Archive | economics

UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 0.0% (headline rate)
  • (page updated 25 March, 2015)

inflation-monthly-target

What is causing the fall in inflation?

  • Lower cost push inflation – falling oil prices
  • Other commodity prices also falling, such as metals, food.
  • Lower energy prices – gas and electricity
  • Low worldwide inflationary expectations. Europe is experiencing deflation and this is keeping inflation low.
  • Supermarket price wars, with big chains, such as Tesco and Sainsbury attempting to maintain market share from Pound Shops and discounters like Lidl
  • Wage growth still weak, despite early signs of some wage growth.
  • Note: RPI inflation is still 1.0%. Also, core inflation stripping out volatile items such as petrol, oil and energy prices is higher than the headline CPI rate.

Historic inflation

uk-RPI-inflation-1948-2014

The current UK inflation rate compares favourable to much of the post-war period. The 1970s frequently saw double digit inflation. In 2014, the annual RPI was 2.2%.

See also: more historical graphs of inflation

Inflation since 1990

inflation-monthly-cpi-90-15-with-target

CPI and CPIH

  • CPIH – 0.3% in the year to Feb 2015

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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Fall in Euro

Recently, the Euro has fallen from 1.5 Dollars to 1 Euro in 2011 to near parity in March 2015.

Fall in Euro

The fall in the value of the Euro has been very steep in the last six months.

This is a very significant depreciation in the Euro, and primarily reflects the greater economic weakness in the Eurozone. Related to the economic weakness, is the decision of the Eurozone to recently begin expansionary monetary policy (quantitative easing).

Why the Euro is falling

1. The ECB are embarking on Quantitative easing – the creation of money to purchase government bonds. Quantatitive easing tends to reduce the value of a currency because:

  • This increase in the money supply tends to reduce the value of the currency (greater supply tends to reduce price.)
  • Q.E raises expectations of higher inflation  – higher inflation tends to reduce the value of a currency because it will become less attractive to buy EU goods.
  • Also purchasing government bonds will reduce bond yields in Europe, making it less attractive for private investors to save money in the Eurozone – you get a lower return on Eurozone assets. Investors would rather save in US assets, where interest rates are more likely to rise and you will get a better rate of return.

2. General weakness of the Eurozone economy. Some analysts believe that EU’s quantitative easing maybe a case of too little too late; they believe Q.E. in Europe may actually have a quite limited effect. This is due to two factors: Continue Reading →

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Venezuela economy and oil dependency

A look at why the Venezuela economy is dependent on oil, why it did not do more to diversify, and the problems of relying on a primary product like oil.

Readers Question: First, why are more than 90% of their exports based on oil? Under Hofstede’s “Uncertainty and Avoidance of Risk”, Venezuela is ranked as a country that goes to great lengths to avoid risk. But basing an entire economy on the prosperity of one commodity seems like the definition of risk. Your thoughts on that are much appreciated.

Firstly a few quick statistics on Venezuela economy. According to Wikipedia

  • Venezuela is an oil dependent economy. Revenue from petroleum exports accounts for more than 50% of the country’s GDP and roughly 95% of total exports.
  • Manufacturing contributed 17% of GDP in 2006
  • Agriculture in Venezuela accounts for approximately 3% of GDP, 10% of the labor force.

Why does an economy base its prosperity around one commodity?

Firstly, Venezuela is not unique. Many countries specialise in oil and then later come to regret this specialisation. I have a Russian student who is asking exactly the same question – Why did Russia not take the opportunity to diversify away from gas and oil. (see: Russian economic crisis)

The problem is that when oil prices are high, it’s tempting to take advantage of the high revenues. Anything else seems much less profitable. Secondly, people may make the assumption oil prices will remain high – so they have plenty of time before needing to diversify the economy.

If you have vast reserves, then in the short term, oil production offers the quickest way to promote economic prosperity, higher tax revenues and higher government spending. By comparison, at the time, manufacturing and agriculture will offer much smaller returns and potential for exports.

In 2007, when oil prices were rising, the Venezuela economy was growing rapidly – 7% a year. With oil revenues, the government was able to begin ambitious spending programmes. Many in 2007/08 may have felt that high oil prices were likely to stay high. (I remember reading articles which predicted oil prices of $200 a barrel. Very few were predicting a collapse in prices to $40.

crude oil prices

St Louis Fed

Why not diversify the economy?

It is easy to say than do. If you have an economy that has a highly profitable oil industry, it is difficult to develop new manufacturing industries. This is for a few reasons.

