Bank of England and The Times Interest Rate Challenge TARGET Bank of England and The Times Interest Rate Challenge 2014/15 CONTENTS Foreword 3 Introduction 5 Section A Introducing the Challenge 7 What the Challenge involves 9 Judging 12 What you might gain from the Challenge 14 Dates, venues and expenses 16 The Challenge rules 17 Contacting the Target Two Point Zero team 18 Section B Monetary policy – setting interest rates to control inflation 19 What is inflation? 21 What causes inflation? 23 What is monetary policy for? 25 Why do we want stable prices? 26 How do interest rates affect inflation? 28 Section C The inflation target and the Monetary Policy Committee 31 Monetary policy in the United Kingdom 33 An independent Bank of England 36 Quantitative easing – injecting money into the economy 38 Monetary policy as the economy recovers 41 Section D Assessing economic conditions and the inflation outlook 49 Assessing economic conditions 51 Judging the inflation outlook 55 © Bank of England 2014 Section E Using economic information 59 Building up the economic picture 61 Official statistics 62 Surveys and business intelligence 67 The economic jigsaw – how many pieces of data should you use? 69 Organising economic information 70 Section F The economy – from money to prices 71 Recap 73 Money and financial markets 75 Demand and output 80 The labour market 89 Costs and prices 93 Guidance for using the datasheets 97 Section G Making your presentation 99 Developing your presentation 101 Delivering your presentation 103 And now... over to you 106 © Bank of England 2014 Bank of England and The Times Interest Rate Challenge 2014/15 Foreword It gives me great pleasure to welcome you to Target Two Point Zero – the Bank of England and The Times Interest Rate Challenge. We introduced the Challenge in 2000 to give students a practical understanding of the way the economy works and an insight into how the Bank’s Monetary Policy Committee goes about its task of achieving the Government’s inflation target. We have been delighted by the enthusiastic response of students and teachers alike. I hope that you will enjoy taking part in the Challenge as much as your predecessors. The competition offers students a great opportunity to broaden their understanding of monetary policy and how it relates to the economy as a whole. You will learn about how interest rates affect inflation and what matters when making interest rate decisions – what information the Monetary Policy Committee uses and how judgements are formed. And, of course, you will have the chance to have a go yourselves and tell members of the Monetary Policy Committee what interest rate you would set – and why. There will also be ample opportunity to develop and demonstrate key skills, which are now an important part of post-16 education. There will be no right or wrong answers – there never are. The Challenge is to demonstrate your understanding, present a well-argued case for your interest rate decision – and any other policy recommendation – you may wish to make and then answer the judges’ questions convincingly. All the necessary information will be provided in this resource manual and on the Bank’s website, but you can use other information if you wish. Finalists will be guests of the Bank of England in London for the two days of the national final. The winning team will receive the Bank of England and The Times Interest Rate Challenge trophy and there are cash prizes for schools. May I take this opportunity to wish you success in the Interest Rate Challenge. We look forward to the fifteenth national final in London in March 2015. I hope that you will always feel that taking part in Target Two Point Zero was worthwhile and rewarding. Ben Broadbent, Deputy Governor, Monetary Policy Bank of England and The Times Interest Rate Challenge 2014/15 Foreword 3 Introduction Monetary policy and the Challenge Inflation, growth, manufacturing, consumers, exchange rates, exports, employment, wages…There seems to be a long list of terms that might be relevant to the Bank of England and The Times Interest Rate Challenge. But do not be put off by this, or by the thought of too much economic theory or too many statistics, or the jargon and the ‘buzz’ words of the day. The level of knowledge and understanding needed to take part in the Challenge is for your team to decide. It will probably be greater in some areas than others. You may want to concentrate on a few key factors. This might depend on what is being covered in the classroom or has already been taught, or what the participants think is most important for their assessment of the outlook for inflation and thus the interest rate decision. You will have to decide where to draw the line. The main requirement is that your team builds up a convincing case to justify its interest rate decision – that is the Challenge. Monetary policy is not just about looking at inflation and interest rates. It is also about the growth of the economy, employment and, ultimately, our collective living standards. But all these considerations are framed around the inflation target and the policies required to achieve it. The Challenge therefore asks teams to set the level of Bank Rate and asset purchases to meet the Government’s 2% inflation target. Target Two Point Zero invites schools and colleges to assume the role of the Bank of England’s Monetary Policy Committee and make a presentation that sets out their view on current economic conditions and future prospects, culminating in a policy recommendation aimed at meeting the inflation target. In doing so, teams may wish to consider how their decision fits with any ‘forward guidance’ communicated by the MPC. Economic theories and concepts can guide our understanding of the economy and help to explain what we observe around us, both in the economic statistics and first-hand. But they cannot tell us what inflation will be or what the interest rate should be. Policy decisions depend on an interpretation of current economic conditions and Bank of England and The Times Interest Rate Challenge 2014/15 events, and judgements about the likely future path of the economy. Many considerations will be relevant to the outlook for inflation – some more so than others, and to a different degree at different times. Evidence on the economic picture is often unclear or contradictory. Some factors will point to less inflationary pressure, others to more. That is why judgement is central to setting monetary policy. There is no complex formula to work out or a mechanical rule to follow. The interest rate decision is based on the best information that we have to hand. That is never perfect, nor does it result in a definitive or certain answer. So when you are reading the resource material, you will find information and tools to help you make your policy decision. But the answer will be up to you. We look forward to your economic assessment, your monetary policy decision and an imaginative presentation. Using the resource material The purpose of this resource manual is to tell you in a clear and concise manner about the main factors that are relevant to what the Challenge is all about – setting interest rates and asset purchases to control inflation. It does not repeat what you can find in text books or in other course material, and we are not going to overload you with everything that is, in some way, connected to monetary policy. Instead, it helps to explain in a practical way how the economy and monetary policy work, and what factors determine and influence inflation and interest rate decisions. We hope the resource manual will benefit you not just in the Challenge itself, but also in expanding your understanding of the economy and monetary policy more generally. You will see that the resource manual contains a large amount of information. But do not be overwhelmed by this. It is designed to be a comprehensive reference source for you to use throughout your preparation. You do not need to read and understand everything all at once. You can use the contents pages to refer to different parts of the manual when necessary. Introduction 5 The following brief summary shows you at a glance what each section of the resource manual contains. A more detailed summary is provided on the contents page of each section. Copies of the minutes of the Monetary Policy Committee’s meetings are available on the Bank’s website. Datasheets and data updates will also be available on the website. Using the website Section A Introducing the Challenge gives you practical information about taking part in the Challenge. A webcast of the 2014 national final, is available on the Bank’s YouTube channel: Section B Monetary Policy – Setting Interest Rates to Control Inflation introduces you to the principles of monetary policy and the control of inflation. It explains why we want low inflation and how interest rates affect inflation. Section C The Inflation Target and the Monetary Policy Committee explains how the Committee takes decisions on the