What IS happening to prices?

During the Great Depression prices in the US fell by 10% a year from 1930 - 33. Fears of deflation are obviously weighing heavily in the minds of the Bank of England's MPC (see 'Turn on the printing press' below) But what exactly IS happening to prices in the UK.

On the government's preferred measure of prices (the Consumer Price Index - CPI), prices were UP 3.0% last month compared to January 2007. So what is all the fuss about deflation? Part of the problem is that whilst the CPI shows prices rising the comparisonn is with the same period last year. So prices may be falling but they may still be higher than last January. The expectation is that by the middle of the year CPI will be showing more of the trend that worries the Bank of England.

An alternative measure of prices, the RPI (Retail Price Index), shows prices last month only 0.1% higher than last January. But the RPI includes a measure of mortage interest payments which are falling due to lower interest rates and falling house prices. The correction in house prices is probably in itself desirable. Asset price bubbles as they are known (over-inflated house prices for eaxmple) tend to devote scarce resources away from their most productive uses - a little less obsession with property prices would not be a bad thing. The house price bubble of the last decade is, after all, why we are where we are today and what led to 'creative' banking practices at the root of the credit crunch.

Prices, then, may not be falling and inflation may still be above the Bank of England's target rate of 2%. But, as we have seen, economic indicators can turn on the head of a pin.

Watch this space ...

Useful weblinks

Spectre of deflation haunts Britain (Independent)

Turn on the printing press

The latest minutes of the Bank of England's Monetary Policy Committee (MPC) recorded a unanimous vote in favour of the Bank requesting premission from the Chancellor of the Exchequer to turn on the priniting presses and print more money. In an unprecented move the Governor of the Bank of England is expected to write to Alistair Darling within the next few days.

There has been much about 'quantitative easing' on this blog and in lessons (thanks to Rex Harrison). Here are just t a couple of links which economics students may find useful.

At the end of 2007 while writing a chapter on macroeconomic performance for the new OCR A2 economics textbook, I remember opening to a Study Tip with the words "you live in interesting times" - little did I know HOW interesting times would become!

Useful weblinks

Bank to request permission to print (Independent)

Stephanie Flanders on quantitative easing

Times graphic explaining quantatative easing

Guardian Q&A on quantative easing

Too high, too low - but not 'just right'

The rate of inflation in the UK is falling, whichever measure you look at. According to the latest CPI (Consumer Price Index) inflation was down to 3% last month. On the RPI (Retail Price Index) measure it was close to zero.

In the current climate monetary policy is being driven by a fear of deflation - falling prices. Listen to Stephanie Flanders report on the Bank of England's fears here.

Yet some believe that the slashing of interest rates is stoking up an inflationary problem for 2011. All of this uncertainty means that the period of price stability ushered in by the granting of operational independence to the Bank of England is over. It is anyone's guess whether prices will actually fall (deflation) or whether prices will rise (inflation) dramatically in 18 - 24 months time. According to Stephanie Flanders, the Goldilocks economy (where prices are 'just right') is a thing of the past. This makes things very tricky for the Bank of England ...

My challenge to Yr 12 economics students

Why are there different measures of inflation and does it matter?

Latte lessons

My Year 12 economics classes are now well into their weekly 'latte lesson'. The concept is simple - each Friday morning is a break from the monotony of the specification and a chance to explore something economic that takes the students' fancy. Oh, and the drinks, biscuits, homemade brownies and chocolate tea cakes the presenter must supply!

The result? Some fantastic research, presentations and discussions so far on the Japanese economy and Zimbabwe. And a couple of inches on my waist line too!

Rex Harrison was spurred on to research Japanese economic performance in the 1990s in order to draw lessons about the current economic downturn and the appropriate policy responses. Rex's explanation of quantitative easing was masterly - who will forget his matchstick bankers? I will make his presentation available on the VLE for everyone to download.

In the meantime, as interest rates in the UK fall to 1%, the likelihood of 'quantitative easing' grows stronger. Year 12 students might be interested in this interactive guide to quantitative easing from the FT as a follow up to Rex's presentation. I think the FT may have borrowed the idea from Rex!

Recession tracker

The word 'tracker' raises my blood pressure - a series of blunders by my mortage broker resulted in me moving from a 'tracker' mortage to a fixed rate mortage some 5 months ago. The dramatic decrease in interest rates since then is having little impact on the family finances!

That aside, the BBC's 'recession tracker' is a great resource for economics and business students. It gives the latest data and news on GDP, unemployment, interest rates, house prices and repossessions on a single page.

Check it out here.

Fed accused of 'drink driving'

Former Vice President and Chief Economist of the World Bank (and Nobel Prize winner for economics) accuses the US Federal Reserve of behaving like a drunk driver over its conduct of monetary policy.

In an interesting article in the Guardian, Joseph Stiglitz shifts attention from the symptons of the global economic downturn to the causes. Stiglitz argues that the current economic crisis is part of the "unwinding of 'global imbalances'". He calls for long term solutions to these imbalances and offers three solutions:

First, we need to reverse the worrying trends of growing inequality.
Second, the world needs enormous investments if it is to respond to the challenges of global warming.
Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates.

