investors have to target nominal rates of return in order to match those on their liabilities. This might well be a good thing if risk premia are too high and there is insufficient risk taking. But it could also store up problems for the future. Rajan (2006), for example, argues that this search for yield was a key factor driving the increase in risk taking in the run-up to the crisis.
In a similar vein, QE works by encouraging institutional investors to hold an increasingly risky portfolio of assets. This helps to increase the demand for debt and equity issued by UK companies. But it comes at the expense of increasing the risks borne by key parts of our financial sector.
More generally, the prolonged period of low interest rates and enhanced support may delay some of the rebalancing and restructuring that our economy needs to undertake. Underlying balance sheet problems can be masked, tempering the incentives to address them. Inefficient firms may remain in business for longer and so slow the reallocation of capital and labour to more productive uses. Low interest rates and the associated forbearance might even explain part of the puzzling weakness in productivity.
Monetary policy can and should provide short-term support in times of need, but it must avoid becoming a long-term crutch obstructing the required rebalancing of our economy.
Consider next the possible risks as we begin to exit from this prolonged period of very loose monetary policy.
At first blush moving to a more normal stance of policy as conditions improve appears relatively straightforward. The structure of UK money markets means that we can raise Bank Rate at any point; there is no need for us to first drain the excess reserves held by the banking system. We will be selling the gilts we hold back into one of the deepest and most liquid sovereign debt markets in the world. And we have worked closely with the Debt Management Office to consider how this might be best achieved.
But we should also recognise that we need to sell a huge amount of gilts back to private sector investors: around 40% of the total stock of conventional gilts. That will require a corresponding reduction in the other types of assets held by private sector investors. Achieving this portfolio rebalancing without unsettling the government bond market and, equally important, causing a substantial crowding out of private sector debt will be a delicate task.
Finally, consider the potential threats to the MPC’s credibility.
The most obvious stems from the inevitable blurring between fiscal and monetary policy when interest rates are close to zero. The purchase of vast quantities of government debt provides an efficient and effective way of injecting into our economy the substantial amounts of liquidity judged necessary to hit the inflation target in the medium term. That is the reason – and the only reason – why QE is being undertaken. But to some observers, QE may look uncomfortably close to monetary financing. The difference will become apparent when we sell the gilts back to the private sector as the economy begins to normalise. But that may well be some way off. And in the meantime, it may look to some a little too convenient that we are choosing to hold vast quantities of government debt at a time when the fiscal deficit remains around post-war highs. However unfounded, those perceptions need to be taken seriously.
More generally, I worry that unless the limits of monetary policy are well understood, a widening gap may develop between what is expected of central banks and what they can realistically deliver. Central banks need to be clear about the limits of monetary policy in order to protect our long-term trust and legitimacy."

Source: Telegraph 

Inflation interest rates and QE- everything you need to know

I am currently researching inflation, interest rates, and QE (Quantitative Easing) for an interview later this week, so I thought I would share/track my research here.

QE:
The MPC has been purchasing assets financed by new money the Bank creates electronically. This policy is designed to inject money directly into the economy. This is in response to a sharp fall in demand as business and consumers reduced their spending. In short, there's not enough money in the economy. The aim is to boost spending to keep inflation on track to meet the 2% target. Alongside its decisions on asset purchases, the MPC continues to set 'Bank Rate' (more on this later) each month.

The Bank purchases assets from private sector businesses, including insurance companies, pension funds, high-street banks and non-financial firms. Most of the assets purchased are government bonds. There's a large market available, so the Bank can buy substantial quantities of assets fairly quickly.

The injection of money into the economy works through different channels and has a variety of potential effects. When the Bank buys assets, this increases their price and so reduces their yield- that means the return on those assets falls. This encourages the sellers of assets to use the money they receive from the Bank to switch into other financial assets like company shares and bonds. As purchases of these other assets start to increase, their prices rise, which pushes down on yields generally. Lower yields reduce the cost of borrowing for businesses and households. This in turn leads to higher consumer spending and more investment.