interest rate and quantitative easing, and how it provides forward guidance. Section D Assessing Economic Conditions and the Inflation Outlook explains how you might think about developing your assessment of current and future inflation and judging the inflationary pressure in the economy. Section E Using Economic Information tells you about the economic information that is used to assess economic conditions and inflation prospects. It explains some of the characteristics of the information and data that we will give you and tells you how to use them. Section F The Economy – From Money to Prices gives you more detailed information about the inflation process and the economy. It explains why the Monetary Policy Committee looks at the different areas of the economy and why they are important. The resource material and data, as well as practical information about the presentation rounds of the Challenge, are available on the Bank of England’s website: www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx www.youtube.com/bankofenglanduk Although we will provide you with information and data that are relevant to setting monetary policy, you can use whatever information you think is relevant from whatever source. You can access the Bank’s regular monetary policy publications on the Bank’s website: www.bankofengland.co.uk/Pages/home.aspx The minutes of the Monetary Policy Committee’s meetings will give you an idea of the factors that are influencing the Committee’s policy decisions. In addition to help from the Bank, teams are encouraged to use the Office for National Statistics and whatever other data and information sources they think will be useful and relevant to their presentation. The Office for National Statistics provides much of its data on its website: www.statistics.gov.uk We hope you find the resource material helpful and enjoy the challenge of setting interest rates for the UK economy. If you have any comments about the Challenge you can e-mail us at: [email protected] Section G Making Your Presentation gives you guidance on preparing and delivering your presentation. Bank of England and The Times Interest Rate Challenge 2014/15 Introduction 6 Section A Introducing the Challenge In this section, we tell you what the Challenge involves and how you and your students might benefit from taking part. We set out the practical arrangements and the rules. What the Challenge involves 9 The teams 9 The task 9 Judges’ questions 11 Resource material 11 Judging 12 Judges 12 Judging criteria 12 What you might gain from the Challenge 14 Understanding the economy 14 Resource material 14 Key/core skills 14 Prizes 15 Publicity 15 Dates, venues and expenses 16 Competitive rounds 16 Expenses 16 The Challenge rules 17 Participants 17 Teams 17 Presentations and questions 17 Contacting the Target Two Point Zero team 18 Bank of England and The Times Interest Rate Challenge 2014/15 Section A Introducing the Challenge 7 Section A What the Challenge involves Target Two Point Zero invites teams of 16–18 year old students to take on the role of the Bank of England’s Monetary Policy Committee. Each team will assess the state of the economy and the outlook for inflation, and then set the interest rate to meet the Government’s inflation target. It will present its analysis and its decision to a panel of Bank of England judges. The teams Each school or college can enter one team. Each team should consist of four students. The composition of the team and the way in which the team members are chosen is entirely up to teachers and students. Although the Challenge will probably appeal mainly to students of economics and business, students studying any subject can take part. The main criteria for taking part are having an interest in learning about how the economy works and having skills which will help the team towards its objective of presenting a well-argued case for its monetary policy decision. Each team should decide on the level of Bank Rate, asset purchases or sales, and whether to provide forward guidance. Each school should nominate a teacher to act as the team’s adviser and coach, and to accompany the team to the presentation events. Each team should also nominate a team captain. He or she will act as the team co-ordinator and, like the Chairman of the Monetary Policy Committee, will have a casting vote, should the team decide to put its interest rate decision to a vote, which then results in a tie. Help and support Although only the four team members will represent their school or college at the presentation events, other class and school members, teachers or friends are encouraged to get involved by helping the team to undertake their research and prepare their case. The more students that get involved the better. You could consider the following approaches. • The team of four could work largely on their own, seeking the assistance of teachers and others as necessary. Bank of England and The Times Interest Rate Challenge 2014/15 Each team should decide on the level of Bank Rate, asset purchases or sales, and whether to provide forward guidance. • The team might want to consider identifying a reserve who will work closely with the team and can replace a team member who is unable to attend a presentation event. • The class could divide into several teams of four and hold an intra-class play-off to decide which team should represent the school or college in the three presentation rounds. • The whole class could help with the research and preparation and then brief the team of four in the same way that economists in the Bank brief the Monetary Policy Committee. The class could divide into small groups, with each group monitoring a different aspect of the economy and presenting their findings to the team. • Some or all of the class members could form a Monetary Policy Committee, could carry out the research and preparation and then, like the real MPC, could vote on what the interest rate should be. A team of four would be selected to present the views of their Monetary Policy Committee in the presentation rounds. The task The Challenge has three identical rounds – regional heats, area finals and the national final. In each round, the team will examine economic conditions and decide what level of interest rate it would set to achieve the Government’s inflation target. The inflation target is currently 2.0% and teams should decide what interest rate they would set, and any other monetary policy recommendation, to achieve this target. Section A What the Challenge involves 9 Each team will then prepare and give a short presentation, arguing the case for its decision, to a panel of judges. The judges will ask team members some questions about their decision and presentation. Using information and data to assess economic conditions Teams can use information and data from any source, but all the essential data will be provided by the Bank. In Section B of this manual, we discuss some of the principal causes of inflation. Essentially, teams will need to assess the balance between demand and supply (output) across the economy as a whole, and the extent to which any imbalance might lead to more or less inflationary pressure. They will look at the various components of demand – for example, consumer spending and exports; developments in the labour market – such as wages and employment; and information on costs and prices. And they will look at data on different sectors, such as manufacturing and retailing. We will tell teams about the data that they may wish to look at to assess trends and the recent picture – both official data and business surveys. But teams can also make use of first-hand information, perhaps from their local areas. Much of the data that are available only provide a partial picture of the economy. Teams will have to piece the various bits of evidence together to form an overall view. But the data rarely say the same thing about the current economic picture, or provide clear signals about the economic outlook. MPC members have to use their judgement throughout the process. And that is what the teams will have to do. The team’s decision has three parts: • whether to increase or decrease Bank Rate; • whether to increase or decrease the level of asset purchases; and • whether to provide any new forward guidance for future monetary policy. date as possible. This could, of course, mean some last minute changes if the team receives new data that cause it to alter its view of the inflation outlook and, hence, its decision. The task is not to find the right answer. There is no right answer. Deciding on the level of the interest rate and quantitative easing are a matter of judgement and, like the real policymakers, team members may disagree. There may, for example, be differences of opinion about whether to change the interest rate. Even if team members agree that the rate should change, they may disagree about whether the rate should go up or down, or about the extent of the change, say ¼% or ½%, or some other number. During