With the problems in the credit markets and prospects of recession, a reader recently asked what would make a good investment in the current economic climate?

I don’t know whether a penniless economist is the best person to advise about investing, however, these are some of the basic principles behind the different options for investment at the present moment.

Housing Market

The housing market has outpeformed most other types of investment in recent years. I still remain a believe in the long term prospects of the housing market in the UK. However, for the next 1-2 years, I expect house prices to fall slightly. If you are thinking of investing for the next 10-20 years in the future, the shortage of supply relative to demand is likely to keep pushing prices higher. However, there is no harm in waiting for 12-18 months to see how much house prices fall. It may also become cheaper to borrow when the credit crunch ends (hopefully within 12 months) Don't Buy

Share Prices

In a recession, firms make less profits, pay lower dividends and so share prices fall. The stock market may seem like a good place to avoid, especially given recent turbulence. However, it is my belief that the impact of a recession is already built into share prices. Sometimes share prices can actually rise in the period of a recession, because analysts are already looking forward to the recovery. Investing in the stock market has given pretty poor returns in the past few years, but, I think many shares now offer good value. Bargains to be Found.

Mineral Prices

In a recession, people often resort to investing in solid products like silver and gold. It is seen as a safe alternative to market based share prices. The price of metals and other commodities are also being pushed higher by:

1. Depreciating dollar. Because of the dollar’s weakness, gold is becoming seen as an attractive alternative. As long as the US economy is suffering falling house prices a declining economy and low interest rates, the dollar will remain weak. This will make Gold attractive as an alternative
2. Rising Demand. Global growth, especially amongst the big two of China and India is causing rising demand for raw materials such as metals, gold and energy. There seems no let up in economic growth in India and China, however, the rising inflation rate indicates chance of boom and bust in China. Nevertheless mineral prices still offer chance for growth because of rising demand.

Government Bonds

Government bonds offer the chance to make a secure investment and stable interest rate. However, on long term bonds, the market price is inversely related to the market interest rate. If interest rates fall by more than market expectations then the price of bonds will rise. In the UK, this is a possibility, but there is a little prospect of dramatic changes in prices, it is most likely that bonds will just offer secure but steady investment

Any Currencies worth buying?

Some are touting the Euro as an alternative to the dollar as the world’s most important currency. But, I would be wary of investing in the Euro as the euro economy is doing pretty poorly. It could follow the US into recession and this would make the Euro look overvalued. If you fancy a gamble look for a currency like the Brazilian Real, which has done very well in the past 12 months (helped by G.Soros’s speculation)

It is widely accepted that the decision to make the Bank of England Independent was a positive move for the economy. Furthermore recent economic data suggest that the the Bank has been successful in achieving its target of low inflation and stable growth.

The Bank can take some credit for this improvement in UK inflation performance. In particular,
The Bank's independence means they avoid cutting interest rates for political reasons.
They have helped increase confidence in Monetary Policy; inflation expectations are lower. This makes it much easier to keep inflation low.

Of course, the low inflation is not entirely due to their monetary policy decisions. They were fortunate to inherit a stable economy in 1997. It will also be interesting to see how they cope in coming years. Their task is made more difficult because there appears to be a rise in cost push inflation and lower growth. This means achieving the inflation target may come at a cost of lower growth. With a general election coming up, the MPC is likely to keep interest rates higher than if the Chancellor was still able to set rates.

However, there is a danger that the Bank's remit is too narrow and that as we discussed here - inflation is not the only target to consider.

More thoughts on the success of the Bank of England in keeping inflation low.

• More on Bank of England
• History of Bank of England at B of E official site
• Brown makes Bank of England free at BBC site

A humorous look at the calculation of the Consumer Price Index, courtesy of News Biscuit.

"Crysta

l meth, crack and skunk have all been added to the typical basket of UK goods used to measure inflation, the Office for National Statistics has announced. Speed, bennies, glue and chewing tobacco are all to be removed from goods used to measure the Retail Price Index.

Increased consumer spending on crystal meth and crack reflects changes in modern shopping habits says the government department, which updates its 650-strong basket of goods and services every year, to better reflect public spending trends. ‘Crystal meth and skunk have been added as the popularity of make-at-home drugs continues to rise.’ said an ONS spokesman.

The bureau’s website explained that skunk was being included for the first time to reflect the fact that rolling your own is now more popular than smoking illegally imported foreign cigarettes and because in volume terms it is thought to outsell most breakfast cereals."

Source: News Biscuit

The interesting thing is that it does raise an issue of how the official measurement of inflation ignores the real cost of living. Clearly goods consumed on the black market are not going to be included in the CPI, but, this does mean the CPI is more limited as a measure of the actual cost of living.
More standard criticisms of CPI focus on the fact CPI ignores housing costs and other common living costs.
Also inflation rates can vary significantly between different sections of society. E.g. old people disproportionately affected by rising energy prices

• CPI and RPI inflation Rates in UK

"If higher unemployment is the price we have to pay in order to bring inflation down, then it is a price worth paying."

- Norman Lamont, Chancellor of the Exchequer. 1992.

John Major also said "If it's not hurting, it's not working"

Unemployment vs Inflation is a trade off that policy makers often face. But, this particular statement was widely seen as a political gaffe or just a callous disregard for the costs of unemployment. To make such a bold statement is to suggest the government cares little for the personal cost of those who are made unemployed but is it justified and is there good economic rationale behind this?

What is the justification for making this statement?

1. The Unemployment will only be temporary and a necessary step to overcome the inflationary pressures in the economy.

If inflation is high, it is invariably necessary to slowdown the economy to reduce inflation. There are no easy ways to reduce inflation. To reduce inflation will require either tight Monetary policy (higher interest rates) or tight fiscal policy (higher taxes and lower government spending.) These policies will reduce aggregate demand and reduce inflationary pressures. However, these will cause a slowdown in growth and rise in unemployment. However, this slowdown is only temporary and after inflation has been reduced and people expect lower inflation, the economy will be able to expand creating low unemployment and low inflation.

• To some extent N.Lamont will claim to be vindicated by events. Although unemployment rose to 3 million in the early 1990s, inflation was reduced and since then the economy has experienced a long period of uninterrupted growth without inflation and unemployment has fallen.

2. Costs of Inflation.

It is argued that inflation leads to lower living standards in the long run. High inflation creates uncertainty and confusion about future prices and costs. This tends to reduce business investment and leads to slower growth. High inflation also creates menu costs for the economy and more importantly will contribute to deteriorating competitiveness in the economy. Unless inflation is reduced the economy will always grow at a slower rate than it could with low and stable inflation.