  • The profitable oil industry will be attracting most investment and skilled labour.
  • Entrepreneurs will be reluctant to create new industries, where Venezuela doesn’t seem to have a comparative advantage; the prospect of profit is low and there is no guarantee they will be able to create new industries. Trying to work in the oil industry may seem more appealing and profitable.
  • The government, in theory could try to diversify the economy. They could tax the oil industry and use the proceeds to subsidise the creation of new manufacturing industry. However, around the world, governments don’t have a great track record of ‘setting up new industries’ – The government is not expert in manufacturing and so it may struggle to decide which industries to create and where to spend money. There is no guarantee the government efforts to subsidise new industries will bear any fruit. Many governments would prefer to take the easier option of benefiting from boom in oil industry and hope the oil price stays high.
  • Governments are not noted for long-term vision and acting on the possibility of changing economic situations. The political process also encourages a short-termism. You don’t tend to win many elections by promising lower income now, and investment which may bear fruit 5-10 years in the future.

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Greece could benefit from leaving the Euro?

Just a short post, inspired by this article by Hamish McRae in Independent – Would it Matter if Greece left the Euro?

So often governments have fought ‘tough and nail’ to stay in an exchange rate system. But, when they finally leave – it is the best thing they ever did, and you’re left thinking – if only they left earlier, it would have saved economic pain. For example:

We don’t really know what would happen if you left the Euro – it is uncharted territory. We can only speculate on potential outcomes. But, perhaps this makes us more conservative and highlight the dangers of leaving.

However, given the Euro has been such an unmitigated disaster for Greece.

  • GDP down from $340bn in 2009 to $240bn 2014.
  • Unemployment of 25%

Could it get any worse?

In the short-term, quite probably. But, is the short term pain not worth becoming masters of your own economic and political destiny?

Greece may lose out in the short term. But, in the long term it will enable them to have their own currency, own monetary policy and own fiscal policy. This should give better prospects of long-term prosperity and economic stability.

The cost of staying in

Suppose Greece does endure another decade of austerity and finally returns to normal growth. Is there any guarantee the crisis of 2007-2015 will not return, at some point? It is quite likely. There is an inbuilt deflationary bias in the Eurozone. The Greek economy is just very different to northern Europe. Future Greeks may be very grateful, if the bold step is taken now.

My main point is, Greece should take the decision for the next 50 years, not just the next 5 months.

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Is it a mistake to focus on inflation?

Readers question: should the government focus on achieving a particular macroeconomic objective over the others?

This is a good question. There is a lot that can be said because it encompasses so many different topics.

Firstly, the three main macro-economic objectives:

  • Higher economic growth
  • Low inflation
  • Low unemployment

There are also less important objectives

  • Reducing government borrowing
  • Satisfactory balance of payments
  • Stable exchange rate
  • Protecting the environment

In this post, I will just consider whether  inflation should be seen as the over-riding primary macro-economic objective

Many economists (and Central Bankers) have often stated that low inflation should be the primary macro-economic objective. They argue

  • Low inflation is essential to long term economic prosperity. If inflation is brought under control, then the stability will encourage firms to invest and consumers to spend.
  • If inflation is too high, then it may require lower growth and higher unemployment in the short term. But, this temporary fall in output is worth the long-term benefit of bringing inflation under control.
  • In the long-term there is no conflict – if you keep inflation low, then we will also see strong growth, low unemployment and more competitive exports (helping balance of payments.
  • For example, in 1980, the new Conservative government promised to tackle the high inflation of the 1970s – They used deflationary fiscal and deflationary monetary policy. Inflation did fall, but it caused a severe recession, unemployment rose to 3 million. (In 1981, 365 economists wrote a letter to the Times saying the government should change approach). But, Mrs Thatcher argued she had to stick to the course to rid the economy of inflation.
  • 10 years later, there was another similar experience when the Conservative government again raised interest rates to tackle inflation, leading to another recession. In 1991, the chancellor Norman Lamont wrote

“Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.”

– Norman Lamont, Chancellor of the Exchequer. 16th May, 1991 (Hansard) (Unemployment a price worth paying for low inflation)

ECB and their objectives

More controversially, since the credit crisis of 2008, the ECB have appeared to have an over-riding objective to keep inflation low – even though economic growth in Europe has been poor. To many it seems the ECB have been too concerned about low inflation, and have been ignoring other macro-economic objectives, such as economic growth and unemployment. This explains the reluctance of the ECB to pursue quantitative easing (until very recently). It explains why growth in Europe has stalled, and unemployment has increased to 12% – double the rate of the UK and US.

Low inflation as a false goal

 

In this particular circumstance it is arguably a mistake to give undue importance to inflation. Europe desperately needs higher growth, and higher inflation to help

  • Reduce unemployment
  • Avoid the threat of deflation
  • Reduce real debt burdens through increasing cyclical tax revenues
  • Higher inflation would also enable southern Europe countries in the Euro to restore competitiveness without prolonged deflation.