the preparation stage, the team may choose to vote on its interest rate decision. If this results in a tie, the team captain will have the casting vote. If there is a split decision, both sides of the argument must be explained in the presentation to the judges. The presentation The policy decision In each round, the team should take the Monetary Policy Committee’s most recent decision on the level of Bank Rate, the level of asset purchases and forward guidance as its starting point. The team’s decision therefore has three parts: Having made its policy decision and prepared its case, each team will make its presentation to a panel of judges. Presentations should be no more than 15 minutes long. The precise format of the presentation is up to the team but it should: • examine current economic conditions; • whether to increase or decrease Bank Rate; • give an assessment of the outlook for the economy and inflation; and • whether to increase or decrease the level of asset purchases; and • present the team’s decision on Bank Rate and asset purchases, together with supporting evidence to the judges. If team members have different opinions on what should happen to the interest rate, this will need to be explained to the judges in the presentation. The team should also be prepared to defend any additional policy recommendations. • whether to provide any new forward guidance for future monetary policy. Just like the MPC, the team’s assessment of economic conditions and the outlook for inflation should be as up to Bank of England and The Times Interest Rate Challenge 2014/15 Section A What the Challenge involves 10 Judges’ questions Following the presentation, the judges will ask the team a series of questions. This is an important part of the proceedings. The questions allow the judges to test the team’s understanding and knowledge, to see how they justify their policy decision, just as the MPC has to do in public, and to see how they think on their feet. Team members might be asked to clarify, or expand on, points made during their presentation or they might be asked about the workings of the economy and how their policy decision will achieve the inflation target. The style of questioning will be constructive and sympathetic. Team members may confer but will be pressed for an answer if they take too long. They should work together as a team when answering the judges’ questions. Answers should not be dominated by one or two team members. The section on Delivering your presentation on pages 103–105 gives more guidance on answering the judges’ questions. The section on Judging on pages 12–13 gives details of the criteria that the judges will use to evaluate each team’s performance. Resource material The resource manual sets out clearly all the economic information and much of the data needed to take part in the Challenge. It explains the main principles behind monetary policy and describes the United Kingdom’s framework and processes. It contains sections on: It includes an explanation of why the Monetary Policy Committee looks at each of these aspects of the economy when deciding the outlook for inflation. It also includes an explanation of how teams might use the data, which will be made available on the Bank of England’s website and will be updated as new data becomes available. Finally, it gives teams guidance on how to set about developing and making their presentation and on answering the judges’ questions. The information in the resource manual and the data, as well as practical information about the competitive rounds and answers to frequent queries can be found on the Bank’s website: www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx A webcast of the 2014 national final can be found on the Bank’s YouTube channel: www.youtube.com/bankofenglanduk You should not be put off by the amount of information and data. You do not need to read and understand everything all at once. You can refer to different parts of the website and the resource manual as necessary. In addition to help from the Bank, teams are encouraged to use the Office for National Statistics and whatever other data and information sources they think will be • money and financial markets; • demand and output; • the labour market; and • costs and prices. Bank of England and The Times Interest Rate Challenge 2014/15 Section A What the Challenge involves 11 Section A Judging In each of the three rounds of the competition, presentations will be made to panels of judges. Judges The regional heats will be judged by staff from the Bank’s Agencies based around the United Kingdom and from its Head Office in London. The area finals are likely to be judged by a Bank of England Agent, a senior member of staff from London and possibly a member of the Monetary Policy Committee. There will be four judges for the national final. The panel will be chaired by Ben Broadbent, Deputy Governor for Monetary Policy, and will include other members of the Monetary Policy Committee. Judging criteria The winning teams will be those who demonstrate the clearest understanding and who present the most convincing decision on Bank Rate and the level of asset purchases. Although the content of the presentations is up to the teams, the judges will expect the teams to examine current economic conditions, assess the outlook for inflation and justify their interest rate decision. If team members disagree about the level of the interest rate, differences of opinion should be explained. The judges will assess teams’ performance against the specific criteria listed below. The judges’ assessment will be based both on the teams’ presentations and on their answers to the judges’ questions. Bank of England and The Times Interest Rate Challenge 2014/15 • Understanding of economics and monetary policy Teams will be assessed on their understanding of how the economy and monetary policy work. They will need to demonstrate that they have grasped the basic economic concepts; that they understand the key economic influences on the outlook for inflation and monetary policy decisions; and that they understand the monetary policy framework and process. The judges do not expect teams to reproduce textbook theories. The judges are interested in how teams explain why they are looking at particular issues or data and their relevance to the interest rate decision. Teams also need to show that they understand how their policy decision will help to meet the inflation target. The judges’ questions are an important way of finding out how well teams understand their material. • Research and information Teams will be assessed on the quality of their research and investigative work. The judges will be looking at the way in which teams have used data and other information. They will be particularly interested in how well teams have covered key issues and the relevance of the data and information they have used. They will be looking at how accurate and up to date the data and information are. The judges may question teams about their data and information. • Quality/structure of presentation and teamwork Teams will be assessed on the structure and clarity of their presentations including their creative approach and their use of visual aids. The judges will be looking at the style of delivery. They do not expect teams to memorise their presentation, but they will expect teams to refer to notes rather than read verbatim from scripts, laptop screens or other visual aids. Teams will also be assessed on how well they work together as a team. Section A Judging 12 The judges will want to see all team members making a significant contribution to the presentations and participating in the answers to questions. • Conclusions and justifications of monetary policy decision Teams will be assessed on the analytical strength and clarity of thought in their presentations and their answers to questions. The judges will be looking at the extent to which the team’s decision is supported by the data and other information and whether the decision flows from the arguments put forward. The judges will expect any differences in opinion between team members to be explained. They will be looking at the extent to which monetary policy decisions are based on teams’ assessment of the outlook for the economy and inflation – ie. the extent to which the teams are looking ahead. The judges will also be looking at whether teams’ answers to questions support their conclusions and decision. Teams must adhere to the rules of the Challenge. These are set out in the section on The Challenge rules on page 17. Teams will receive written feedback on their performance shortly after the presentation event. The judging and feedback criteria are as follows. Understanding of economics and monetary policy Quality/structure of presentation and teamwork • Good understanding of basic economic concepts. • Presentation was engaging and had a good, clear structure. • Sound knowledge of the monetary policy framework and processes. • Good grasp of the key influences