Read more by clicking here.

Who and what next?

'Cheers' to Charles Barry (U6) for his blog entry (see below). Anyone else want to join us?

1,200 job losses announced by M&S. Another 1,200 jobs lost at Nissan, Sunderland, the UK's most productive car plant. My Year 10 group may be quizzing me tomorrow, after today's discussion of the importance of productivity - guess which car manufacturing plant we were looking at?

Britain's oldest name in the clothing industry, Viyella, goes into administration (or at least part of the business does). The Sofa Workshop is on the brink of administration. Who is next? The impact of the recession deepens by the week - by the day would not be an exaggeration.

And UK interest rates come down to their lowest level since the Bank of England was founded in 1694. As Charles has explained there is a limit to how far interest rates can fall. With 0.5 percentage points knocked off the base rate today, the UK is now reaching this limit. What next? Will we see 'quantitative easing' and deliberate 'printing' of money to prevent the UK entering a period of deflation? Maybe. When the very politicians that gave the Bank of England its operational independence just over 10 years ago start talking about having a say in monetary policy you know that you are living in historic times. I first started to study economics at the height of 'monetarism' - a theory (actually more than that, as it provided the bedrock to a whole new political philosophy - Thatcherism) which urged governments to restrict the growth of the money supply. For an independent central bank to be contemplating deliberate expansion of the money supply is an even bigger shock than the return to fashion of Keynesian demand management.

What intrigues me about this is the battle for control over monetary policy which I suspect will grow over the coming months. Alistair Darling is effectively saying that responsibility for monetary policy decisions will now revert back to politicians. As an economist this scares me, but it doesn't surprise me. Monetary policy decisions made for political reasons are apt to destablise rather than stabilise the economy. And there is now talk of a further boost to government spending too. Economists don't always agree about appropriate policy responses, but at least the debate can be rational and objective. I know who I would want with their hands on the tiller.

Useful weblinks

Darling wants say on 'quantitative easing'

Economy may need a second cash boost

Bank cuts interest rate to 1.5%

"Quantitative Easing" - A way forward?

About roughly a month ago, I asked Mr Walton that perhaps, with the threat of deflation looming, the best thing for the Bank of England to do would be to print more money. My thinking was that by printing more money, the government would be literally shoving more money into the economy, which would in turn stem off deflation and potentially help to self-right the economy.

Sadly, as it was the end of period 3, Mr Walton gave me one of those looks which said "I really want to go and have a cup of tea", quickly mumbled "Yes" and made a sharpish exit from the room.

Now, without wishing to sound like I am the new prophet of the credit crunch or anything, looking at the papers now, my prediction seems to have come true.

Only 4 days ago the Open Market Committee of the US Federal Reserve (the American equivalent to the Monetary Policy Committee) announced its intention to start buying mortgage-backed securities (the supposed 'dodgy debt' that caused the credit crunch in the first place). Where would the money for this come from? The short answer: nowhere. The Federal Reserve will simply create money, electronically or through printing, to use to buy this 'toxic debt'.

Now, the upside for this is obvious: by putting money straight into the economy through such purchases, there are strong cash injections into the economy. Best of all, the government gets to do this for free. This will improve liquidity, allowing banks to start lending and business thus to start investing. It will reduce the cost of borrowing, allowing consumers and business alike more breathing space, reducing any potential falls in GDP and increases in unemployment.

You might start to wonder, however - since this is all so good, why don't we do it all the time? Well, as the saying goes, there's no such thing as a free lunch. The main danger with printing more money is that it has a strong inflationary pressure upon the economy. Milton Friedman won the Nobel Prize for Economics in 1976 for, amongst other things, the simple equation:

MV=PQ

Where M is the Money Supply, V is the speed at which money circulates through the economy, P is the price level (ie the level of inflation) and Q is the real economic output. Increasing the supply of money, by printing more of it, will increase inflation and/or GDP growth.

This effect can be so extraordinary that in Zimbabwe, where the government has been printing money for years, the economy suffers Hyperinflation. This is the rather comical situation where inflation reaches levels that devalue the currency so much that the economy cannot function properly. The official inflation level in Zimbabwe is 231,000,000%, meaning that when the $100 billion dollar note was introduced last October, it was only worth 8p.

However, inflation is not our main concern. We are currently experiencing a demand side slump in the world economy. Demand side slumps, or falls in the Aggregate Demand of the economy lead to higher unemployment, lower inflation (or possibly deflation) and falling economic output. The threat is actually from the pessimistic and demoralised economic situation that deflation can cause, and the economic depression that may result from the declines in consumer spending and reductions in employment levels of recent times.

Overall then, printing more money is potentially the only way forward. We are nearing the end of the usefulness of interest rates as a means of controlling the economy. In fact, low interest rates, as seen in Japan in the 1990s, may prove counter-productive (though something called "The Liquidity Trap" - where returns are so low that investment in anything is severely discouraged and people simply hoard money). In the short run, printing money may prove to be the most useful tool available to the government. But even in the medium term, it must avoid using it as a "magic bullet", a fix-all cure, and must know when to stop.

