Evaluation of the 2011 Policy of the Bank of England - Essay Example

?Evaluation of the Policy of the Bank of England In the Bank of England maintained the interest rate low even when the inflation rate was higher than the targeted level. Is this policy sound? The “monetary policy objective is to deliver price stability --- low inflation --- and, subject to that, support the Government’s economic objectives including those for growth and employment” (Bank of England 2012a). Low inflation itself is not defined but “price stability is defined by the Government inflation target of 2%” (2012a). Table 1. UK inflation, current and real GDP, and average bank interest rate, 2000-11 Year Inflation % Current GDP in billion ? Real GDP (in 2005 billion ?) Annual average bank interest rate 2000 0.79 976.53 1,108.54 5.97 2001 1.24 1,021.83 1,135.82 5.12 2002 1.26 1,075.56 1,159.64 4.00 2003 1.36 1,139.75 1,192.21 3.69 2004 1.35 1,202.96 1,227.39 4.39 2005 2.10 1,254.06 1,254.06 4.65 2006 2.33 1,325.80 1,289.83 4.64 2007 2.32 1,398.88 1,322.84 5.51 2008 3.61 1,448.39 1,330.09 4.68 2009 2.17 1,395.87 1,264.65 0.64 2010 3.29 1,453.62 1,349.54 0.5 2011 4.48 n.a. n.a. 0.5 Source: Rateofinflation.com (2012), Chantrill (2012a and 2012b), and Bank of England (2012) Maintaining t a 2% inflation rate is the continuing target of the United Kingdom through the Bank of England which is the central bank of the UK. Yet, as indicated by Table 1, inflation was 2.1% in 2005, 2.33% in 2006, 2.32% in 2007, 3.6% in 2008, 2.17% in 2009, 3.29% in 2010, and 0.5% in 2011. If the inflation rate “target is missed by more than 1 percentage point on either side ---i.e. if the annual rate of CPI inflation is more than 3% or less than 1%---the Governor of the Bank must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen to such an extent and what the Bank proposes to do to ensure inflation comes back to the target” (Bank of England 2012a). During the period 2005-11, annual average bank interest rate decreased from 4.65% to 0.5% when the usually logical action to take is to increase the interest rate given the overall trend of an increasing inflation rate. If she wants to, the Bank of England can influence bank interest rates through several policy instruments such as her control over government. Over the period 2005-11 or 7 years, inflation rate was above 2% and, yet, interest rate has been made extremely low. Inflation has been on the uptrend since 2005 but interest rates were on the downtrend beginning the same year. The United States sub-prime crisis that became the trigger for the ongoing world crisis started to express itself sometime 2007. In the United Kingdom, the gross domestic product dropped in 2009 and recovered its 2008 level in 2010 but the GDP per capita figures probably continued to decrease. UK inflation, on the other hand, has been increasing since 2005. This indicates that the ongoing UK inflation is independent from the United States crisis and its aftershocks. At the same time, this also implies that it may be possible to address the two problems separately or that specific measures are needed to address UK inflation independent from the measures needed to address the fallouts on the UK from the U.S. sub-prime crisis. Nominal GDP or GDP in current values decreased in 2009 despite an inflation of 2.17% during the year. Needless to say, the impact of this double hit of a decrease in the nominal value of the GDP combined with inflation is that the quality of life deteriorated for at least several households in the United Kingdom. Chart 1. Quarterly GDP change, 1955 to 2011 Source: Roger, et al. 2012 Using Chart 2 for looking at the period 2000-2011 within a longer term horizon or between 1955 to 2011, it is to see that 2000-2011 is a period wherein GDP change on a per quarter basis is lower compared to the GDP change on a per quarter basis over the period 1955 to 1980. A lower growth rate should imply a lower demand for money and provides a merit for higher levels of interest rates. Chart 3 also suggests that the pattern of GDP quarterly change between 1997 to 2003 change, except for the sharp drop in 2009, is almost the same as the pattern of GDP change from 2009 to 2011. Yet, based on the Chart 2 on the next page, the pattern of UK interest rate levels between 2009 to 2012 is extremely low. The extremely low interest rate levels between 2009 to 2012 do not appear to be justified by the pattern of the GDP quarterly change levels. Chart 3. UK interest rate, January 2000 to January 2012 Source: Trading Economics 2012a Chart 4. UK inflation rate, January 1989 to January 2012 Source: Trading Economics 2012b In view of the foregoing discussion or in