on inflation. • Confident delivery, without reading verbatim from scripts or visual aids. • Answers to questions demonstrated clarity of thinking and the ability to defend their views. • Even contribution from team members, without one or two members dominating answers to questions. Research and information • Made good use of time allocated for presentation, without overrunning. • Evidence of good research and investigative work, with data drawn from a range of sources. • Covered the relevant issues well, without significant omissions. Conclusions and justifications of monetary policy decision • Decision based on assessment of the outlook for the economy as a whole. • Data, charts and other information were used effectively to support arguments. • Decision based on forward-looking analysis, taking account of the risks to the outlook for inflation. • Data were accurate and up-to-date, and charts were clear and well labelled. • Decision flowed from the presentation, supported by relevant information, with no unsubstantiated assertions. • Balance of opinion within the team was explained, including the reason for any difference of view. Bank of England and The Times Interest Rate Challenge 2014/15 Section A Judging 13 Section A What you might gain from the Challenge The Challenge offers a number of benefits to students, teachers, schools and colleges. Understanding the economy The Challenge provides students with the opportunity to deepen their understanding of the economy and the way in which interest decisions affect economic growth and inflation. It will allow students to apply economic concepts and principles to the analysis of developments in the real economy and to appreciate the interrelationships between the different topics that they cover in their course in a practical and lively way. It will also help them to develop their critical thinking and other skills. Accepting the Challenge will bring students into direct contact with working economists. Resource material The resource material should be useful for anyone teaching or taking an AS, A level, the IB, Higher, Advanced Higher, Vocational A level or equivalent course in economics or business. The wealth of macroeconomic information and carefully selected, up-to-date data make the resource material highly relevant to many of the units and modules in post-16 courses. In particular, it will be relevant to those relating to government policy, macroeconomics, the national and international economy, the business environment and the operation of markets. Information technology IT will be a useful tool for anyone accepting the Challenge, which will give students the opportunity to: • use different IT sources to search for and select information; • develop information and lines of enquiry, including using spreadsheets; and • present and edit information, including text, numbers and images. Communication skills The Challenge is about gaining understanding and gathering and communicating information, both to other members of the team and to the judges. It will give students the opportunity to: • read and summarise information; • contribute to discussions; • make a presentation; and • write documents, such as visual aids for the presentation or perhaps a report on the Challenge for their school or college or a press release for the local media. Problem solving Key/core skills The Challenge will give students the opportunity to: Key/core skills are an important part of post-16 education. This section gives examples of how the Challenge could help teachers to deliver key/core skills and how it might be used by students to provide evidence of these skills. • explore problems and different ways of solving them, and select the appropriate solution; Application of number/numeracy During the Challenge, students will handle large amounts of data. The Challenge will give students the opportunity to: • gather and interpret numerical information from different sources; • carry out calculations; and • plan and implement the chosen solution; and • ensure the problem has been solved and review the approach. Working with others The Challenge is a team activity which will give students the opportunity to: • plan work as part of a group, including agreeing objectives, responsibilities and working arrangements; • present findings and explain results. Bank of England and The Times Interest Rate Challenge 2014/15 Section A What you might gain from the Challenge 14 • establish and maintain co-operative working relationships; and Area finals • review work and agree ways of improving future collaborative work. The winning team in each area final will receive a trophy for their school or college. There will be certificates for all the area finalists. Improving own learning and performance Regional heats By being clear about what they want to achieve from undertaking the Challenge, and by planning the work round their other commitments, students will have the opportunity to show that they can: All team members that participate in the competition will receive a certificate of participation. Publicity • agree personal targets such as improving confidence, team work, critical thinking, presentation or IT skills, and plan how these will be met; The Challenge is being run in conjunction with The Times, which will provide national coverage of the various stages of the competition. Local and regional media will also be encouraged to take a close interest in the progress of teams from their areas. Schools that do well can expect to receive coverage in the local and national press – you might have to justify your monetary policy decision to your local community! • use the plan, seeking feedback and support from others; and • review progress and present evidence of achievements. Prizes National final For the six teams in the national final there will an expenses-paid trip to the Bank of England in London, including a programme of events and an opportunity to meet senior Bank staff. The winning team will receive the Bank of England and The Times Interest Rate Challenge trophy. All national finalists will receive a cash prize for their school or college. There will also be non-monetary prizes and certificates for all the national finalists. Bank of England and The Times Interest Rate Challenge 2014/15 Section A What you might gain from the Challenge 15 Section A Dates, venues and expenses Competitive rounds Expenses The Challenge is organised in three rounds: regional heats, area finals and the national final. Schools will be expected to make their own travel arrangements to the regional heats, and area and national finals. With the exception of short journeys, reasonable travelling expenses will be reimbursed on prior application to the Bank. Regional heats Those teams successful in the ballot will participate in one regional heat. The regional heats will take place between 17 November and 28 November 2014 during the school day at venues across the United Kingdom. The winning team in each heat will progress to an area final. A runner-up will also be announced. Area finals There will be six area finals. Each regional winner will participate in one area final, which will take place in February 2015. The area finals will be held during the school day. The areas will be announced after the regional heats, when the geographical spread of the regional winners is known. The winning team in each area final will progress to the national final. A runner-up will also be announced. Teams which have to travel long distances may require accommodation for the regional heats and area finals. The cost will be reimbursed by the Bank. The Bank will provide accommodation for the national final in London. Schools and colleges wishing to claim expenses should contact the Target Two Point Zero team (see page 18) for contact details to agree the claim and request a claim form before making their arrangements. National final Six teams will compete in the national final at the Bank of England in London. The national final will be a two-day event, which will take place on 12 and 13 March 2015. Bank of England and The Times Interest Rate Challenge 2014/15 Section A Dates, venues and expenses 16 Section A The Challenge rules Participants The Challenge is open to any school or college in the United Kingdom. Each school or college can enter one team. If the demand for places is high, the number of schools taking part will be restricted, in which case entry will be by ballot. The Challenge is limited to students aged 16 to 18 who are taking an AS level, A level, the IB, Higher, Advanced Higher, Vocational A level or equivalent course. Employees and relatives of employees of the Bank of England and The Times may not participate. There is no restriction on the subjects being studied but the Challenge will probably appeal mainly to students of economics and business. Teams The team should consist of four students, who must be registered at the school or college. Each team should nominate a teacher to act as a coach and