3. Inflation and Hysteresis.

It is widely accepted that previous inflation rates have a strong bearing on future inflation. If an economy experiences high inflation, people expect high inflation in the future. This becomes self fulfilling as workers demand higher wages and firms push up costs. If inflation is reduced then it becomes much easier to keep it low in the future.

Problems of the Statement.

1. Unemployment Can Last for A Long Time

When the Conservative party came to power in 1979, inflation was over 20% the government implemented high interest rates and tight fiscal policy in an attempt to control the money supply and inflation. They were successful in reducing inflation but at the cost of a deep recession. Unemployment rose to 3 million and high rates of unemployment persisted until the late 1980s. Arguably the social costs of unemployment are far greater than inflation. If there are lower levels of investment it is not as damaging and dispiriting as having no work. The fact that the early 1980s saw many riots in the inner cities show the social problems which unemployment can create.

2. Targeting Inflation lacks balance.

If your only target is low inflation then the danger is that the monetary authorities will become blind to other economic issues. It is my belief that the 1981 recession was deeper than necessary. The enthusiasm to reduce inflation was overdone; if they had given greater importance to unemployment they would not have persisted with anti inflationary policies for so long. Similarly the 1991 recession was deeper than necessary because of the insistence of remaining in Exchange Rate Mechanism for so long. True, low inflation is important but to target at the exclusion of all else misses the whole point.

Conclusion

One irony of the statement was that the inflation was largely avoidable. The economy was allowed to expand far too quickly in the late 1980s leading to the boom and inflation. If the economic cycle had been better stabilised the government wouldn't have been left with the difficult dilemma.

Stagflation.

The danger of targeting only inflation becomes more apparent in a period of stagflation. This means both inflation and unemployment rise due to the Aggregate Supply shifting to the left. In this case, keeping to a low inflation target risks causing a widespread downturn in the economy. In periods of stagflation flexibility may be required in inflation targets, even if this risks reducing confidence in inflation policy.

Chinese Reckless Gamble for Growth

China on the other hand is an example of an economy which should be putting more emphasis on low inflation. It is has allowed inflation to creep up over 7% in a bid to maintain very high levels of growth. But, at these rates of inflation, they risk a boom and bust economy.

Moral hazard means that certain policies merely encourage more bad economic decisions.

A simple example is insurance. If our bike is ensured for the full amount, we have less incentive to look after it. Therefore, when we get insurance there is a greater chance it will get stolen. This is why insurance firms do not insure for full amount but make us pay the first £50 or £100.

Many, including Chairman of the Bank of England, Mervyn King, have argued the Fed's decision to cut interest rates will cause moral hazard in the US finance sector.

Why Cutting interest Rates could cause The Same Problems to Reoccur.

1. US finance companies made a lot of very poor decisions to lend to borrowers who were likely to default. These bad loans were made to people with poor credit histories or low incomes.

2. Because the banks made many poor decisions they suffered the consequence of record loan defaults. Banks and mortgage companies need to take responsibility for their poor decisions and lack of self regulation.

3. The loan defaults caused problems throughout the banking sector. The magnitude of loan defaults caused a freezing of money markets because the finance sector has swung to the other extreme and no longer wants to lend to anyone.

4. This credit crunch has caused a fall in stock markets and has endangered the future of the US economy.

5. To Avoid recession and restore confidence in the finance markets, the Fed have aggressively cut interest rates from 4.25% to 2.25% in a matter of months.

6. This is the main problem. The Banks have created a crisis and the authorities respond by trying to mitigate their bad decisions. Because Bear Sterns has been rescued, because interest rates have been drastically cut, the finance sector hopes to avoid the consequences of their previous bad decisions.

7. However, the problem is that if the authorities prevent the negative consequences of poor lending the finance sector may feel that it will be fine to do it in the future. Basically, if they make poor lending decisions it doesn't matter because the Monetary authorities have promised to bail out the finance sector. If poor lending decisions are punished then in the future, banks have a clear incentive to avoid making inappropriate loans.

8. The interest rate cuts which occured in the past months, maybe good from a short term perspective, but, in the long term it may merely create a future financial crisis

The Only Thing We Learn is that We learn Nothing.

Remember the dot com bubble? Financial investors got carried away speculating on dot com shares. The effect was that prices became divorced from reality before a spectacular crash.

This crash threatened a short term downturn, so the Fed aggressively cut interest rates to 1% to avoid a serious recession.

However, this rate cut to 1% created moral hazard. The finance sector was bailed out. - Create a bubble and it doesn't really matter because the monetary authorities will try and bail us out. In 2001 and 2002, these exceptionally low interest rates helped to create another bubble. This time in the housing market. Again this bubble burst in 2006 and now we see the monetary authorities responding by trying to mitigate the short term effects.

To be fair the Fed are between a Rock and a whirlpool. If they keep interest rates high a deep recession is inevitable. Cut interest rates and they risk causing moral hazard and a future bubble. It is easy to criticise the decision to rescue Bear Sterns and cut in interest rates. However, it would also be easy to criticise a decision not to rescue Bear Sterns and keep interest rates high. The Fed certainly face a difficult dilemma; unfortunately it is of their own making. In particular the decision to keep interest rates for so long during the early 2000s means they are now having to deal with the consequence of boom and bust

Readers Question: You are a market analyst specialising in the oil industry and have been asked to forecast the likely price of oil in 2008. Carefully explain the reasons behind the forecast you make.

Oil Price Increases

Oil prices have increased significantly since 2003. They are now trading at over $100 a barrel and there is uncertainty about their future directions.

Graph of Oil Prices

Future Direction of Oil Prices

It really is quite difficult to predict oil prices in the coming 12 months. The rise in the price is partly due to demand rising faster than supply however, it is also been driven higher by speculation. It is difficult to know how the markets will treat oil in a climate of increased financial insecurity. However, I would expect oil prices to remain above $100 and possibly even increase by another 10%

Factors that will cause Rising Oil Prices

1. Continued growth of Chinese and Indian economy. With China growing at 10% a year and India growing at 7%, there is a strong and continued increase in demand for oil. It is important to bear in mind the significance of these increases. Rising demand from China is likely to outstrip a slowdown in US.
2. Demand is Income Elastic. As China, India and other countries develop there is evidence that demand for oil is income elastic. It means that as income rises the new middle class consumers spend a bigger % of their income on cars and petrol. Therefore demand is quite significant.
3. Constraints on Supply. Political uncertainty in the middle east, especially around Iraq and Iran is putting limits on supply of oil. Therefore, this raises scope for future higher prices. There still seems to be some difficulties around the supply in countries such as Mexico and Siberia. If these are unresolved prices could continue to rise.

