Inflation target during deflation

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Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

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What happens when the government runs out of money?

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Readers Question: Since the debt is mainly in the form of government bonds or gilts then it can only be paid back when the term of the bond terminates. What happens if there is not enough money to pay this back?

bond-government-us

Government bonds are a method for the government to borrow money. They sell bonds (e.g. for £1,000) and promise to pay back the bond holder in say 30 years. In the meantime, they will pay an interest rate of e.g. 5% a year as compensation.

Default on debt. If the government has no money to pay bond holders, then it will be defaulting on its debt. Bond holders lose their investment.

The government will be reluctant to do this because once it has started to default on its debt – no-one will want to buy or hold government bonds – so you will see the price of government bonds fall, and the market interest rate rise. The government will have to pay much higher interest rates to compensate for the risk of default and it will be difficult to attract buyers of bonds in the future.

Haircut / partial default. If the government is in great financial difficulty it may offer a deal to bond holders that it will pay back a certain percentage, e.g. 50%. In response for writing off 50% of the bond, bondholders may feel it is better to get 50% than nothing. Alternatively, the government may extend the maturity of the bond, e.g. change a 30 year bond into a 45 year bond, to give itself more time to pay it back.

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The price of petrol and tax levels in UK

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The UK has one of the highest tax rates on petrol / diesel in Europe – roughly 60% of the final price of petrol goes to the government in excise duty or VAT.

  • UK fuel duty is currently 58p per litre for petrol and diesel
  • VAT accounts for 20-25p per litre
  • The product cost is around 50p per litre
  • firms profit margins is often as low as 5p per litre – even lower for supermarkets, who use petrol as a type of ‘loss leader’ to entice shoppers into the supermarket to spend on groceries.

Between 1993 and 1999, fuel duty rose at 3% above inflation, causing an increase in the price of petrol. However, in 2011, the chancellor introduced a fuel duty stabiliser with a pledge to pledge to keep rates down.

fuel-duty

Source: Fuel duty UK

However, there are economic arguments to suggest that breaking the fuel duty escalator is a mistake. With falling inflation, falling oil prices and rising congestion levels – higher petrol tax could help improve struggling government tax revenues and also contribute to a better environment and lower congestion levels.

Arguments for higher tax on petrol

Environmental costs of petrol. Using petrol causes carbon dioxide (CO2 emissions which contribute to global warming. But, also burning petrol / diesel creates other compounds  toxic to life. For example carbon monoxide and methanol. Also, fine particulates of soot cause from car exhausts cause lung problems and are carcinogenic. Air quality standards in cities would be improved by reducing petrol and diesel consumption. Higher tax would act as an incentive to reduce the pollution caused by driving petrol/ diesel cars (See: tax on negative externality for more on the economics of taxing these negative externalities)

Costs of congestion. Cheaper petrol will cause increased congestion levels. Time wasted in traffic jams is a major individual cost and also cost for business. Without increasing the price of petrol, there will be a rise in the social cost of traffic congestion. The CBI estimate that congestion costs the UK economy £8bn a year. Given the limited scope for increasing the road network in many areas, pricing will have to pay a role – otherwise, we will pay for cheap petrol in other ways.

Improved fuel efficiency and falling tax revenue. One of the benefits of increasing petrol duty in the past has been to increase the incentive for manufacturers and consumers to choose more fuel efficient cars. The consequence is that although petrol tax has risen, the total amount of fuel duty we actually pay is falling – because we are using less fuel. This means government tax revenue from petrol tax is falling. In 2012, the government could expect £38bn from fuel duty and VED. (Link) But, by 2029, this tax revenue could be £13bn lower.

A study by the Institute for Fiscal Studies (IFS) has stated the government face a significant fall in tax revenue from fuel duty and vehicle excise duty (VED). They state that revenue will fall from the current levels of 1.7pc and 0.4pc of GDP respectively, to 1.1pc and 0.1pc by 2029 – in its report Fuel for Thought, commissioned by the RAC Foundation.

Given the poor performance of UK tax revenues in recent years, increasing petrol tax would help meet this deficit. Also, higher petrol tax would further increase the incentive for greater fuel efficiency.

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Attempting to reduce debt after First World War

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In the recent blog – Post-war economic boom and reduction in debt, we saw how the UK successfully reduced national debt as a % of GDP from 230% of GDP to 30% of GDP, over a period of 40 years. However, the story after the First World War was very different. The UK finished the …

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National debt – mortgage comparison

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Readers Question. You make the point that the debt to GDP fell in the post war period since the GDP rose faster than the debt but that still left the debt to be repaid and as such there was still the interest to be paid. I was expecting you to explain how the current debt …

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Saving rates in the UK

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It is not a good time to be a saver in the UK. Interest rates are 0.5% and inflation has been above 2% for a high proportion of the previous five years. Because inflation is higher than nominal interest rates, we are seeing negative real interest rates. This means many savers are seeing a decline in the real value of their savings. Pensioners who are relying on interest payments as income, are seeing a decline in their income.

Inflation and interest rates

inflation-base-rates-since-03

In most of the post-war period we have seen positive real interest rates – Base rates above the headline inflation. This means that savers are protected from the effects of inflation.