adviser and to accompany the team to the regional heats and the area and national finals. Although the team members alone will represent the school or college in the regional heats and the area and national finals, teams may enlist help and support with their research, analysis and preparation from other class and school members, teachers and friends. There is detailed guidance on this in the section on What the Challenge involves on pages 9–11. Team membership must not change during the competition except in exceptional circumstances and with the prior agreement of the Bank. Presentations and questions When making their presentations and answering questions, teams should adhere to the following rules. • Presentations should be no more than 15 minutes long. The chairperson of the judging panel will indicate when 13 minutes has elapsed, after which the team should start to conclude its presentation. Teams which overrun will be marked down by the judges. Bank of England and The Times Interest Rate Challenge 2014/15 • Each team member must make a significant oral contribution to the presentation. • Team members may refer to hand-held notes and to their visual aids but they should not read verbatim from their scripts, laptop screens or visual aids. There is no requirement to memorise the presentation. The rules permit students to refer to notes but they should look at the audience as much as possible. Verbatim reading from scripts, laptop screens or visual aids or exceptionally heavy reliance on notes does not automatically disqualify teams from winning but teams who do this will be marked down by the judges. • In the regional heats and area finals the format of the presentation is at the discretion of the teams. National finalists will be expected to use PowerPoint. • Teams should bring 3 printed handouts of their presentation for the judges. The handouts will not be taken into consideration by the judges in their marking and teams will not be penalised if, for technical reasons, they are unable to provide them. The handouts are simply to help the judges, who find it useful to have hard copies of the presentation on which to make notes. The format is up to teams. The important thing is that the printed slides are clear and easy to read with space to make notes. Any last minute changes to slides can be done in manuscript at the event. Teams will not be marked down for this. • When answering the judges’ questions conferring is allowed, but teams will be marked down for lengthy or excessive conferring which limits the number of questions that can be asked. • When answering judges’ questions, the approach used is at the discretion of teams. The key point is that team members should work together as a team. Teams will be marked down if answers are dominated by one or two team members. • When making their policy recommendation and when answering the judges’ questions, team members do not have to agree with each other, but each point of view must be explained. • The judges’ decisions are final. They will be announced at the end of each round. Section A The Challenge rules 17 Section A Contacting the Target Two Point Zero team If you have any queries about Target Two Point Zero – the Bank of England and The Times Interest Rate Challenge, please contact the Target Two Point Zero team at: Target Two Point Zero Education & Museum Group HO-M Public Communications and Information Division Bank of England Threadneedle Street London EC2R 8AH Tel: Fax: e-mail: The material provided for Target Two Point Zero is available on the Bank of England’s website. www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx 020 7601 5366 020 7601 5808 [email protected] Bank of England and The Times Interest Rate Challenge 2014/15 Section A Contact details 18 Section B Monetary policy – setting interest rates to control inflation Monetary policy is about setting interest rates to control inflation. It sounds straightforward enough. But to undertake the Interest Rate Challenge, participants will need to have some understanding of what inflation is and how it occurs. And they will need to know how monetary policy works. This section provides some background to set teams on their way. What is inflation 21 The inflation rate 21 Price indices 21 Changes in the inflation rate 21 What causes inflation? 23 The gap between demand and supply 23 Inflation expectations and monetary policy 24 What is monetary policy for? 25 Price stability 25 Monetary policy, prices and output 25 Why do we want stable prices 26 The value of money 26 The role of prices 26 Economic stability 26 How do interest rates affect inflation? 28 Bank Rate 28 From Bank Rate to inflation 28 The effects on demand 28 How long do these effects take to work? 29 Bank of England and The Times Interest Rate Challenge 2014/15 Section B Monetary policy 19 Section B What is inflation? Inflation is a general rise in prices across the economy. This is distinct from a rise in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices and preferences, and changing costs. If the price of one item – say a particular model of car – increases because demand for it is high, we do not think of this as inflation. Inflation occurs when most prices are rising by some degree across the whole economy. percentage weights are revised annually to reflect changes in spending patterns. Sometimes new goods and services are added and sometimes they are taken out. In 2014 interchangeable lens digital cameras were added to reflect their increasing share of the camera market. The inflation rate We often hear about the rate of inflation being 2% or 2.7% or some other number. The inflation rate is a measure of the average change in prices across the economy over a specified period, most commonly 12 months – the annual rate of inflation. We typically hear about the annual inflation rate for a particular month. If, say, the annual rate of inflation in January this year was 3%, then prices overall would be 3% higher than in January last year. So a typical basket of goods and services costing, say, £100 last January would cost £103 this January. The inflation rate is a measure of the change in prices over a specified period Until December 2003, UK monetary policy was based on a measure of inflation called RPIX. RPIX inflation is almost the same as RPI inflation but it excludes one component – namely mortgage interest payments. But on 10 December 2003 the Chancellor of the Exchequer announced that in future monetary policy would be based on the Consumer Prices Index (CPI) which is explained on page 34. Price indices There are a number of different measures of inflation in use today. The most familiar measure in the United Kingdom is the Retail Prices Index (RPI). But monetary policy is now based on the Consumer Prices Index (CPI). Both measure the prices of products and services that consumers buy. A price index is made up of the prices of hundreds of goods and services – from basic items like bread to new products, like eBooks. Prices are sampled up and down the country every month; in supermarkets, petrol stations, travel agents, insurance companies and many other places. All these prices are combined together to produce an overall index of prices. The goods and services included in the index are chosen and weighted on the basis of the spending patterns of UK households – for example, if gas bills account for around 1% of consumers’ total spending, then gas prices will account for about 1% of the total index. The Bank of England and The Times Interest Rate Challenge 2014/15 Changes in the inflation rate Any individual price change could cause the measured rate of inflation to change, particularly if it is large or if the item has a significant weight in the price index. But we are more interested in the general increase in prices rather than individual price changes. A large rise in the price of petrol, for example, might affect the overall rate of inflation. But unless this price carried on rising, the annual rate of inflation would eventually fall back again – the example in the box below explains this, if you want to know more. Events affecting a range of prices can also result in a change in the inflation rate. For example, a rise (or fall) in oil prices might affect the price of other goods if producers pass on the increase (or decrease). But, again, unless the oil price continues to rise (or fall), this influence on the inflation rate will eventually wear off after a time. Section B What is inflation? 