Forecast for the Dollar Price of Oil

It is important to remember that oil is price in Dollars. Therefore the rise in the price of oil is partly caused by the weakness of the dollar. Measured in Euros or Yens, the rise in price of oil is less significant. However, the outlook for the Dollar remains poor in 2008. The Fed have cut interest rates sharply in response to impending recession. A recession will weaken inflation and enable interest rate cuts. Lower interest rates attract less hot money flows.

The Difficulty of predicting Oil Prices.

There is a strong element of uncertainty about future oil prices. This is because oil prices are often driven by speculation and non-fundamentals. e.g. high growth and high demand are fundamental reasons explaining higher prices, but oil prices are also determined by speculators and their general mood. For example, the assassination of Benazir Bhutto was said to have explained a temporary increase in the price of oil. However, there is no obvious link between her death and the supply and demand of oil.

• Suppose, you bought a cup final ticket for £30 and then lost it. Is it ever rational to pay £100 to a ticket tout so you can get to see the game?
• If you bought goods for £5. Is it ever rational to sell them for £1?

Economists note that consumers often behave in an irrational way. In particular we get attached to past actions and therefore fail to maximise our present utility.

Suppose you buy a CD player for £25. This means that you give the good a value of at least £25. However, if it gets stolen, do we immediately go out and replace it? A rational consumer would, because presumably they still will get the same utility from the good. If it was worth £25 yesterday, it should be worth £25 today.

But, in practice many consumers no longer want to buy another CD. They tend to think of the cost as being £50. They think £25 is good value, but to spend a total of £50 is too much. Alternatively, we delay buying the CD player for a long time. However, if we are going to get a CD player, the sooner we buy it the higher our total utility will be.

The problem is that we think of the total cost rather than the marginal cost. The initial £25 is spent, regardless of whether we get a new CD player or not. If we still think it is worth £25 it makes sense to buy the good and not worry about the initial £25 we have lost.

The other problem is that we may buy the second CD player but feel miserable because we have spent a total of £50 which is more than we want. However, we have not made any wrong decisions in buying a second player. We have maximised our utility given the choices facing us.

Admittedly, for some consumers there may be budget constraints; but budget constraints aside the above example is worth careful examination. The important thing is that taking into account past purchases does not help maximise our future utility.

To answer the first question is it worth paying £100 to a ticket tout. - Well it is if you give value to the cup final of £100 or greater. The price of your first ticket is immaterial.

Buying Goods That Go Up in Price

Sometimes we get the opportunity to buy really cheap goods but decide not to buy them. When they go up in price we become reluctant to buy them because we perceive them as being 'more expensive' But, the previous price shouldn't weigh on our decisions. The important thing is whether it is worth paying £40 now or not.

• If a coat is reduced in price from £200 to £40 we have an incentive to buy it because we think it is 'good value'
• In another shop the same coat is increased in price from £20 to £40 - we are reluctant to buy because it has doubled in price.

But, it is still the same coat. It's value should not depend on its previous price.

Selling Christmas Trees

Suppose you bought Christmas trees for £5 each and started selling them for £10. However, on Christmas Eve you still have 20 left over. In this case, it is better to sell them for £1 and get £20 rather than not sell any more and then have the cost of disposing of them.
The Christmas tress are a fixed cost. On Christmas eve, the fixed costs are gone, so you might as well get as much revenue as you can.

It is an example of the phrase, 'no use crying over spilt milk'

Related Essay:

• The Difference Between Economists and Non Economists

Readers Question: Why is the US economy facing an economic meltdown?

The US economy faces many severe problems, a falling stock market, record levels of public debt, banks on the verge of bankruptcy, frozen money markets, a plummeting dollar and the imminent threat of a recession. How did the US economy get into such a desperate situation?

The Housing market

The housing market plays a crucial role in determining consumer spending and therefore the rate of economic growth. When house prices are rising, consumers experience an increase in wealth; this boosts their confidence and enables them to remortgage and gain equity withdrawal to spend. When house prices fall, the opposite happens.

The Housing Bubble.

Up until 2006, US house prices rose rapidly; against a backdrop of rising house prices many analysts felt that even risky mortgage loans were safe and this encouraged even more unsuitable mortgages. For example, it was hoped 100% mortgages would be easier to pay back because rising prices would give homeowners an effective deposit.

The combination of low interest rates, aggressive marketing of mortgages and overly optimistic predictions for the housing market caused house prices to rise. However, the ratio of house prices to income went far above the long run trend rate; making mortgages increasingly unaffordable for first time buyers. Then in 2006 the Fed were forced to raise interest rates to over 4% because of inflationary pressure in the economy. This increase in interest rates caused many mortgage owners to struggle with their repayments. Also, there was another problem - many new mortgages were 'balloon mortgages' this means that for the first two years homeowners had a specially low introductory rate. However, after two years, the mortgage rate suddenly shot up increasing monthly payments very significantly. Therefore, first time buyers who had stretched themselves to get a mortgage suddenly found themselves with a large increase in monthly payments. There are several examples of homeowners with mortgage payments greater than their total income. These mortgages should never have been sold, but, in the housing boom there was a lack of self regulation. The needs of the consumers were ignored in the pursuit for selling 'profitable mortgages'

The Housing Bubble Bursts

Therefore, with a rise in defaults and fall in affordability, the US housing market turned. Suddenly after years of growth, the 'unthinkable' happened and house prices started to fall. This came as a shock to many who assumed house prices could only rise. Therefore, people who had been speculating in the housing market felt this was the time to get out and sell. Therefore, prices fell even more. Since their peak in 2006, house prices have fallen by 10% (in some areas it is much higher, the housing market is very localised). Furthermore, there is still the prospect of even more falls in house prices. As house prices fall consumers have less confidence to spend. There has also been a worrying increase in unemployment in real estate related jobs, such as construction.

The Credit Crunch

The problems in the US housing market and in particular the subprime mortgage sector soon spread to the rest of the finance system. Many big investment banks and commercial banks had been enthusiastic purchases of these CDOs. Basically, big banks had been refinancing these risky mortgage loans. When mortgage defaults started to occur, the commercial banks realised they were facing huge losses. Their losses were exaggerated by the risky nature of the loans. Some hedge funds collapsed completely. Despite the magnitude of the defaults, many of the big banks could afford to write off billions of pounds and still remain solvent.

However, the experience left Wall Street and the global finance system realising the dangers of risky lending. Therefore, the market sentiment changed to one of great conservatism. Banks were reluctant to lend to anyone, even each other and usually secure lending. This led to a shortage of funds in the money markets (such as interbank lending). This credit crunch is basically about a shortage of liquidity in the finance sector. The effects are that ordinary borrowing becomes more expensive and more difficult. Both the UK and US have seen most 'subprime' lending products withdrawn.