Otherwise we could leave the recession to find ourselves waking up to a inflationary crisis in 5 years time.

Further Info:

Forget Hard Choices. We need pampering - Anatole Kaletsky, The Times.
Press Release of 16th December - The Board of Governors of the Federal Reserve
Federal Reserve slashes Interest Rates to zero - Larry Elliot and Ashley Seager, The Guardian
Deflation: Making sure it doesn't happen here - Ben Bernanke, Governor, US Federal Reserve

When down is up

My Year 11 groups are looking at the management of the economy this week and have been asked to assess the effectiveness of fiscal and monetary policy in stimulating demand in the economy. Quite a big question, since that is exactly the one which is exercising the likes of Gordon Brown, Alistair Darling and Mervyn King.

Today we got to the point where we had traced through the impact of lower interest rates on the economy - the monetary transmission mechanism. OK, so that makes it all very simple we thought. That should mean that the Fed's latest interest rate cut (which brings US interest rates down to 1%) and the much anticipated cut in the Bank of England's Base Rate (some think as much as 1% will be lopped off the Base Rate) should give a welcome boost to demand.

But these cuts in interest rates just aren't getting through to households and firms who. in some cases, are paying higher interest rates than they have done in the past. So why when the Base Rate of interest is coming down are market rates of interest going up?

The answer lies in our attitude to risk. Lending money to anyone is now much riskier than it has been. So the rate at which banks lend to each other has risen (so-called interbank rates) and the rates they offer to savers has gone up to try to plug the hole in the bank's balance sheets. Look at the chart at the top of this post to see what is going on. Down really does mean up.

Watch this space as the Bank of England decides what should happen to UK interest rates this Thursday. In the meantime you might like to read some of the recent articles listed below.

Useful weblinks

Robert Peston's recent blog post on interest rates

US interest rate cuts

Bank of England may cut Base Rate by 1% point

It's all a beauty contest ... and the winner is ...?

John Maynard Keynes introduced the concept in his book, The General Theory of Employment, Interest and Money, in 1936. It goes something like this. The stock market behaves like a beauty contest in which people are asked to select the six faces they like most from a selection of around 100. Those picking the most popular face are entered into a prize draw to win a fantastic prize. How do you go about maximising your chances of being in the prize draw. According to Keynes, you don't choose what to you is the prettiest face:

"It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there aresome, I believe, who practisethefourth, fifth and higher degrees."

And so it is with the stock market. Or housing markets. Investors would be prepared to pay more for something that it is worth if they believe that others will pay even more for it in the future. And so you get bubbles in these markets which grow and grow, even if the fundamentals don't justify the high prices being paid. But bubbles burst and when they do, the rational thing to do is to keep selling whilst you believe that everyone else believes that prices will continue to fall. In short, what we have experienced over the last month or so is a classic failure of markets to value assets at their correct value.

Inevitably at this time, there is a more traditional beauty contest playing itself out. The contestants are flaunting their ideas for how best to rescue the economy from the downturn which we now know officially is under way. Alistair Darling thinks the solution, in part, is to bring forward public expenditure plans. A group of 16 economists writing in yesterday's Sunday Telegraph think not - best to rely on interest rate cuts, they say.

So, my question is 'who wins the economists' beauty contest (who is right) and why'? Usual rewards on offer ...

Useful weblinks

Stephen King's' article on the Keynesian beauty contest in today's Independent.

BBC report on the 16 economists disagreeing with Darling.

The letter itself

Roger Bootle's seven point summary of Keynesian economics in today's Telegraph

Beauty Expectations - online beauty contest game

All hands on the interest rate lever

When this blog was running on the department's VLE, a week didn't go by without some reference to the dilemmas facing the Bank Of Engalnd's Monetary Policy Committee (MPC). At that time the tension was between keeping interest rates unchanged to keep inflationary pressures under control and bringing them down to anticipate a feared slowdown in economic growth.

All that seems a long time ago now! The crises in the financial markets have dominated thinking - Paulson plans, rescue packages, nationalisations and falling stock markets to name but a few debates raging. Last week's 0.5% co-ordinated cut in interest rates by the Bank of England the Federal Reserve and others didn't get the attention it might otherwise have got in more 'normal' times.

However, the global slowdown now gives central banks greater freedom to act to loosen monetary policy. Oil prices have fallen and so too have commodity prices. The inflationary pressures that concerned central bankers at the beginning of the year are receeding.

And so, some economists are now predicting historically low interest rates by the end of 2008. Roger Bootle, interviewed on Radio 4's Money Box programme, has predicted that interest rates might fall as much as 1% by Christmas and be down as low as 2% by next spring. If they did fall this low it would be the lowest interest rates have been since the creation of the Bank of England in 1694.

Forecasts are just that, forecasts. What is more important than whether interest will fall is what impact falling interest rates will have on the economy. Will lower interest rates stimulate spending and growth and can governments rely oon monetary policy alone to fend off a recession?

Two quick questions (give your answers via a comment to this blog)

1. Under what circumstances might reductions in the Bank of Engalnd's interest rate have little impact on the overall level of spending in the economy?

2. What is the 'liquidity trap' and with which British economist is this concept most closely associated?