Higher asset prices also make some people better off, which provides an extra boost to spending on goods and services. The Bank of England is also buying smaller amounts of private debt like corporate bonds. These purchases are aimed at improving conditions in capital markets, making it easier for companies to raise money which they can invest in their business.

There is another way the Bank's purchases of assets could put more money into the economy. Those selling assets to the Bank deposit more money into their bank accounts, so commerical banks have more funds which they can use to finance new loans, and more bank lending supports spending and investment. But this channel is likely to be relatively weak as banks continue to repair their finances in the wake of the crisis. That's why the Bank of England is buying most of the assets from firms other than banks. The extra money the Bank of England is injecting into the economy should increase spending to help keep inflation on track to meet the Government's 2% target.

Without that boost, the amount of money in the economy would be too low, spending would be weaker, and inflation might fall below target. But as perceptions of an improvement in the economy begin to spread, this will stimulate business and consumer confidence. That will help to underpin expectations that policy is beginning to work, which should itself encourage more spending and keep inflation in line with the target.

As it sets policy each month, the Monetary Policy Committee will continue to be guided by the outlook for inflation relative to the 2% target. If the Committee thinks inflation looks set to rise above target, it could raise Bank Rate, and sell assets to remove the extra money it has put into the economy.

Source: Bank of England

How Monetary Policy Works: 

When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation.

The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.

A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.

Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.

Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.

Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices.

Some of these influences can work more quickly than others. And the overall effect of monetary policy will be more rapid if it is credible. But, in general, there are time lags before changes in interest rates affect spending and saving decisions, and longer still before they affect consumer prices.

We cannot be precise about the size or timing of all these channels. But the maximum effect on output is estimated to take up to about one year. And the maximum impact of a change in interest rates on consumer price inflation takes up to about two years. So interest rates have to be set based on judgements about what inflation might be – the outlook over the coming few years – not what it is today.

In March 2009, the Monetary Policy Committee (MPC) announced that it would reduce Bank Rate to 0.5%. The Committee also judged that Bank Rate could not practically be reduced below that level, and in order to give a further monetary stimulus to the economy, it decided to undertake a series of asset purchases. (See QE above)

Source:Bank of England

Transmission Mechanism of Monetary Policy:
The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the ‘transmission
mechanism’ of monetary policy.

First, official interest rate decisions affect market interest rates (such as mortgage rates and bank deposit rates), to varying degrees. At the same time, policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held, as well as affecting asset prices and the exchange rate.

Second, these changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. For example, other things being equal, higher interest rates tend to encourage saving rather than spending, and a higher value of sterling in foreign exchange markets, which makes foreign goods less expensive relative to goods produced at home. So changes in the official interest rate affect the demand for goods and services produced in the United Kingdom.

Third, the level of demand relative to domestic supply capacity—in the labour market and elsewhere—is a key influence on domestic inflationary pressure. For example, if demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some
firms may be able to pass through into higher prices charged to consumers.

Fourth, exchange rate movements have a direct effect, though often delayed, on the domestic prices of imported goods and services, and an indirect effect on the prices of those goods and services that compete with imports or use imported inputs, and hence on the component of overall inflation that is imported.

Source:Bank of England

August 2012 inflation report: 
Global demand growth has slowed, with activity in the euro area being especially weak. In the
United Kingdom, output has been broadly flat over the past two years. Although output is
estimated to have fallen for three consecutive quarters, the scale of that contraction was amplified
by a number of erratic factors and so probably exaggerates the weakness of underlying activity.
Even so, underlying demand growth is likely to remain muted in the near term. But a gentle pickup
in the growth of households’ real incomes, combined with the stimulus from the asset purchase
programme and the Funding for Lending Scheme should spur a modest recovery. The impact of the
euro-area debt crisis, together with the fiscal consolidation and tight credit conditions at home, is
likely to continue to weigh on demand.