The credit crunch has also caused great difficulties for banks such as Northern Rock in UK and Bear Sterns in the US. Basically the banks couldn't raise enough money on the money markets so had to resort to some kind of rescue package. The concern is that more banks could suffer a similar fate and future bank rescues will be more difficult.

Because of the credit crunch, since July, the monetary authorities have been forced to inject liquidity into the money markets three times to avoid a complete shortage of funds. However, there is no guarantee that the markets won't keep freezing again.

Effect on Consumers and Economic Growth

Falling house prices, falling confidence, higher costs of borrowing have all contributed to a fall in consumer spending and it is this which is the main factor causing a downturn and likely recession. Furthermore, the credit crunch has caused difficulties for many borrowers, who now struggle to borrow at affordable rates. The US also has very high levels of consumer borrowing, therefore, increased cost of borrowing has caused widespread problems. - although the rate cuts by the Fed have made it less painful, it may still not be enough.

It Gets Worse

On its own the Housing crash and credit crunch would cause serious problems. However, the US economy has other underlying problems which makes it more difficult to deal with the problem.

Devaluing Dollar. In one sense the depreciating dollar is helping to increase exports and maintain growth in the export sector; to some extent this may counter the fall in consumer spending. However, the depreciating dollar is contributing to both cost push inflation and declining living standards. This means the US could face the unpleasant occurrence of both inflation and lower growth. It makes the job of the Fed more difficult; in particular rate cuts further weaken the dollar and increase inflation. At the moment, the Fed have decided the recession is more serious than inflation, and rates have been cut.

Current account deficit. The current account deficit is an indication of an unbalanced economy - too much spending, low savings ratio. A downturn in the economy and depreciation in dollar are necessary to deal with this.

National Debt. The US national debt stands at 65% of GDP, (even more if you include future pension liabilities). This gives the economy little room for expansionary fiscal policy. It means the US pays a lot in debt interest payments and the forthcoming recession will only aggravate the debt situation

See also:

• Problems with US Economy
• Reasons for Fall in US Dollar

Readers Question: We as a UK importer and distributor are seeing price rises of 10-37% on steel and non ferrous based products from Chinese/Taiwanese suppliers. With the continuing fall of the Chinese RMB to the US$, suppliers are seeking further increases. We will have to pass on these costs in the next few months so surely many other importing companies around the world will do the same and thereby fuelling inflationary pressures dramatically. How will this affect the Bank of England's decision to change interest rates when balancing the needs to curb inflation yet prevent a recession?

It is not easy for the Bank of England to balance the different problems. Officially their target is low inflation so they will give importance to cost push inflation factors, but, if the UK economy does enter a recession it will be interesting to see how the Bank responds because at the moment it is not clear.

Yesterday CPI inflation rose to 2.5%[link], largely on the back of rising energy prices. There are also other cost push inflation factors such as food and rising housing costs. As you mention, the weakness of the pound and dollar are contributing to imported inflation. With US interest rates falling to 2.25% the dollar's weakness is likely to continue.

Furthermore, the Bank of England have another problem. CPI seems to underestimate inflation, RPI gives a higher figure for inflation because it includes housing costs. Therefore, although CPI inflation of 2.5% doesn't sound too high, underlying inflation is actually more of a problem. Comparison of RPI and CPI

Producer Inflation in UK

If we look at producer inflation, this suggests an even higher figure. Producer inflation is currently running at 5.7% -[Producer inflation] Record number of producers are reporting increased factory gate prices BBC link (Producer inflation is the price of manufactured goods leaving factories)

Although this is a problem for manufacturers, the MPC will not give too much importance to producer inflation. Their target is CPI 2% - they will not target producer inflation directly. For example, when house prices were rising by 25% in recent years, the MPC did not think it needed to do anything because CPI inflation remained low. (This decision is now criticised by some as fostering a housing boom. )

MPC v Federal Reserver on Interest Rates

Nevertheless, the MPC has shown that it is Hawkish on inflation. Also, producer inflation is often seen as a good guide to future inflation trends because it takes time for factory gate prices to filter through to the economy. Therefore, it is definitely a factor in limiting rate cuts. Since the start of the credit crisis, the Bank of England have been conservative in reducing rates only very slightly to 5.25%. This is in stark contrast to the US Fed reserve who have cut rates aggressively to 2.25%. It is interesting to note that the US have the same cost push inflationary pressures. In fact the US currency depreciation is far worse. However, at the moment, the FED sees its job as avoiding a serious recession it seems to see the inflation problem as rather insignificant. They argue that as the American economy slows down, demand pull inflationary pressure will slow anyway.

The Bank of England still want to maintain a strong line on dealing with inflation, they don't want to appear 'soft' on inflation. But, if the economy does take a nose dive they will be placed in a difficult position as they may have to sacrifice their low inflationary objective. Although in a recession lower demand will reduce demand side inflation.

Threat of Recession in UK?

Compared to the threat of inflation, the prospect of recession is perhaps much more serious.

There are various factors which could lead to recession in the UK:

• Stagnating housing market - falling prices would cause lower consumer spending
• Credit Crisis makes borrowing more difficult and expensive.
• Slowdown in US could spread to rest of the world.
• High borrowing levels and low savings ratio
• Declining confidence as a result of financial markets in turmoil
  

Recent weeks have offered a range of depressing economic statistics on the US economy. Although technically the economy is not in a recession, most analysts feel the economy is on the brink of recession and most debate centres around how protracted and deep the forthcoming downturn will be.

Different Sectors of the US economy

Housing Market.

The housing market has been experiencing severe problems for over 12 months. House prices have fallen 10% from their peak and there is evidence that the fall in house prices is accelerating. [Source 1] For a long time rising house prices have enabled US homeowners to maintain high levels of consumer spending through equity withdrawal. The fall in house prices will definitely harm consumer confidence and consumer spending. The concern is that if house prices continue to fall, it will increase the number of people with negative equity and the fall in consumer spending could become quite damaging.

Credit Crisis

The troubles of America's 5th biggest investment bank, Bear Sterns, has been a significant development in the past week. It is illustrative of the problems caused by the credit crisis. Bear Sterns has lost significant investments in the subprime markets and other banks became nervous and started to withdraw their cash. The authorities hope it can be passed off as a one off, but, similar problems could potentially occur in other investment banks as well. There is still a real prospect of further credit defaults; many homeowners could soon face the prospect of higher interest rates as their introductory period ends. The blow has been softened by lower rates, but, this doesn't alter the fact many loans were inappropriate in the first place.
Students of the great depression will know how damaging any bank collapse can be to the economic system. Although Bear Sterns looks to have been rescued by J.P.Morgan there is a real danger that worse is still to come. (Forget soft landings at Guardian)

Falling Stock Markets

The falling stock markets are mainly a reflection of the economic and financial weakness. In particular the problem stems from the lack of confidence. One of the most worrying feature has been the way credit markets have 'frozen' 3 times in the past few months. The problem is even acute in triple AAA markets where loans are supposed to be very safe.

source: Economist
Note: Freddie Mac and Fannie Mae are two quasi government agencies responsible for issuing government debt.