view of the extremely low levels of interest rate, it is not surprising to see that the pattern of the inflation rate levels demonstrated by Chart 4 of the earlier page is that the inflation rate levels between 2007 to 2011 are among the highest in UK inflation history from 1989 to 2011. Chart 5. UK inflation rate 1971 to January 2012 Source: Trading Economics 2012c How does the United Kingdom rate in fighting inflation compared with select countries like the United States, Australia, New Zealand, Canada, Euro Area Countries, and South Korea? Table 2 illustrate how the United Kingdom performs in comparison with the said countries in fighting inflation. As indicated by Table 2, excluding the UK performance in 2007, the UK performed poorly compared to the said countries based on its higher inflation rate versus the average inflation rate for the said countries. Table 2 therefore indicates that the relatively high inflation rates in the United Kingdom are not warranted as a number of countries have managed to avoid inflation. Table 2. UK inflation rate compared with other countries, 2005-2011 Country Latest 2011 2010 2009 2008 2007 United Kingdom 3.40 4.20 3.70 2.90 3.10 2.10 United States 2.90 3.00 1.50 2.70 0.10 4.10 Australia 3.10 3.10 2.70 2.10 3.70 3.00 South Korea 3.10 4.20 3.50 2.80 4.14 3.61 New Zealand 1.80 1.80 4.00 2.00 3.40 3.20 Canada 2.60 2.30 2.40 1.30 1.20 2.40 Euro Area 2.70 2.70 2.20 0.90 1.60 3.10 Average 2.80 3.04 2.86 2.10 2.46 3.07 Source: Trading Economics 2012d Given Table 2, Table 3 next page indicate that it is possible for the UK to increase interest rates in fighting inflation. This is because Table 3 shows that the interest rates in the United Kingdom are very low compared to interest rates in a number of countries. The UK interest rates are lower compared to the average interest rates of countries like the United States, New Zealand, Canada, Australia, Euro Area and South Korea. Table 3. UK interest rate compared with other countries, 2005-10 Country Latest 2011 2010 2009 2008 2007 2006 2005 United Kingdom 0.50 0.50 0.50 0.50 2.00 5.50 5.00 4.50 United States 0.25 0.25 0.25 0.25 0.25 4.25 5.25 4.00 Australia 4.25 4.25 4.75 3.75 4.25 6.75 6.25 5.50 South Korea 3.25 3.25 2.50 2.00 3.00 5.00 4.50 3.75 New Zealand 2.50 2.50 3.00 2.50 5.00 8.25 7.25 7.00 Canada 1.00 1.00 1.00 0.25 1.50 4.25 4.25 3.00 Euro Area 1.00 1.00 1.00 1.00 2.50 4.00 3.25 2.25 Average 1.82 1.82 1.86 1.46 2.64 5.43 5.11 4.29 Source: Trading Economics 2012e Our discussion so indicated so far that the UK implemented a low interest rate policy. Yet, her low interest rate policy is not justified by the interest rate level of her peers: the United States, Canada, New Zealand, South Korea, Euro Area, and Australia. The interest rates of the United Kingdom are generally below the average interest rates of the said countries. At the same time, as indicated by our earlier discussion, the low interest rate policy of the United Kingdom is also not justified by her high inflation rates. Other than being above the 2% inflation target, the United Kingdom’s inflation rates are above the average interest rates of the countries we chose to compose our comparison group. Table 5. UK GDP growth compared with select countries Country 2011 Q4 2011 Q3 2011 Q2 2011 Q1 2010 Q4 2010 Q3 2010 Q2 2010 Q1 2009 Q4 2009 Q3 United Kingdom 0.80 0.50 0.60 1.60 1.50 2.70 1.60 -0.20 -2.90 -5.30 United States 1.60 1.50 1.60 2.20 3.10 3.50 3.30 2.20 -0.50 -3.70 Australia 2.30 2.50 1.10 1.20 3.00 2.70 3.30 2.70 2.80 0.90 South Korea 3.40 3.50 3.40 4.20 4.70 4.40 7.50 8.50 6.30 1.00 New Zealand 1.80 1.80 1.10 1.40 1.10 1.60 2.00 1.90 0.20 -2.00 Canada 2.20 2.60 2.10 2.90 3.30 3.80 3.60 2.10 -1.40 -3.50 Euro Area 0.70 1.30 1.60 2.40 1.90 2.00 2.00 0.60 -2.10 -4.10 Average 1.83 1.96 1.64 2.27 2.66 2.96 3.33 2.54 0.34 -2.39 Source: Trading Economics 2012f Are the low interest rates in the United Kingdom justifiable by the GDP growth? Table 5 indicate that UK output has been lower compared to the average GDP growth of her peers. Thus, it if is argued that the UK’s low interest rate policy is justified precisely because the low interest rate policy can boost output, the argument is not supported by UK data because UK output continues to be low despite the low interest rate policy. Table 6. Long-term government bond yield and M1/M2 and M3/M$ YEAR Long-term government bond yield (%) M1/M2 M1/M2 Growth (%) M3/M4 M3/M4 Growth (%) 2000 6.00 602797 n.a. 846857 n.a. 2001 4.00 656094 8.84 900896 6.38 2002 4.00 710272 8.26 962374 6.82 2003 3.75 783115 10.26 1025111 6.52 2004 4.75 852546 8.87 1099854 7.29 2005 4.50 931709 9.29 1207773 9.81 2006 5.00 1005201 7.89 1328904 10.03 2007 