CPI inflation fell further, standing at 2.4% in June. The near-term outlook is lower than three
months ago, reflecting falls in energy prices and some broader-based weakness in price pressures.
Under the assumptions that Bank Rate follows a path implied by market interest rates and the size
of the asset purchase programme remains at £375 billion, inflation is a little more likely to be below
than above the 2% target for much of the second half of the forecast period, as the impact of
external price pressures wanes and domestic cost pressures ease. The risks to inflation around the
target are judged to be broadly balanced by the end of the forecast period.

Would definitely recommend reading the Bank of England's report if you wish to learn more- it is very accessible!

Hope this was helpful!

Unemployment figures-how do you explain it?

Just realised I have been neglecting this blog for far too long! I am entering a very hectic period in regard to university applications and the like, but I am going to make it an aim to post at least twice a week!

Many things have been going on since my last post, but my attention has been caught by some of the latest unemployment figures. I am baffled by the decrease in unemployment, even though we are still in a recession. I have read a few blog posts by senior economists on this matter, but the one that caught my attention was one by Stephanie Flanders. She provides a range of explanations for the figure, along with some statistical data to back up her claim.

If you examine the figures further, you find that there has been a large increase in the number of people taking up part-time work, therefore contributing to the decrease in unemployment. There has also been a rise in those who are self-employed, and therefore it is hard to tell how much they are adding to the economy, after all being self-employed doesn't ensure a great deal of economic activity.

It will be interesting to see the level of unemployment after this olympic euphoria has died down (London accounts for half of the increase in employment.) Here is a copy of the article:

"Here's the statistic that Britain's finest economic brains simply cannot explain: the number of people in work in the UK has risen by 201,000 in the three months to June, a period in which our national output is supposed to have shrunk, by 0.7%.

It's good news that there are more people in work, and that unemployment has fallen by 46,000 in those months as well. But it's not necessarily good news that collectively, as a nation, we seem to be needing to hire a lot more people, to make less stuff.
I have discussed this many times before, because it's a puzzle that has been with us for a long time (see, for example, this article from June 2011).
You might ask why it's so important to get to the bottom of this. If there's one part of the economy that's producing some good news - why not just sit back, and enjoy the novelty? The trouble is that the longer the puzzle continues, the more potentially worrying it becomes, because it becomes less and less likely that simple measurement error explains it.
It is quite possible that the economy is stronger than the official statistics suggest: in fact, we already know that construction and industrial output were stronger in June than the ONS expected when they came up with their first estimate for the change in GDP in the second quarter. Other things equal, that could see them revise up their numbers later this month, to show the economy shrinking by 0.5%, instead of 0.7%.
But that's a pretty small revision. Even if the extra Bank Holiday also pulled down the numbers temporarily, we'd still be looking at a flat economy, which somehow produced more than 200,000 jobs.
And, to state the obvious, it's not just the past few months that needs explaining. The latest figures suggest there were 501,000 more people in work in the UK in the second quarter of 2012 than there were two years earlier, when our economy is supposed to have been slightly larger than it is now.
To get rid of that longer term mystery, the ONS would have to decide that everything it had said about GDP in the past two years was wildly wrong -that instead of being flat, we actually grew by more than 2%.
That is possible. But implausible, even to those - like the Bank of England - who believe the ONS does tend to understate growth. You don't find that amount of missing output behind the sofa.
Of course, there is the other possible explanation, that the jobs figures are actually worse than they look. It is true that about a quarter of the rise in private sector employment in the past two years has been part-time work. Today we saw the number of people reporting they were in part-time work because they couldn't get a full-time job reach another record high.
More than 1 in 4 of the new private sector jobs created in that time were self-employed. Here at the BBC we have interviewed many self-employed people in recent months, including for tonight's piece for the television bulletins. Many say they are barely working at all - certainly a lot less than they would like. There are some who look and feel like budding entrepreneurs. But quite a lot of them would not describe themselves in this way at all.
Still, that leaves a roughly 280,000 increase in the number of people working full-time for a private sector employer during the past two years, when the economy has been weak, at best.
Pay may be part of it: today's figures show average earnings are still not keeping up with inflation. Wages for most workers have been falling, in real terms, for several years. That has made it easier for companies to keep people on or hire more workers to do the same job. But again, it can't be the whole story.
Some say the simplest explanation is also the right one. There is no puzzle. We're just a lot less productive than we were before the crisis, because we've ended up shrinking our highly productive sectors, and expanding our less productive ones. But, as the Bank of England points out in its latest Inflation Report, the figures don't really support this explanation either. About two-thirds of the increase in private sector employment has been in high-skilled occupations.