21 Similarly, if the value of the pound falls against other currencies – ie. the exchange rate depreciates – the price in the shops of some imported goods might rise. But only if the exchange rate keeps falling will this influence on inflation continue. A change in price If petrol prices had been £1.25 a litre for some time and then they increased in, say, February 2014 to £1.50 a litre while no other prices changed, the annual rate of consumer price inflation would increase. If petrol prices remained unchanged after that, the annual rate of inflation would then fall back in February 2015. That is because the annual rate of inflation in February 2015 measures the change in prices between February 2014 and February 2015, during which time the price in our example has stayed the same at £1.50 a litre – the rise in petrol prices recorded in February 2014 drops out of the calculation. So, although the price of petrol remains at the higher level, annual inflation is not higher after a year or more. Bank of England and The Times Interest Rate Challenge 2014/15 Price changes like those described can have other indirect effects on inflation. But individual price changes in themselves do not have a lasting impact on the inflation rate. The rate of inflation in a particular month will depend on movements in all prices. But we need to distinguish between individual price changes – which might change the measured rate of inflation for a period – and the notion of inflation as an ongoing, general increase in prices. Section B What is inflation? 22 Section B What causes inflation? The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy – whether it is 1%, 10% or 100%. Demand... One of the underlying causes of inflation is the level of monetary demand in the economy – how much money is being spent. We can demonstrate this by considering what happens when the prices of some products are rising. Imagine the price of cinema tickets has risen. If consumers want to buy the same amount of all goods and services as before, they will now have to spend more – because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes, and save less. But if total spending does not rise, then higher prices will mean consumers will either have to buy fewer cinema tickets or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising. On the other hand, if the price of some goods falls, people will need to spend less to buy the same amount of all goods and services as before. But if people still earn the same, they will have the same amount of income as before. So they will be able to buy more of those goods or of something else. Demand in the economy will rise and this, in turn, might cause some prices to rise. The underlying causes of inflation relate to the amount of demand in the economy Of course, this process takes time. And the situation will be complicated if some people’s incomes are affected by the falls in prices – say because lower import prices cause firms competing with imports to lose sales and reduce the Bank of England and The Times Interest Rate Challenge 2014/15 number of people they employ. However, it demonstrates a key feature of inflation – that it relates to the amount of demand in the economy. ...and supply But inflation is not just about demand in isolation. Inflation reflects the amount of demand in the economy relative to the available supply of goods and services – in other words, the amount of money people are spending relative to what can be produced. Inflation tends to rise when, at the current price level, demand for goods and services in the economy is greater than the economy’s ability to produce goods and services – its output. One of the original descriptions of inflation remains valid – that ‘too much money chases too few goods.’ The gap between demand and supply How much the economy is able to produce will reflect the rise of the working population. Increases in output will also depend on factors that enable more output to be produced from available resources – in other words, productivity increases. The amount the economy is able to produce, ie. supply, might increase due to the introduction of new technologies, extra investment in new equipment, improved methods of production and distribution or by enhancing the skills of the workforce. These things can all lead to higher productivity. There will be some price level at which there is a broad balance between the demand for, and supply of, goods and services. At this point there tends to be no upward or downward pressure on inflation. Firms will be working at their normal capacity – producing everything they can in the most efficient way with their existing resources. Section B What causes inflation? 23 Too much demand... But what happens if there is an increase in demand for some reason, for example due to a reduction in income tax, or because consumers suddenly feel more optimistic and start spending more money rather than saving? When demand rises above what firms can produce at their normal level of operation, there tends to be upward pressure on costs and prices Firms can usually increase production to meet higher demand. But this may only be possible by incurring higher costs. For example, it might be necessary to introduce overtime working or hire extra people. If many firms are trying to recruit extra people in order to produce more, wages might start to rise. And firms might have to pay more for additional materials or run their processes and machinery in a less efficient way. So to produce more, firms increase their demand for resources, and this may result in upward pressure on production costs and prices – for example, the price of bricks and the wages of bricklayers might rise if there is high demand for the construction of new buildings such as houses or offices. At the same time, imports are likely to rise and the gap between what the country imports and exports – its trade balance – might widen. Higher prices in general might lead people to demand higher wages so they can still buy the same amount of goods and services. An increase in wage costs might then feed through to a further rise in prices. The inflation process can then continue until prices have risen to such a level that demand is once again equal to supply. We say more about demand, output and inflation on page 25 and in Sections D and F. Inflation expectations and monetary policy Even when demand and supply (output) are roughly balanced, inflation will not necessarily be zero or indeed particularly low and stable. When firms and employees negotiate wages and when companies set their prices, they often consider what inflation might be in the period ahead, say the next year. Expected inflation matters for wages and prices because future price rises reduce the amount of goods and services that today’s wage settlement can buy. So, if inflation is expected to be high, employees might push for a higher wage increase. If wage settlements build in these expectations, then firms’ costs increase, which in turn could be passed on to customers in higher prices. So if people expect inflation, their behaviour can lead to inflation. If people expect inflation, their behaviour can lead to inflation What determines the expected rate of inflation? The simple answer is monetary policy and how much people believe in the ability and commitment of the authorities – the government and the central bank – to achieve their inflation objectives. People have to believe that there will be low inflation before they stop building expectations of high inflation into their decisions. The authorities have to demonstrate that they will not allow inflation to rise – that they will act to ensure demand does not rise too much ahead of output. ...too much supply The opposite to this is when there is slack – ie. spare capacity – in the economy. That is when the amount that can be produced is greater than demand. In this situation, there tends to be downward pressure on costs and prices. Inflation is usually generated by an excess of demand over supply To contain inflationary pressures in the economy, demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. If demand grows faster than this, unless there is spare capacity in the economy – such as after a recession – inflation is likely to rise. Bank of England and The Times Interest Rate Challenge 2014/15 The ultimate cause of inflation can really be said to be central banks, like the Bank of England. Their behaviour and actions determine whether inflation is allowed to rise or is kept low – in other words, whether they allow prices to rise unchecked by monetary policy, or whether the central bank seeks to influence the amount of money in the economy. To keep inflation low, we want to ensure that the growth in demand does not get ahead of the growth in what the economy can produce. We want output to rise, but at a steady rate across the economy as a whole and not so fast that the resulting demand for resources generates upward pressure on costs and prices. Section B What causes inflation? 