5.50 1070268 6.47 1469811 10.60 2008 2.00 1120253 4.67 1524616 3.73 2009 0.50 1186738 5.93 1540983 1.07 Source: Bank of England Database, 24 March 2012 With regard to interest rates, an important point of attention is the level of M1/M2 and M3/M4. Table 6 above indicates that UK’s low interest rate policy continues to promote a rapid growth in M1/M2 despite a rate of inflation that is already above the target inflation rate of 2%. Even the level s of M3/M4 are high despite their low levels in 2009. Consistent with Table 6, Table 7 indicates that broad money has continued to increase in significantly in 2011 despite the relatively high inflation rate during the year. This data plus our earlier discussion do not support the view that monetary policy was wisely implemented in the UK in 2011. Table 7. Broad moneya Source: Bank of England 2012b, p. 11 Chart 6 . Public net debt as percentage of GDP Source: Chantrill 2012c Chart 6 indicates that although the levels of public net debt are generally lower , the level has been consistently increasing since 2002. The level of money supply and public net debt as a percentage of the GDP are important variables to consider in address the problem of high inflation rate, especially when the budget deficit is monetized or paid through an inflation tax. Finally, according to a report of the Bank of England, the 2011 monetary policies of Monetary Policy Committee was premised on an expectation that output will continue to drop and was justified by an expectation that inflation would drop to “only” 4.2% by December 2011 (2012b). The expected drop of inflation to “only” 4.2% was even considered encouraging by the Bank of England report (2012b). With this estimate in mind, the Monetary Policy Committee voted to maintain the interest rate at 0.5%. However, based on Table 1, it is easy to see that the inflation figure for 2011 was more than double the inflation target of 2.0%. It is also easy to see that the inflation figures, with the exception of the figure for 2009, have been increasing. This fact alone should have been sufficient to make a conclusion that the Bank of England’s Monetary Policy Committee decision to maintain the interest rate at an extremely low figure of 0.5% is unjustified given that the primary function of interest rates, based on the Bank of England’s inflation-targeting policy framework for interest rates, is to meet inflation rather than output targets. References Bank of England (BOE), 2012a. Monetary policy framework. Available at http://www.bankofengland.co.uk/monetarypolicy/Pages/framework/framework.aspx (accessed 23 March 2012). Bank of England (BOE), 2012b. Inflation Report (February). London: Bank of England. Chantrill, C., 2012a. UK real gross domestic product GDP history. Online. Available at http://www.ukpublicspending.co.uk/uk_real_gdp_history#copypaste (accessed 23 March 2012). Chantrill, C., 2012b. UK gross domestic product GDP history. Online. Available at http://www.ukpublicspending.co.uk/spending_chart_2000_2010UKb_11s1li011mcn__UK_Gross_Domestic_Product_GDP_History (accessed 23 March 2012). Chantrill, C., 2012c. UK total government debt as percentage of GDP, 1900-2011. Online. Available at www.ukpublicspending.co.uk/uk_national_debt_chart.html (accessed 23 March 2011). Rateofinflation.com, 2012. UK historical inflation rates. Online. Available at www.rateinflation.com/inflation-rate/uk-historical-inflation-rate.php?form=ukir (accessed 23 March 2012). Rogers, S., Sedghi, A., and Evans, L., 2012. UK GDP since 1948. Available in http://www.guardian.co.uk/news/datablog/2009/nov/25/gdp-uk-1948-growth-economy (accessed 23 March 2012). Trading Economics, 2012a. United Kingdom interest rate. Available in http://www.tradingeconomics.com/united-kingdom/interest-rate (accessed 24 March 2012). Trading Economics, 2012b. United Kingdom inflation rate. Available in http://www.tradingeconomics.com/united-kingdom/inflation-cpi (accessed 24 March 2012). Trading Economics, 2012c. United Kingdom inflation rate, 1971 to 2012. Available in http://www.tradingeconomics.com/united-kingdom/interest-rate (accessed 24 March 2012). Trading Economics, 2012d. United Kingdom inflation rate compared with other countries, 2005-11. Available in www.tradingeconomics.com/inflation-rates-list-by-country (accessed 24 March 2012). Trading Economics, 2012e. UK interest rate compared with other countries, 2005-10. Available in www.tradingeconomics.com/interest-rates-list-by-country (accessed 24 March 2012). Trading Economics, 2012f. UK GDP growth compared with select countries, 2009-11. Available in http://www.tradingeconomics.com/gdp-growth-rates-list-by-country (accessed 24 March 2012). Read More