Some economists argue that in the current circumstance of a liquidity trap and stagnant economy, we actually need a higher inflation rate to help improve growth.

Macro-economic objectives depend on the circumstances

There are times, when low inflation could be a desirable goal. If growth is too fast and unsustainable, then using monetary policy to reduce inflation and stabilise the rate of inflation can help to prevent an unnecessary boom and bust.

Low inflation is generally desirable. There are many good reasons to target low inflation in the long term.

However, it is also a mistake to target low inflation and ignore other objectives, which are potentially more important. Arguably the social and political costs of mass unemployment are much greater than a moderate inflation rates. Also, moderate inflation (4-10%) is not good, but also reasonably easy to reduce. The costs of deflation are much higher, and possibly much more difficult to solve.

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Macro Economic Objectives + Conflicts

A look at the possible conflicts between different macro-economic objectives.

The main macro economic objectives are:

  1. Positive and sustainable economic growth (UK, long run trend rate is around 2.5%)
  2. Low inflation (UK target 2% +/-1)
  3. Low unemployment / Full employment (e.g. around 3%)
  4. Satisfactory current account on balance of payments (i.e. avoid big current account deficit)
  5. Low government borrowing
  6. Exchange rate stability

You could also consider:

  1. Issues of equity
  2. Environmental factors (long run environmental sustainability)

Economic Growth vs Inflation

The main conflict can come between economic growth and inflation (which leads to a similar conflict between unemployment and inflation). When the economy expands it is more likely that inflationary pressures will increase. Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases faster than AS.

Inflationary growth

AD-AS-spare-capacity-Yf

For example, in the late 1980s during the Lawson boom, the UK experienced a high rate of economic growth (4-5% a year). This growth rate was above the long run trend rate of growth and this caused inflationary pressure. When the economy is growing very quickly, firms have difficulty employing sufficient skilled labour; this can lead to wage inflation which leads to higher prices. Also if growth is very quick, there may be supply constraints pushing up commodity price increases.  This economic boom of the 1980s proved unsustainable and ultimately led to the recession in 1991 (as the government increased interest rates to try and control inflation.

The excessive economic growth of 1986-1989 led to inflation increasing to 10%. It required interest rates of 12% and the recession of 1991/92 to bring inflation under control.

However, it is possible to have economic growth without causing inflation. If growth is sustainable – if it is close to the long run trend rate, then LRAS will increase at the same rate as AD, and therefore, we will not see inflation.

Low inflationary growth

inflation
In the UK from 1993-2007, we had our longest period of economic expansion on record. The economic growth did not cause inflation. This is sometimes know as the great moderation.

inflation-growth-90-12

The UK great moderation from 1992 to 2008 – low inflation, positive economic growth.

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Impact of deflationary fiscal policy in UK

A report by NIESR suggests that austerity pursued by the government in 2010, needlessly led to a delayed economic recovery and could have cost the UK 5% of GDP or £1,500 per person.

economic-growth-quarterly

The austerity was unnecessary because

  • The lower growth led to delayed rises in tax increases and
  • Interest rates were at 0%, and demand for government bonds high.
  • By delaying budgetary changes until the recovery was stronger, the government could have avoided a double dip downturn and still be able to reduce debt to GDP in the long term.

The impact of the deflationary fiscal policy could have been worse if:

  • The government had stuck to its initial austerity targets for cutting spending even more over the first Parliament
  • If the Bank of England had not used monetary policy to offset the decline in aggregate demand.

 

“The delay in the UK recovery over the first part of the coalition government’s term is at least in part a result of the government’s fiscal decisions. I have argued that these decisions were a mistake… It will be many years before we can settle on a figure for the total cost of that mistake, but measured against the scale of how much governments can influence the welfare of its citizens in peace time, it is likely to be a large cost.”

Professor Simon Wren-Lewis NIESR

Impact of discretionary fiscal policy

Implied discretionary fiscal change

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Deflationary Bias in the Eurozone

Readers Question: Is there an inbuilt deflationary bias in the Eurozone?

Note: I originally wrote this post in 2010. Unfortunately, every year there is a reason to update the post and suggest the deflationary bias in the Eurozone keeps getting stronger.

eu-inflation

Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth. Now, we are seeing outright deflation (fall in prices)

I agree that there is a deflationary bias in the Eurozone. This is proved by the long period of low economic growth (2007-15) and an inflation rate that is remaining well below target. Headline inflation in the Eurozone has fallen to -0.2% (Outright deflation, though core inflation, is still 0.7%). Growth is anaemic and unemployment well into double figures (11%) – Unemployment is higher in Europe than many other countries.