Unemployment

Unemployment in the US is currently low 4.8% (data at US dept of Labour) However, 2008 has seen a worrying increase in unemployment and job losses. This has been particularly obvious in sectors such as construction and manufacturing. Since 2006 nearly 400,000 jobs have been lost in trade jobs (electricians e.t.c) and construction.

Weakness of the Dollar

The weakness of the economy and reduction in interest rates have only served to further weaken the US Dollar. Ironically, the dollar's devaluation is helping to boost US exports which at least help provide some growth. But, exports will not be able to take up all the slack from lower consumer spending. Also the weak dollar creates other problems such as more expensive imports and a decline in confidence about investing in the US.

The Good News on the US economy?

• Tourists are attracted to the US because of the low dollar
• Exports are rising, helping to reduce the trade deficit.
• The efforts to stimulate the economy - lower taxes, lower interest rates could prove successful in avoiding a full scale recession. However, there is also a danger that monetary policy will prove ineffective. i.e. even cuts in interest rates to 1% may be insufficient to encourage consumers to spend money. The gains from lower interest rates may not be able to offset the losses from the housing market.
  
• There is a feeling that markets may have overreacted to some of the bad news. Although others will argue that markets are still overvalued.
• GDP growth is still positive GDP stats
• However, most forecasts predict negative growth by May. The real question will be - how long lasting will the recession be?

Related:

• How long do Recessions last?
• Can A recession really be a good thing?
• Can US avoid recession?

Labels: US economy

Tim Harford, is the author of the best selling economics book - "The Undercover Economist". This book was part of a new genre of 'worldly economics' - Economic books that seek to make the subject relevant to real life issues in a non technical way.

The Logic of Life is another book written in a similar vein. The logic of life seeks to offer more economic explanations for seemingly irrational behaviour. Amongst other things it explores why your boss is likely to get overpaid, why restaurants can overcharge a large group and why perceived risk of sexual transmitted diseases can change the sexual behaviour of teenagers.

It is fairly non-dogmatic and doesn't aim to be the answer to everything. But, it succeeds in raising interesting questions and solutions that could easily be ignored.

You don't have to be an Economist to appreciate the book. It is written in a interesting and conversational style which is appealing to all readers. There is also a lack of economic terminology. In fact, the book is as much about life decisions as it is about economics. Many of the issues could easily be taken up by sociologists.

Tim Harford works for the Financial Times and lives in London. In the past he has worked as an Oxford tutor and for the world Bank.

• The Logic of Life at Amazon.com
• The Logic of Life at Amazon.co.uk

2008 has bought no respite for the falling dollar. The weakening US economy has encouraged investors to continue selling dollars and move into alternatives such as, the Euro, the Yen and Commodities.
Recent evidence showed that there was a sharp drop in US retail sales during February. Combined with falling house prices, the once mighty, American consumer is now showing signs of a sharp drop in spending. With Consumer spending accounting for the majority of domestic demand, this fall makes the prospect of a deep recession more likely. Therefore, the Fed may be forced to lower interest rates further making dollar holdings even less attractive.

Negative Factors Affecting the Euro

1. Peg to the Dollar.

Many asian economies have pegged their currencies to the dollar. However, the continual fall in the dollar makes this a problematic experience. Countries such as Vietnam and China are experiencing increasing inflation because their currencies are undervalued (making imports expensive). As a consequence, many Asian economies are considering abandoning their link to the dollar. This would allow their currencies to appreciate and would cause the dollar to fall further.

2. The Bandwagon effect

The other worry is that the decline in the dollar may become a rout because the falling value may encourage a bandwagon effect as investors just sell their positions to get out of a falling asset. Asian investors have huge levels of American dollar holdings; it is a big cause for concern if these positions start to be sold.

Reasons Why Euro may be overvalued.

3. Is the Euro Strength Justified?

The remarkable rise of the Euro should not be seen as a ringing endorsement of the EU economy. Its rise is mainly due to the fact that it's not the dollar. The Euro area includes many countries experiencing particular problems. Countries like Greece and Italy have public debt of over 100% GDP. So far the Central Bank has been resolute in keeping interest rates at 4%. However, the credit crunch and global slowdown could increasingly harm the Euro economy and motivate the ECB to cut rates. If this occurs the Euro starts to look overvalued. On a basic level, a European consumer on holiday in America can hardly believe how cheap American goods are; this reflects the fact that exchange rates have become detached from living costs.

4. Will Central Banks Intervene?

Another likely occurrence is that the main central banks will start to intervene in currency markets. The ECB is concerned that the Euro's strength harms European exports. Similarly the Japanese fear that the appreciation in the Yen could cause significant problems for their faltering economy.

Related

• Effects of a falling dollar
• Plunge in Dollar against the Euro

This year's budget, delivered by the dour Alistair Darling, contained few surprises and is not too bad unless you are a smoker, heavy drinker and drive around in a gas guzzling SUV. This is a brief summary of the main budget changes

The main issue to arise out of this year's budget is the decline in the world economic prospects. This is reflected in lower economic growth forecasts and a deterioration in the government's finances. This left the chancellor little room for manoeuvre.

Alot of the UK's financial problems have been blamed on the credit crunch. This is an explanation of the credit crunch Some more questions on the credit crisis

Other links

• A random walk through economic statistics

It is an observed fact that when people go to Supermarkets they are spending much more per visit now than 10,20 or 30 years ago. Why do people spend more on their weekly shop than ever before?

The reason people are spending more on their weekly shop has received many different explanations.

1. Better Marketing. Arguably supermarkets have got better at sales techniques to make us buy more. For example, special offers such as: buy 4 for the price of 3. Supermarkets are geared towards increasing the average spend. This is why there are many offers for buying more than one. Another example is placing complementary foods next to each other. But, can marketing really make us want to eat more?

2. Rising Incomes. If incomes increase demand for goods usually increase. However, we would expect demand for food to be very income inelastic. If your income goes up, you don’t think – great now I will buy 2 loaves of bread rather than one. This is appropriate only for people who are very poor.

3. Convenience shopping is more expensive. Nevertheless, some foods are income elastic, e.g. ready prepared meals. The cost of the ingredients would be much lower. But, with higher incomes, we would rather spend £3 to save the time of preparation.