H0wever, 2008 marks a sharp contrast, with Bank of England base rates falling to 0.5% and inflation reaching above 5%.

In recent months, inflation has fallen to below 2%, but that is still higher than base rates of 0.5%

Effectively, you are getting 0.5% return on your saving, but prices are going up 2%, so the real value of your savings is falling by 1.5%.

Base rates and bank rates

The contrast between base rates and inflation looks very high. But, actually bank savings rates have not fallen as much as base rates. This is because banks were short of money in the credit crunch and were keener to attract deposits than lend money. Therefore, when the Bank of England cut interest rates to 0.5%, commercial banks were not so keen to reduce their own interest rates by as much. Usually commercial bank rates closely follow base rates, but after 2008 we see a break in this correlation.

saving-rates-base-fixed-instant

Source: Bank of England. Series IUMB6VJ | IUMWTFA

In 2008/09, base rates are cut from 5% to 0.5%, but fixed interest rates  (series IUMWTFA) only fall to 2.5 / 3%. Interestingly since mid 2012, fixed interest rates have continued to fall closer to 1%. This suggests the banks are less desperate to attract saving deposits and so can reduce interest rates.

It is a similar story with instant access saving rates (series IUMB6VJ) Since mid 2012, rates have fallen from 1.6% to 0.6%. This suggest the financial sector is in better health, but it means a poorer return for savers.

saving-rates-inflation-since-05

However, if you look around, you can still see higher fixed rates for those willing to ‘lock their money away’

It also depends how much money you can save. For example, according to ‘Money Saving Expert‘ you could get 3.25% if you can put £25,000 away for 5 years. – hardly a great deal, but you would just about get a positive real interest rate.

Should the Bank of England do more for savers?

In the past few years, many groups representing savers have felt they have been ignored – and the government / Bank of England should have done more to give a better rate of return for savers.

However, the past five years have seen declining living standards for most groups of people – real wages have fallen. Unemployment has been very high. The cost of renting has been very high. Given the general economic decline, savers have not been alone in seeing falling living standards. It is complicated by the fact that people with high levels of saving are more likely to be household owners. Homeowners have seen record low mortgage interest payments and rising house prices, which, to some extent, have offset the fall in the return on savings.

Young people without savings, but paying rent, have seen a bigger squeeze on their living standards.

However, someone who is relying on their savings to pay rent, is definitely in a bind.

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Should the world adopt a unified currency?

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global-currency

Readers Question: Should the world adopt a unified currency?

global-currency

I haven’t given it much thought; given the great difficulties of the Euro single currency within parts of the European Union, the idea of extending this to include even more disparate countries seems a non-starter.

From a philosophic point of view, I think the world is heading towards greater integration, and perhaps in a thousands of years we will global governments, global fiscal transfers and we could move towards a global single currency. But, this would require a completely different mindset of selflessness, breaking down parochial self-interest and seeing the world as one world-family.

Alas, I can’t see this spiritual evolution happening quickly. Some issues to consider in a single currency.

What happens when countries have different inflation rates, but the same currency? In Europe, countries with higher inflation rates (e.g. Greece, Spain, Portugal) were left with large current account deficits, lower exports and lower growth. A global currency, would see even bigger disparities in relative costs and competitiveness.

Single monetary policy. For a single currency to be practical, the assumption would be that you need a single monetary policy. That would be highly impractical and could be devastating for some economies who have different rates of economic growth. For example, we might have very low interest rates, but countries with fast rates of growth could see inflation. It might be more practical to have a single currency, but have regional variations in interest rates. I’m not quite sure how this would work or what the consequences would be. But, with a single global currency you would see a lot of capital flows from less prosperous countries – especially with any variation in interest rate.

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Economic growth with falling real wages

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The UK recovery paints an unusual situation. We have both positive economic growth and falling real wages. How can we have economic growth with falling real wages?

Real wages are not the only source of economic growth. We can see growth from other components of AD –

I (Investment), G (Government spending) plus net exports (X-M)

Also, it is possible for consumer spending to rise despite falling real wages (at least in the short term). For example, if spending is financed by borrowing or declining savings ratio. Consumer spending could also be financed through re mortgaging houses (equity withdrawal) against the backdrop of rising house prices.

Economic growth in the UK

economic-growth-quarterly

Since 2013 Q1, we have seen a decent rate of economic recovery. In the past 12 months – between Q2 2013 and Q2 2014, GDP in volume terms increased by 3.2%

Real wages

uk-real-wages-06-14

Real wages have been falling since the start of the great recession in mid 2008. In a recessing falling real wages are to be expected, but since the recovery, we might have expected real wages to match the growth in real GDP.

Why are real wages falling despite economic growth?

1. Flexible labour markets creating low paid employment. In this recovery, unemployment has fallen more rapidly than previous recessions. Evidence suggests the economy has been successful in creating new employment (often temporary / part-time/ self-employment). These new jobs are not particularly well paid. The recovery is good for job-seekers, but less good for those already in work. The relatively elastic supply of labour willing to take low paid jobs is keeping any wage growth low.

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