Achieving the Governments Target - Book Report/Review Example

How effective has the MPC been at achieving the Government's target Chart in the appendix shows how inflation levels have evolved over time since 1990. It is notable how inflation levels are lower and less volatile since the formation of the MPC in 1997. Table 1, which shows the mean and standard deviation of the CPI either side of 1997 demonstrates this even further. We can measure exactly how well the MPC have performed by comparing the inflation levels to the government targets (2.5% RPIX target before December 2003 and 2% CPI target after December 2003). If the Bank misses the target just by a margin of more than 1 percentage point on any side, be it up or down, the Governor of the Bank is required to write an open letter to the Chancellor explaining all the reasons as to why it happened. Chart 2 shows that this has happened only 6 times since the MPC began controlling interest rates. In fact before 2007 there were no such occurrences. There are various other points worth noting to demonstrate the good performance of the MPC: Since the formation of the MPC, the average deviation from target has been 0.08%. In the past decade, only Japan which has suffered from long period of deflation, has had lower average inflation than the UK, among the G7 economies . This contrasts the decade preceding that in which the UK had the second highest inflation rate in the G7. UK interest rates have remained at an average of 5% since the MPC began compared to just over 9% in the previous economic cycle. This has subsequently allowed a long period of sustained low inflationary economic growth. There are many references over the last decade in which they have reacted quickly to prevent inflation getting out of control. In fact, up till the middle of 1997, the MPC met 120 times and on 34 of such occasions, these meetings have resulted in a change of the base rate. It is clearly obvious to the general public, that the MPC change interest rates in response to economic events/outlook. The MPC has therefore reduced market expectations of inflation. Since the Bank is independent and has developed a good track record, people have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low. APPENDIX CHART 1 CHART 2 TABLE 1 UK Inflation Dynamics 1950 -2007 Period Mean Standard Deviation Jan 1950 - April 1997 6.1 5.1 May 1997 - March 2007 1.5 0.5 Effectiveness of MPC due to Interest rate cuts and External Factors MPC has been effective in keeping the inflation low since the very beginning of its formation. We can analyse this better with the help of figure below, also the table given above proves the same point, as the mean inflation between 1997 and 2007 has been low at 1.5 percent, which is very much within the target of MPC. (Impact of Credit Crunch on UK Interest Rates) The diagrams above clearly show that inflation started picking up with the onset of 2007, whereas the interest rates was marginally raised between 2006-2007 from 5.25 percent to 5.75 percent, which is a 50 basis points cut. A 50 bps cut in an inflationary scenario was a very proactive step from the Bank of England, but the economic situation worsened because of a couple of factors like the Sub-prime mortgage crisis taking a toll on liquidity of the banks world over and also the high crude prices. Sub-prime mortgage not only affected the US, but it marred the liquidity situation so badly that many prominent institutions in the US and UK went bust. The subprime crisis started with the subprime lenders lending at higher rates than usual to the borrowers with bad economic history and lesser ability to pay back. The subprime lending functions on the principle of no collateral and higher interests. There debt instruments are then traded and are passed on to other banks or institutions which are ready to take them for the higher interest they get out of them. Effects on the US and World Economies and Recent Shutdowns Due to the passing on of the debt instruments some prominent hedge funds have failed to declare their current asset values. The problem has led to a total crunch of liquidity in the US. The markets witnessed BNP Paribas announce that it had frozen 3 of its hedge funds due to evaporation of liquidity, totaling around 1.6 billion pounds. The reason was that, it was not possible for the bank to value units of the funds due to the affect of the US subprime market on them. The funds contained the bundles of subprime loans, the demand for which have fallen drastically over the last few months. Banks around Europe feared a total liquidity crunch as they feared that they might run out of cash to sustain day to day lending. ECB went to the extent of injecting 155 billion pounds to ease the system of. Investors around the world started backing off from the markets fearing the ill effects of over exposure to the mortgage markets. (How the US Subprime Mortgage Crisis Affect Irish Markets) The high liquidity crunch faced by the US has made the Fed cut key interest rates several times over the last one year. The liquidity crunch that the US has witnessed had also done bad to the commodity prices and the willingness of the banks and financial institutions to lend each other or even to the consumers. This would also result in the housing prices falling in the UK as the buyers will not be able to raise mortgage finance and sellers will be forced to cut down their asking prices. The collapse of Bear Sterns has affected their London operations with over 2,000 jobs in London. (Q&A: How will the financial crisis hit us) Another unfortunate incident that took place a few days back was of the 158 year old firm Lehman Brothers filing for chapter 11 bankruptcy due to the credit crunch. Financial institutions around the world have recorded $ 500 billion credit losses and write-downs due to the subprime crisis. At the end of August, the company is believed to have had assets worth $ 600 billion funded with equity of just $ 30 billion. (Lehman Is In Advanced Talks To Sell Key Business) The crude oil prices touched a whopping USD 147 a barrel earlier this year before cooling off. The Bank of England also cut rates to 4.5 percent in its latest monetary policy despite inflation being at its 16 year high. AIG also faced the liquidity crunch due to the crisis and approached the Fed for funds as a temporary measure. American International Group was hit to the tune of $ 18 billion in losses over the last 3 quarters due to the guarantees they wrote on mortgage derivatives. (AIG, Facing Liquidity Crunch, Reaches Out to Regulator). The problem has also had a very deep impact on the equity markets across the globe, that have tumbled down to their lowest levels in as many as 6 years. Dow Jones had plunged to below 8,000 levels for the first time after 2003. The latest story on the crisis is that of the US government making available $750 billion to bail out distressed institutions that have been reporting abysmal earnings quarter on quarter due to write downs they have faced in the property market. The Fed seems determined to stem the subprime problem and is prepared not to stand down until the crisis is fully resolved, but it remains to be seen whether the rescue measures will have any impact on the economy in the medium term, for the short term though, it seems like the crisis will take at-least a couple of years to clear itself. It will be long before the US economy starts to revive and look up once again. Works cited "AIG, Facing Liquidity Crunch, Reaches Out to Regulator" CNBC. 16 Oct. 2008. http://www.cnbc.com/id/26710104 "How the US Subprime Mortgage Crisis Affect Irish Markets". 16 Oct. 2008. Irish Mortgage Brokers http://mortgagebrokers.ie/index.phpa=mortgage_article_view&article_id=21 "Lehman Is In Advanced Talks To Sell Key Business". CNBC. 16 Oct. 2008. http://www.cnbc.com/id/26708143 Read More