4. People are Busier. Because people are busier we go to the supermarket less often and therefore when we do go, we need to buy more.

5. Comfort eating. When I googled ‘Why are people spending more’ there were many results suggesting people spend more when they are sad. People spend more when sad Maybe the increased size of our shopping trolleys is just indicative of the fundamental existentialist nihilism inherent in the core of our consumerist, materialistic society (or words to that effect)

6. Out of Town Shopping Centres. More supermarkets are being built away from the town centres. Therefore, it takes longer to travel and so we do go shopping we should spend more per visit, to maximise the economies of scale in bulkbuying.

7. More goods on sale. Tesco doesn’t just sell bread and milk. These days you can come back with some new underwear, garden fertiliser and DVD player, and still have change from a £20 note.

8. Credit Cards. If you have to buy with cash, you feel more reluctant about passing over your hard won money, therefore, you spend less. The argument is that with increased use of credit cards you can buy now and pay later. This is consistent with a falling savings ratio.

9. Online Shopping. This is the reason I spend more. If I spend £70 at Sainsbury’s I get delivery for £2.50 rather than £5.00. Therefore, I will happily buy 36 toilet rolls or something just to get my purchase over £70. My house is full of piles of things like bottled water, which I have tried to use to get cheaper delivery.

10. Bigger Shopping Trolleys. In fact it is argued by some that the reason people are buying more is that supermarkets have increased the average size of shopping trolleys. With more space in the trolley, it's easier to spend more. Or is it the other way around? People buy more so supermarkets respond by offering bigger supermarkets?

Related Posts

• Costs and Benefits of Tesco's
• The Rise and rise of Tesco's
• The decline of the small shop
  

Blog Carnival

• My post on How to Survive a Recession was featured in this week's personal finance blog carnival

Do Statistics Measure People's Mood?

Looking at the UK's main economic statistics, it would suggest a positive economic picture.

• Economic growth is high.(2.9%) Since 1992, the UK has achieved the longest unbroken period of growth on record.
• Inflation is low. At 2.2% CPI inflation is very close to the government's target of 2%
• Unemployment is very low 5.2% (labour force survey) and Employment has reached record levels.

Source: National Statistics snapshot (March 2008)

When the chancellor delivers his budget tomorrow, expect a lengthy self congratulatory note about the strength of the Economy. However, why will people be sceptical about the rosy picture he tries to paint? He is not making the statistics up. - Unemployment really is low and the record period of economic growth is very impressive.

These 3 main economic variables do suggest a positive economic outlook. However, if you conducted informal interviews with people in the street, you would probably find that the average consumer doesn't view the economy in a similar light.

Recently, I asked my economics students to ask other people about their perspectives on the economy; the results were quite interesting. People don't tend to think in terms of national economic statistics; their economic view is determined by their individual circumstances and anecdotal evidence.

For example, people notice things like the cost of housing, food at supermarkets and the price of petrol - they not even know what is meant by CPI inflation. In the Times today, there is an opinion poll with questions on things that reflect people's living standards. For example questions like:
Compared to last year:

• Are you more worried about losing your job?
• Are you eating out in restaurants?
• Are you buying new clothes?

The current snapshot suggests people are more pessimistic. For example,

• 8% say they are buying more clothes than last year, but 55% say they are buying less.
• 36% are more worried about losing their job, 12% are less worried.

An important question to consider is how valuable are these anecdotal opinions and judgements?

Some Notes on these Opinion Polls and Statistics

1. They are unscientific and rely on broad judgements from people. They are very much normative opinions.
2. It is noted that people often tend to give a greater weighting to negative things rather than positive things. For example, people complain about rising petrol prices, but they give less attention to the fact the price of electrical goods has been falling.
3. Official statistics are often backward looking. Growth of 2.9% is largely indicative of economic decisions made in the past 12 months. Current opinions will shape growth rates for the next 12 months. For example, if we become pessimistic, it may take a while for us to reduce our spending and lower growth rates. There is a time lag; therefore capturing the 'mood' of shoppers can be useful for gaining an insight into the future direction of the economy.
4. People can forget how bad things were and have a rosy view of the past. For example, interest rates at 5.25% make mortgage payments relatively cheap compared to 1990 when interest rates reached 15%.
5. There is always a danger that people can 'talk themselves into a recession'. If we are excessively pessimistic and fear losing a job (even if it is not really rational) then it may become a self fulfilling prophecy. If you fear a recession, you spend less, save more and therefore aggregate demand will slowdown and this change in behaviour could cause a recession.

Anecdotal opinions should be treated with caution, they can never replace actual statistics. But, at the same time, just using economic statistics can give only a limited perspective. These snapshots of opinion can be a useful guide to giving a different perspective and indications of future behaviour.

In a previous post we looked at the problem of personal debt in the UK. However, problems of debt are not just confined to the private sector, government borrowing also is a major issue.

Just a couple of years ago, the Government could boast about the national debt being reduced to just 29% of GDP. By international standards this is pretty impressive. This reduction was due to

• Several years of economic growth and lower unemployment
• strict limits on public spending, started by the Conservatives and continued by the Labour Party
• Windfall from sale of mobile phone licenses

However, despite continual economic growth, the public finances have shown a worrying deterioration. National Debt is £612 billion and is forecast to rise to 44% of GDP. In 2008/09 the UK government will have to borrow over £42 billion; a very high amount for this stage in the economic cycle.

National Debt Chart


National Debt is actually a lot Higher

A public debt of 44% of GDP is not unmanageable; but the real problem for the government is the fact that public sector liabilities are actually much higher. In a way the government are underestimating the true level of national debt. The Institute of Fiscal studies suggest that the true level of national debt is actually much higher. This is because the government is currently excluding

1. Public Sector Pension provision. Public sector pensions are a liability that the government has to pay out of current spending. There is no 'investment in a pension plan'. Pension liabilites are very high and expected to get worse with an ageing population.
2. Private Finance Initiatives. The government has been keen to promote private finance inititatives which involve projects financed partly by the government and partly by the private sector. At the moment, the government do not include these spending committments, but effectively they are public liabilities.
3. Guarantee of Northern Rock. The government have given guarantees to Northern Rock for upto £100bn. Hopefully, the government will not lose money, but it remains a liability
4. Demographic Factors will Make the National Debt worse in years to come. The UK is facing an ageing population. This will become particularly an issue from 2016 onwards. Around this time, the baby boomer generation will start to retire. This will reduce the size of the labour force and increase the dependency ratio (the number of non workers to active members of the labour force). Therefore, the government will receive lower tax (e.g. income tax) and is committed to paying pensions. The government is trying to alleviate this by raising retirement age to 68. But, with life expectancy increasing, this is unlikely to be insufficient
   

Problems of National Debt.