Another common explanation is that companies have been "hoarding" staff, taking a hit during the slump for fear of not being able to re-hire good people when the economy picks up. But the latest figures don't really back that up either: figures from the Labour Force Survey don't show any fall in the number of people leaving their jobs, relative to the years before the crunch. Quite the contrary.
Finally we're left with the explanation favoured by Britain's finest economic detectives at the moment (not to mention senior policy makers): it's a mixture of all of these possible factors, plus, maybe "something else".
That's a pretty unsatisfying conclusion. If it were the last page of a detective novel, you'd be asking for your money back. But this isn't a novel. Economic mysteries usually get solved, eventually, you just have to "let the data run long enough". That's economist-speak for waiting to see what happens.
We know that the Olympics and other one-offs have distorted the recent figures: London accounts for nearly half the rise in employment. In Yorkshire, Midlands and Northern Ireland - unemployment actually went up last month.
Many analysts think the rest of the country will also see unemployment tick up again in the next few months: the latest private surveys of employers have been pretty gloomy. But the curious case of the UK labour market that wouldn't quit is likely to keep Britain's economic minds enthralled for some time to come. "

BBC- Stephanie Flanders 

Inflation down-but is it what we want?

Sorry for the gap in posting...have been trying to get on top of a whole pile of books that need to be read before the end of the summer!

The Bank of England recently announced that inflation was within its intended target of 2% +/- 1%. It has fallen from 2.8% in May to 2.4%, which is the lowest inflation rate since the end of 2009. However, while this seems like a rest-bite for the Bank, which has come under scrutiny lately for the Libor scandal, do we actually want an inflation target of 2%?

I am currently reading Paul Krugman's End This Depression Now! which suggests that we should actually have an inflation target of 4%, which was actually the rate of inflation during Ronald Reagan's second term in office when he presided over a period of economic recovery, often referred to as "Good Morning America." An inflation target of 4% is not ridiculously high, and fears of hyperinflation and the like are unnecessary.

Over my AS course, I have been taught that inflation is not desirable, and inflation can have serious negative consequences for an economy. However, if you take our current situation as a depression, higher inflation could be desirable for three reasons.

The first reason was published in an IMF report in 2012, where a chief economist reported:

"When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint.

It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap. But it is clear that the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions."

To summarise this idea, if we had started with a higher inflation target, when the crisis came about in 2008, we would have had more room to manoeuvre our interest rate target in order to deal with the crisis. As it was, the zero nominal interest rate was reached quickly, and I believe I would be right in saying this lead to us being in a liquidity trap, where 0% interest rate isn't low enough.

The second reason for a higher inflation target would be greatly beneficial to European nations such as Spain, where their wages are very uncompetitive in comparison to Germany. If they were not in the Euro, they could simply devalue their currency, but as that is not an option, they must enforce nominal wage decreases, which are always going to be highly unpopular. As the Economist reported, "If inflation is humming along at 4%, however, then real wages can adjust downward more easily, simply by not keeping up with the price level. A higher inflation rate is therefore consistent with greater labour market flexibility and lower unemployment." 


