Just because it has not changed does not mean its not significant

Today both the European Central Bank (ECB) and Bank of England decided to leave interest rates unchanged. For the UK it means interest rates have been at an all time low of 0.5% since March 2009.

This lack of change is deceptive. The low interest rates reflect concerns over the very low levels of demand in the economy and the expansionary monetary policy which is trying to stimulate Aggregate Demand. So what is happening is an ongoing active monetary policy.

But rates are pretty much as low as they can go (although there are rumours of a fall to 0.25% next month) and additional help through more Quantitative Easing (printing money) may still be required to help the economy recover.

The decisions to be made about monetary policy are not straightforward. The Bank of England must predict what inflation will be in two years time. As the linked article below shows it is not even clear what the July to September GDP figures will be, so predicting influences on inflation up to two years ahead is far from straightforward.

Monetary policy is a key policy weapon. Balancing the needs of growth (which needs low interest rates) and inflation, which is still above target, is a continuing headache.

The BBC explain some of the difficulties here

Inflation figures a blip, but a blow too

The CPI figure rose last month to 3.5% (from 3.4%). The Bank of England has been saying that there was a danger of being below the 2% target by the end of the year and this is a concern for them.

The cause of the rise in inflation was mainly due to energy prices (which rose but more slowly than a year ago), food and clothing prices. These are items that monetary policy finds difficult to control as they are supply side or exchange rate driven and monetary policy works on AD.

However there is a concern in these figures for the pace of recovery. The higher inflation rate means that real disposable incomes are falling faster. Wage rises are less than 3.5% and so it means that households have less real income to spend on consumption. Also as households are very aware of inflation rates (indeed they exaggerate the rise in their minds) and this rise in inflation will affect consumer confidence. As we all know consumption is around 2/3 of AD and so short-term growth can easily be reduced.

It is pretty much impossible for the Bank of England to do more. They also believe, as do most economists, that inflation will fall for the rest of the year. (RPI did fall this month.) But this change in the direction of inflation, however temporary, may have a much bigger impact than the actual small change suggests.

The Guardian covers the story here

Growth, inflation and government budgets

The Bank of England have slashed their growth forecast and predicted a rapid fall in inflation over the next two years. At the same time the governments aim at reducing the government budget deficit now appears optimistic due to the slowdown in the Eurozone economies.

This latest news illustrates the relationship between economic variables.

Economic growth leads to upward pressure on prices as demand rises, while slow growth exerts little inflationary pressure. The slowing of the Eurozone economies has affected Britain because Europe is the main market for British exports. Lower export growth has led to a stalling of British growth as net exports are a component of Aggregate Demand. The general uncertainty of the whole crisis is making UK households save and pay off debt rather than spend so reducing Consumption, another component of AD.

The result is that the Government is not gaining as much revenue as they thought (through lower income tax, VAT and corporation tax receipts) and are spending more than they hoped (on unemployment benefits for example). The result is the government budget deficit is larger than predicted.

Of course this is exactly what should happen and is caused by the operation of automatic stabilisers. For the Bank of England there are new problems. Inflation is well above target but threatening to drop below over the next two years. It means that interest rates will not rise anytime soon and more Quantitative Easing is possible.

The Guardian lead article is here

Watch the latest Inflation Report presentation here