European Unemployment Eurozone vs Non-Eurozone economies

eurozone-unemployment

Source: Eurostat

Although core inflation is still positive. Many countries on the periphery are experiencing a real threat of prolonged deflation.

What explains the deflationary bias of the Eurozone?

Low Inflation Target

The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, temporary cost-push inflation, led to an increase in the EU headline inflation rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It showed the ECB are much more willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)

Whilst the ECB have an inflation target, they have no explicit target for unemployment or economic growth. EU Unemployment has risen to 12%, but there has been little action to increase aggregate demand.

The ECB have worried than any unconventional monetary policy may reduce their credibility and long-term ability to tackle inflation.

Reluctance to pursue unconventional monetary policy

Despite a prolonged period of low inflation, the ECB have been very reluctant to actually implement unconventional monetary policy  (e.g. Quantitative easing). It took outright deflation to finally push the ECB into proper Q.E, in Jan 2015.

The ECB is reluctant to engage in any quantitative easing because

  • They are reluctant to create any possibility of future inflation, printing money is an anathema to German Central Bankers, who wield considerable influence over ECB monetary policy.
  • The ECB has a reluctance to start buying bonds of different countries, deciding which to buy; and there have been constitutional excuses for not printing money.

The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can not.

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Impact of Immigration on UK Economy

In the past two decades, the UK has experienced a steady flow of net migrants into the economy. Net migration is a significant factor in the growth of the UK population. But, does this net migration help or hinder the UK economy?

net-migratinon-91-14-UK

Net long-term migration to the UK was estimated to be 260,000 in the year ending June 2014. This compares to net migration of 182,000 in the previous 12 months.

In the past five years, the UK population has been boosted by net migration of around 1,000,000.

Inflows and Outflows

net-migration-outflows-inflows

  • In 2011, the top 3 countries for source of migrants was India, China and Pakistan.
  • The top 3 destinations for people emigrating from  the UK was Australia, India and US.

Impact of Net Immigration on UK Economy

1. Increase in Labour Force

Migrants are more likely to be of working age – such as, students, and those looking for jobs. They may  bring dependants, but generally net immigration leads to an increase in the labour force and increases the potential output capacity of the economy.

2. Increase in aggregate demand and Real GDP

Net inflows of people also lead to an increase in aggregate demand. Migrants will increase the total spending within the economy. As well as increasing the supply of labour, there will be an increase in the demand for labour – relating to the increased spending within the economy. Ceteris paribus, net migration should lead to an increase in real GDP. The impact on real GDP per capita is uncertain.

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UK Debt Burden

What is the UK’s debt burden?

Firstly, there are different types of debt to consider

  1. Government debt – See: public sector debt (often referred to as National debt)
  2. Private sector debt – indebtedness of householders, finance sector and non-financial companies.
  3. External debt – the amount we ‘owe’ to other countries

In addition, you might take into account – future liabilities, e.g. pension fund commitments. Also, equally important, is future economic growth, tax revenue and the ability to meet the current debt burden.

Debt  burden as % of income

The most useful way to consider the debt burden. Is to consider:

  1. Debt as a % of income.
  2. Also, the % of income / taxes spent on debt interest payments

Government debt

uk-national-debt

Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010.

UK government borrowing fell to record levels in the early 1990s, but since the financial crisis, national debt as a % of GDP has increased to 78% of GDP (2015).

A related to concept to total national debt is the budget deficit. The budget deficit is the annual amount the government is borrowing.

Debt interest payments as % of GDP

Another important consideration is how significant are debt interest payments.

debt-interest-payments-percent-gdo

With low interest rates, the cost of servicing the UK government debt is lower than we might expect. Many economists suggest that when interest rates are low, the government should take advantage and borrow to finance investment.

See also: UK Debt interest payments

The amount spent on debt interest payments is important for understanding the ‘debt burden’ If you take out a mortgage, the crucial thing is not the total amount outstanding, but the percentage of your income that is spent on mortgage monthly payments.

Who is the UK debt burden owed to?

Another important consideration is who does the UK government borrow from?

The majority of UK public sector debt is owned by the UK private sector / Bank of England.

Private sector debt

In addition to government debt it is also important to look at private sector debt. In particular household debt / company debt. For example, at the start of the recession, household debt fell because householders sought to increase savings and pay off their debts, due to low confidence. In this case the government borrowing is partly offsetting the rise in private sector saving.

total-uk-debt

Financial debt is more complicated. The UK tends to have a large share of financial debt as a % of GDP because it has a large finance sector. But, these large liabilities are offset by high financial sector assets. Financial sector debt becomes a problem if assets fall in value. (e.g. during credit crunch)

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