Another advantage of higher inflation is that the real value of debt would decrease the higher the inflation. This would be both beneficial to the government in terms of dealing with their debt, and private households. If we had higher inflation, then households would be encouraged to take out loans and increase demand for products now, as the real value of their debt would decrease in the future.

These arguments are just some food for thought, and there are many counter-arguments!

QE3- late but worth a mention

Sorry that this post is a bit late- been quite busy lately!
Well the Bank of England announced last week that it was to inject £50bn into the economy in its third round of Quantitative Easing. Surprisingly, I haven't seen that much coverage of the plan around the internet (most likely because the effects of this plan are already known), but Stephanie Flanders' analysis is both interesting and accessible:

"The Bank's monetary policy committee (MPC) voted to spend another £75bn on government bonds last October, and another £50bn in February - to make a grand total of £325bn since March 2009. The additional £50bn announced today will take it up to £375bn, though it's worth noting that the new money will be spent at a slower rate than before - over four months instead of three.
Some will see that slower pace as a hint that members of the MPC think this bout of easing will be less powerful than in the past - or perhaps that they are worried about possible negative effects of continuing the policy for so long. But the Kremlinology is less important than the fact that they have done it at all.
On the face of it, the Bank has not got a lot in return for the £125bn it has spent since the autumn, other than a pile of government IOUs.
The narrowest measure of the money supply - in effect, cash on bank balance sheets - has risen by 58% since September, as you'd expect when the Bank is handing their customers all that freshly created money in exchange for the purchased gilts. But there is not much sign of that getting out into the broader economy. Lending to households and companies has risen by just 0.2% in that time. (Thanks to Vicky Redwood, chief UK economist for Capital Economics, for pulling these numbers together for me. For those that care about these things, we're using the M4 measure of lending - excluding transactions between different parts of the financial system which otherwise distort the figures.)
Other things have also been moving in the wrong direction, from the Bank's standpoint. The pound has risen about 6%, on a trade weighted basis, since October, and the FTSE is only slightly higher.
Finally, borrowing costs for companies and households, if anything, have crept up. The Bank's own figures showed the average new mortgage rate creeping up to 3.75% in May, higher than in April and more than a third of a percentage point higher than at the start of the year.
Of course, you can blame the eurozone crisis for a lot of these unhelpful developments - maybe all of them. Without that extra liquidity sloshing around the financial system, Bank officials would say things would have been considerably worse.
As ever, the argument would be that the Bank cannot hope to control what is happening across the Channel, or prevent it from darkening the prospects for the UK. But it can do all it can to offset the upward pressure on bank funding costs and the downward effects on confidence. They would also point out that if their forecast shows inflation dipping below target in two or three years, the Bank can hardly sit on its hands.
All of that is true. But it is a striking reflection of our times that the MPC is continuing with more QE, three weeks after the Bank's governor and deputy governor admitted, in separate speeches, that asset purchases, on their own, were not enough.
Sir Mervyn King could scarcely be gloomier about the short-term outlook for the eurozone - and the UK. He repeated again recently that we were "only halfway through" the crisis - and warned that the economic situation had deteriorated dramatically in a matter of just a few weeks.
Yet, somehow, he and his fellow policy-makers at the Bank must convince the country, and the City, that more quantitative easing will meaningfully offset this gloom, and that further steps - like easing the liquidity requirements for banks, and the "funding for lending" scheme - will finally encourage banks to lend, and firms and households to borrow and spend. That's despite the fact that British banks are already holding idle liquidity worth around £500bn - about 30% more than regulators have formally required them to hold.
There might not be many other avenues open to our central bank in the current climate, but making that case is going to be a challenge, to say the least" 

It strikes me, someone who is not a professional economist and has very limited economic knowledge, that although the Bank's policies can have some tangible impact, the real need for these policies is all to do with confidence. The effect of QE is to increase confidence of households and firms in banks. However, with a gloomy economic outlook, it seems as if the Bank need to do something radical if they want to have a real impact. 
http://www.bbc.co.uk/news/business-18725082