To what extent should we worry about National Debt? It is something that the UK has experienced for a long time and there are many countries with a more serious problem. However, there are many good reasons to be concerned about a National debt.

Interest Payments.

People do not lend to the government with any sense of charity. The government have to pay interest on debt, like anyone else. Last year the government spent £31 bn on interest payments alone. To put this into perspective this equate to the equivalent of 15 p on income tax. It is more than the UK spends on National Defence. Government borrowing for 2007/08 is forecast to be £42 billion - a similar figure to the amount the government pays in interest payments.

Crowding Out.

The argument is that government debt crowds out the private sector. If the government have to borrow they sell bonds to the private sector. Because the private sector are buying bonds this leads to less private sector investment. Furthermore it is argued that government spending tends to be more inefficient than private sector spending.

Financial Crowding Out.

If the government have to borrow a lot of money, interest rates on bonds may need to rise to attract sufficient lenders. If bond interest rates rise, this can put upward pressure on general interest rates. The higher interest rates in the economy will reduce spending and investment and lead to lower growth in the long term.

Tax rises for the future.

Growing public sector debt means that future taxpayers will end up picking the bill. Even if the public sector debt is not reduced, future taxpayers will have to pay the interest on the debt. This is particularly a problem because, as has been mentioned, changing demographics will mean that government finances will be placed under increased pressure, even without borrowing from today.

Limits Fiscal Policy

Ideally, the government should be able to pursue expansionary fiscal policy if the economy is facing a downturn and possible recession. If the government have a very large public debt then it limits the scope for cutting taxes to boost Aggregate demand. For example, the government should really be increasing taxes or cutting spending in this 2008 budget. But, that is not desirable given that a slowing housing market is already causing problems.

• UK National Debt
• Should We include future pension commitments in National Debt?
  
• History of UK National Debt at Institute of fiscal studies pdf
• National Debt costs as much as armed forces
• Government debt at National statistics online
  

This is part of a series on problems in the UK Economy

The UK housing market is one of Britain's favourite topics of conversation. There is eith much (barely disguised) gloating over how much your house is worth; or there is also a large section of new first time buyers who despair at the cost of trying to buy a house. There also seems to be endless speculation about the future direction of house prices. When it comes to house price predictions you can take your pick anything between a 40% fall in prices and a 50% increase in the next 10 years. But, behind all the newspaper headlines what are the real issues at stake in the housing market?

Problems in the UK Housing Market

1. First Time Buyers Priced Out of the Market.

According to the Halifax, average house prices are just over £197,000. Therefore, even on an income multiple of 4 times salary, there are not may young people who earn sufficient salary to be able to buy a house. Furthermore, many mortgage lenders are now expecting a bigger deposit; 10% of £200,000 is difficult to save when you consider many graduates are leaving university with big debts. Due to the UK's obessesion with owning a house, first time buyers have simply tried to get on the housing ladder through taking out riskier mortgages such as interest only, or 100% mortgages. Therefore, young people have become increasingly indebted in order to buy a house. The rising house prices has also caused intergenerational inequality - people who bought 10 years ago have made capital gains, but, young people will be forced to take on increasing levels of debt.

Possible solutions:

• Subsidised Mortgages for young peopl, but expensive and doesn't tackle fundamental problem of high prices.
• Subsidised government building of housing. High prices are due primarily to the shortage of supply. Building new houses will ease the long term lack of affordability.
• A move away from home ownership to renting - like on the continent. This requires a change in people's expectations and may prove quite difficult.

2. Volatile Prices

The UK housing market is susceptible to booms and bust. For example, in the late 80s, house price inflation exceeded 30%; this was followed by a year of house prices falling 15% (1992). In recent years, house prices have risen by over 20% and now many fear a housing price drop. The volatility of the house prices in the UK is due to a number of factors.

• People choose variable mortgages and take out large loans. This means mortgage payments are a high % of income (over 20%) therefore, any change in interest rates has a significant impact on affordability.
• Shortage of supply exaggerates any change in demand.

Possible Solutions.

• Encourage fixed Rate mortgages
• Encourage renting.
• Encourage the building of houses in property hot spots (not always easy to do.)

3. House Price Drop could cause a recession.

If house prices do fall in the UK, it will have an adverse impact upon consumer spending and consumer confidence. House prices have become a key barometer to the economy. Rising house prices have also been used to fund equity withdrawal and have caused a drop in the savings rate to 3%. If house prices do fall, it will create negative equity and discourage spending; if the price falls are rapid this could cause a recession in the UK.

Solutions.

• If consumer spending does fall the MPC is likely to cut interest rates because inflation will hopefully be less of a problem. However, the MPC won't cut rates just to try and boost the housing market - their primary target is low inflation. Furthermore, some would argue house prices need to fall to correct a long term imbalance.

4. Shortage of Land

Many problems in the UK Housing market stem from a shortage of supply. However, the problem is that building new houses is not so straight forward especially in the South East. Local councils are reluctant to allow the building of houses on greenbelt land. They are also reluctant to encourage more pollution and congestion in their area. The planning process tends to make it difficult to develop new land and local councils usually have a NIMBY approach. More houses are fine - but not in this district.

Solution:

• Encourage building on brown field sites with greater housing density e.g. like the continent.

5. Mortgage Crisis

Due to problems in the US subprime market, there is difficulty in financing mortgage lending. This is causing several mortgage products to be withdrawn e.g. 125% mortgages and 100% mortgages.

• However, maybe the idea of a crisis is exaggerated. True, mortgage companies are becoming stricter on lending, but this is perhaps a desirable response to a period of very lax lending criteria. Although it causes some inconvenience, especially for first time buyers, it does at least prevent future problems in the market.

Related

• Boom and Bust in the US Housing Market
• The effect of the UK Housing Market on Economy
• Problems of personal debt in UK Economy
  

The UK has become a nation of borrowers. The savings ratio has fallen and an increasing number of consumers have taken on dangerously high levels of personal debt.

Diagram of Personal Debt in UK
The UK is experiencing record levels of personal debt. Statistics from april 2007, suggest that debt levels in the UK have increased to £1.3billion
Britain's consumer debt mountain has topped £1.3 trillion in april 2007. This is more than the UK's total GDP.

To be fair a high % of this debt is secured against the value of houses. With UK house prices rising, most homeowners have assets greater than the value of their mortgage debt. However, stripping aside mortgage lending, there are many reasons to be worried about the UK's growing debt levels.

Bad Debts UK

Rise in Student Debts. UK student debt has increased to over £14bn BBC link This means that many students are leaving university with large debts. This makes it particularly difficult for them to enter the housing market. It displays the fact that debt issues are much worse amongst the young, contributing to intergenerational debt problems.

Rise in Extreme Debt. The number of people in debt by over £100,000 has doubled in recent years bbc link

Increase in bankruptcies. There has been a worrying increase in the number of bankruptices, partly due to the ease of declaring bankruptcy and also due to debt problems

Economic Effects of Debt

1. Risk to households who fail to meet loan repayments. Can lead to home repossession and banruptcy.
   
2. Economy is very sensitive to any interest rate rises. This could be a problem in an economy characterised by rising cost push inflation.
   
3. High levels of debt mean the economy is more vulnerable should people wish to switch to being savers. UK economic growth has come to rely on a low savings rate and high levels of consumer spending. If the situation changed people may become pessimistic and start saving. This could cause a big downturn in spending and could lead to a recession.
4. Financial Instability. The recent US sub prime crisis shows how vulnerable the financial sector is to a rise in loan defaults. Loan defaults do not just effect the bankrupt and the individual mortgage lender. They effect the whole financial sector, leading to a freeze in lending and rising cost of mortgages. This can dampen growth and lead to recession, e.g. America
5. A culture of spending has left many people reluctant to take frugal steps with their finances.
6. Large current account deficit. The high levels of personal spending and low savings is one factor behind the current account deficit, which is approaching 5% of GDP
   

The problem of consumer debt is compounded by high levels of government borrowing

References

1. Record Debt levels threaten UK economy
2. Diagram from ESRC
3. UK Policy blamed for debt mountain at Telegraph

Over the next few days I am going to start a series looking at the various economic problems facing the UK economy. Many of these problems are equally relevant for other economies such as the US. The first problem I have chosen is inflation.

Is Inflation a Problem for UK

• Current CPI inflation is 2.3%. The government's target is 2% +/- 1

The MPC recently warned that by the end of 2008, 3% inflation would be likely if they cut interest rates to 4.5%. Most of the current inflationary pressures are cost push, and are related to the rising price of wheat, oil and other commodities.
But, to be honest, inflation of 3% is hardly a major problem - especially if the inflation 'spike' proves temporary. It's rather ironic that these days we get worked up about inflation potentially rising to 3%. By historical standards, 3% is quite low for the UK. Even at 3% many of these costs of inflation are quite limited. However, the MPC might argue that if inflation does rise to 3%, it may become more difficult to keep it low in the future and rising inflation is something people become to expect. In other words, we should worry about a change in expectations of inflation.

A Return to Stagflation?

The real difficulty comes if, the UK enters a serious economic downturn or recession, and inflationary pressures continue to worsen. This is an experience known as stagflation and present policy makers with an unenviable dilemma - Increase interest rates to keep inflation down, but worsen the recession; or cut rates to stimulate demand and make inflation worse.

Inflation combined with lower growth is a real problem. My main concern is that the MPC is so fixated on reaching the government's inflation target that they may ignore other macroeconomic objectives. My feeling is that the MPC are likely to keep interest rates high, even if it causes an unnecessary downturn.

Does Inflation Measure the Cost of Living Any more?

A different issue regarding inflation is whether CPI accurately reflects the cost of living. Many argue UK CPI inflation rate is no longer an accurate reflection of people's living standards. Ask a variety of people about the cost of living in the UK and most would scoff at the idea of 2% inflation. For example:

• pensioners see their council tax bills rising 100% in the past few year (see this blog post)
• Due to rising house prices, young first time buyers are inundated with large mortgage payments or expensive rents.
• There is also inequality with regard to inflation. Low income groups often spend a higher % of income on food, heating and transport. It is these items which are seeing above inflationary growth. Therefore, many people living on index linked benefits are seeing a decline in their living standards.

This graph shows an increasing divergence between CPI inflation (official method and old measure of RPI.


If you buy electronic goods and cheap clothing imports then your cost of living is probably accurately reflected by the CPI. But, some low income groups are suffering from having benefits linked to CPI inflation when their cost of living is rising at a faster rate.

• Reasons for low inflation in the UK

Readers Question: What will the Federal Open Market Committee do with the Federal funds rate at their March 18, 2008 meeting?

1. The FOMC will reduce the Federal funds rate by one-half point or more.
2. The FOMC will reduce the Federal funds rate by one-quarter point.
3. The FOMC will leave the Federal funds rate unchanged.
4. The FOMC will increase the Federal funds rate by one-quarter point.
5. The FOMC will increase the Federal funds rate by one-half point or more.

I think it is #3. Inflation concerns will keep them from lowering rates further, growth concerns will keep them from raising rates. I am not too sure my answer, so i’m looking for some input, thanks.

Thanks for question. It is hard to say, because recent economic data suggests a weakening economy. However, the fact that the FED have already cut interest rates by 1.25% recently doesn't give them a huge amount of room.

Some of the negative economic data recently:

1. Falling Car Sales - In Feb General Motors Corp(GM.N), Ford Motor Co (F.N) and Chrysler LLC (CBS.UL) reported drops of 16 percent, 10 percent and 17 percent respectively
2. Manufacturing activity weakest level for five years. Manufacturing activity came in Monday at 48.3. This is lowest level since 2003, despite the boost from the weakening dollar on exports
3. Construction spending in January fell by 1.7 percent, the steepest amount in 14 years.
4. Housing Market still in decline with house prices falling and mortgage market still in turmoil.

Cost Push Inflation makes decision difficult

The decision of the Federal reserve is made more difficult because of the increase in inflationary pressure from cost push factors. Rising prices of oil, commodities and food such as wheat mean many prices are rising, despite the slowdown in growth. This could push the FED into a difficult situation - deal with inflation or try and solve the economic downturn If things continue to deteriorate it could lead to stagflation, last seen in the 1970s.

Personally, I feel they will leave them unchanged. Although, I think they will be cut later in the year, perhaps in April. A problem that they may face is that interest rate cuts have less effect in boosting demand than they hoped.

Related

• Problems of US Economy
• Will US economy benefit from tax cuts?

The poverty trap occurs when people have little or no incentive to get a better paid job or work longer hours. (not to be confused with unemployment trap where there is no incentive to get a job at all.)

In the UK, there are a wide range of benefits. It is estimate that 5 million people receive some kind of government benefits and these benefits may create a disincentive to get better paid jobs

The poverty trap occurs due to benefits such as income support, housing benefit, single parent allowance and family tax credit. If somebody got a better paid job they would lose benefits and pay more tax (income tax and NI. Therefore, their take home pay may be the same as before.

Policies to reduce poverty trap