24 Section B What is monetary policy for? Price stability The aim of monetary policy is to achieve stable prices. Price stability means that changes in the general level of prices across the economy are relatively small and gradual – in other words, prices do not rise by much from month to month and from year to year. In practice, price stability equates to low and stable inflation. The broad aim of monetary policy is to achieve price stability A quote from Alan Greenspan, a former Chairman of the US Federal Reserve – the central bank of the United States – is one of the most apt. "For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household decisions." The goal of price stability has become widely accepted as the appropriate objective of monetary policy, and is now one of the primary considerations of central banks around the world. This consensus reflects an understanding of how the economy works and a practical experience of the ineffectiveness of using monetary policy to achieve other economic objectives. Monetary policy, prices and output The effects of monetary policy are ultimately seen in prices. A change in interest rates feeds through the economy, influencing demand, costs and then prices. This process is explained on pages 28–29. Boosting demand, by lowering interest rates, may cause output to rise at a faster rate for a time. But monetary policy does not have a lasting impact on output. Suppose the Bank of England printed double the amount of money in the economy and left it on street corners for people to help themselves. People would go out and spend more. But the economy cannot simply Bank of England and The Times Interest Rate Challenge 2014/15 produce twice as much. Firms would try to increase output to meet the extra demand and imports might rise. But the extra demand for resources would force costs and prices higher. In the same way, changing interest rates will result in changes in demand in the economy. But, overall, it cannot affect what the economy is able to produce, other than in the short term as output responds to fluctuations in demand. Some of the mistakes in economic policy in the past resulted from a belief that it was possible to raise output and employment permanently by accepting a degree of inflation – there was an assumed trade-off between inflation and unemployment. But efforts to exploit it, by trying to boost demand through higher government spending or lower interest rates, led to increasing rates of inflation – they revealed that, in the long run, there was no such trade-off. There is no general, lasting trade-off between output and inflation There is, however, a recognised trade-off between output and inflation in the short term, ie. a few years. This is very important to the workings and conduct of monetary policy. In the short term, if demand and output are growing too quickly, increasing interest rates can reduce output growth back to a level which does not result in inflationary pressure. Conversely, reducing interest rates can increase output growth. But, in the longer run, there is no lasting trade-off between output and inflation. Changes in interest rates affect prices only. The effects of monetary policy are ultimately seen in prices The role of monetary policy is restricted to influencing the level of demand in the economy in order to control inflation. Changes in monetary policy do affect output and employment in the short term. But these influences do not last. Section B What is monetary policy for? 25 Section B Why do we want stable prices? The value of money Ensuring that prices are fairly stable amounts to trying to maintain the value of money, ie. ensuring that what £1 buys today will be roughly the same as what it will buy tomorrow or next month. If people expect the value of their money to fall, this undermines the role of money as a measuring rod for the value of goods and services in the economy. It no longer acts as a standard and stable measure of value, because its own value is falling and uncertain. At worst, when confidence in a currency deteriorates completely, money can stop being used as a means of exchange. When prices were rising rapidly in Germany in the 1920s, people had so little confidence in their currency that they demanded to be paid several times a day, so they could quickly spend their wages before they fell in value. In the United Kingdom in the 1970s, the annual rate of inflation was more than 20% for a time – what £1 would buy was reduced by over a fifth in one year. In response, people sought wage increases to compensate them for this decline in the value of money. This placed further upward pressure on prices – creating what is known as a wage-price spiral. The role of prices Uncertainty about the value of money – the future prices of goods and services – can be damaging to the proper functioning of the economy. Prices are at the core of a market-based economic system. They help to determine what goods and services are demanded and what is supplied. When prices across the economy are fairly stable, specific changes in the prices of individual goods and services allow firms and individuals to make decisions about how much to consume, how much to produce and invest, and how much to save or borrow. These price changes are reasonably clear to see; they are not obscured by a general rise in prices. Bank of England and The Times Interest Rate Challenge 2014/15 But when the prices of most goods and services are rising, it is more difficult to know which items are rising in price relative to others. For example, if the demand for organic vegetables is high and prices are rising, this should be a signal to other companies to increase supply to this market. But if prices in general are rising, it might not be clear whether the higher price is part of this general increase or specific to an individual product. Economic stability When inflation is high, it also tends to be more variable and uncertain. Many of the costs of inflation are associated with its uncertainty. Price stability is important because high and volatile inflation creates economic instability Savers and lenders might want some insurance against the uncertainty of the future value of their money, ie. a higher rate of interest for lending their money. This will mean higher borrowing costs for individuals and firms. And uncertainty about prices and the value of money might discourage firms from making long-term investments. One of the main consequences of high inflation has been greater instability in economic conditions as a whole – periods when demand and output have been growing strongly but then fallen sharply. These episodes are commonly referred to as boom and bust cycles. In the past, when demand rose much faster than output and inflation increased, sharp increases in interest rates were necessary to bring demand back into line. This often resulted in large falls in output – ie. a recession – as the imbalance in the economy was abruptly corrected. One of the costs of unsustainably high output growth – an economic boom – and the resultant upward pressure on costs and prices, has been large falls in output and employment. These falls were probably greater than would have been the case had demand and output grown in a steadier and more balanced way. Section B Why do we want stable prices? 26 One such episode in the United Kingdom was during the late 1980s and early 1990s. Inflation rose to over 10% as demand increased strongly. Interest rates were increased to as high as 15%. With consumers and companies burdened by high levels of debt, higher interest rates led to a large contraction in demand and resulted in falling output and employment in the early 1990s. The boom was followed by the bust. These episodes inevitably affect individuals’ and firms’ behaviour. Firms find it more difficult to plan ahead when there is uncertainty about demand, prices and interest rates. Until the first quarter of 2008, output had grown for the longest continuous period since the mid-1950s – when current statistical records began – and inflation had been relatively low over the previous decade. But the sharp rise in energy and food prices pushed CPI inflation well above target to a peak of 5.2% in September 2008. Output growth had started to falter at the end of 2007, and by 2009 Q2 output had fallen by 7.2% from its peak in 2008 Q1. Monetary policy is aimed at achieving price stability. But the goal of price stability is not an end in itself. Stable prices are a necessary condition for the economy to grow in a stable and sustainable way, and for the effective functioning of prices and money in the economy. Bank of England and The Times Interest Rate Challenge 2014/15 Section B Why do we want stable prices? 27 Section B How do interest rates affect inflation? Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economy’s ability to produce goods and services. This stops output rising too quickly or slowly. Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation. How does this work? Bank Rate The effects on demand Monetary policy operates by influencing the price of money, ie. the cost of borrowing and the income from saving. When Bank Rate is changed, demand can be affected in various ways. The MPC sets the interest rate for the Bank of England’s financial market transactions In the United Kingdom, the Monetary Policy Committee (MPC) sets the interest rate that is paid on deposits held at the Bank of England by commercial banks and building societies. This interest rate is known as Bank Rate. From Bank Rate to inflation Changes in Bank Rate affect the whole range of interest rates set by commercial banks, building societies and other financial institutions for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as savings accounts. A change in Bank Rate will also tend to affect the price of financial assets such as bonds and shares, and the exchange rate. These changes in financial markets affect consumer and business demand and, in turn, output. Changes in demand and output then impact on the labour market – employment levels and wage costs – which in turn influence producer and consumer prices. • Spending and saving decisions A change in the cost of borrowing affects spending decisions. Interest rates will affect the attractiveness of spending today relative to spending tomorrow. An increase in interest rates will make saving more attractive and borrowing less so. This will tend to reduce current spending, by both consumers and firms. That includes spending by consumers in the shops and spending by firms on new equipment, ie. investment. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms. • Cash flow A change in interest rates will affect consumers’ and firms’ cash flow, ie. the amount of cash they have available. For savers, a rise in interest rates will increase the money received from interest-bearing bank and building society deposits. But it will also mean higher interest payments for people and firms with loans – debtors – who are being charged variable interest rates (as opposed to fixed rates which do not change). These include many households with mortgages on their homes. These fluctuations in cash flow are likely to affect spending. Lower interest rates will have the opposite effects on savers and borrowers. • Asset prices A change in interest rates affects the value of certain assets, such as house and share prices. Higher interest rates increase the return on savings in banks and building societies. This might encourage savers to invest Bank of England and The Times Interest Rate Challenge 2014/15 Section B How do interest rates affect inflation? 28 less of their money in alternatives, such as property and company shares. Any fall in demand for these assets is likely to reduce their prices. This reduces the wealth of individuals holding these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect, ie. they tend to increase asset prices. • Exchange rates A particular influence on prices comes through the exchange rate. A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into the United Kingdom, as investors are attracted to the higher sterling rates of interest. This will tend to result in an appreciation of the exchange rate against other currencies. In practice, the exchange rate will be influenced both by expectations about future interest rates and any unexpected changes in interest rates. That is because if investors expect interest rates to rise, they may increase the amount they invest in a currency before interest rates actually rise. So there is never a simple relationship between changes in interest rates and exchange rates. Other things being equal, an increase in the value of the pound will reduce the price of imports and, because many imported goods are included in the CPI, this will have a direct influence on inflation. In addition, a higher pound will tend to reduce the demand abroad for UK goods and services. Any fall in export demand will, in turn, reduce output, as will any shift of domestic spending to imported goods. A reduction in interest rates will tend to have the opposite effect. How long do these effects take to work? Changes in the official Bank Rate take time to have their full impact on the economy and inflation. All the factors we have described have an impact on demand and, in turn, prices. Some influences, such as those on the exchange rate, work very quickly. A change in the official Bank Rate takes around two years to have its full impact on inflation But it often takes time for changes in the official Bank Rate to affect the interest payments made by consumers or firms – such as mortgage payments – or the income from savings accounts. It is likely to take a further period of time before changes in mortgage payments or income Bank of England and The Times Interest Rate Challenge 2014/15 from savings lead to changes in spending in the shops, and longer still for this spending to work its way up through the supply chain to producers. Changes in production, in turn, can lead to changes in employment and wages and eventually to changes in prices. We cannot know with any certainty the precise size or timing of these influences. And the effects might vary depending on factors such as the stage of the economic cycle – for example, the impact of higher consumer demand on inflation just after a recession will be different than that after several years of growth. This is because after a recession, when output has been falling, there will be plenty of spare capacity in the economy – output will be able to rise quite strongly without generating inflationary pressure. Interest rates have to be set based on what inflation might be over the coming two years or so A change in the official Bank Rate may have some instant effects – for example on consumers’ confidence – which may influence spending straight away. But, more generally, a change in the official Bank Rate will take time to influence consumers’ and firms’ behaviour and decisions. Overall, a change in interest rates today will tend to have its full effect on output over a period of about one year, and on inflation over a period of about two years. This is of course a very approximate guide. In this sense, monetary policy has to look ahead. Interest rates have to be set based on what inflation might be over the coming two years or so, not what it is today – though that is a relevant consideration. Policymakers have to judge what the likely economic developments will be over that period, in particular what the rate of growth in demand will be relative to the growth in supply (output). This is why the Monetary Policy Committee uses forecasts of growth and inflation to help it decide on the right level for interest rates. We don’t expect you to produce forecasts but we explain more about their role on page 37 and on pages 56–57. This section has provided a thumb-nail sketch of what is referred to as the ‘transmission mechanism’ — the economic route-map between changing interest rates and inflation. We tell you more about the transmission mechanism on pages 73–74. We also describe the different parts of the economy in Section F. The data you will need to look at to assess demand, output and price pressures in the economy will be available on the website. Section B How do interest rates affect inflation? 29 Section C The inflation target and the Monetary Policy Committee This section outlines the United Kingdom’s monetary policy framework. It tells you about the inflation target, how the Monetary Policy Committee takes decisions on Bank Rate and quantitative easing, and how it provides forward guidance. Monetary policy in the United Kingdom 33 Inflation targets 33 A symmetrical inflation target 33 From RPIX inflation... 33 ...to CPI inflation 34 2.0% on average 34 Why is the target positive? 34 An independent Bank of England 36 The Monetary Policy Committee (MPC) 36 MPC meetings 37 Explaining the MPC’s views and decisions – public accountability 37 Quantitative easing – injecting money into the economy 38 What is quantitative easing? 38 Why was QE needed? 38 How does QE work? 38 How much QE is needed? 39 QE2 – a second round of asset purchases 39 Exiting QE as the economy recovers 39 Has QE worked? 40 The team’s policy decision 40 Monetary policy as the economy recovers 41 Fresh guidance 41 An expectation, not a promise 42 Recovery and the stock of purchased assets 42 The Chancellor’s remit for the MPC 43 Bank of England and The Times Interest Rate Challenge 2014/15 Section C The inflation target and the Monetary Policy Committee 31 Section C Monetary policy in the United Kingdom In the United Kingdom, the monetary policy framework has evolved to reflect differing experiences and circumstances. But since the late 1990s an inflation target has been the defining feature of the framework. Inflation targets A symmetrical inflation target In 1992, the Government decided to adopt for the first time an explicit target for inflation. Instead of targeting something like the exchange rate as a means of controlling inflation, a rate for inflation itself was targeted. Interest rates were set to ensure demand in the economy was kept at a level consistent with a certain level of inflation over time. Similar policies were already operating in New Zealand and Canada, and have subsequently been adopted by other countries. The Chancellor announced on 12 June 1997 that he was setting an inflation target of 2.5%. The new target of 2.5% was quite a significant change from the previous target of 2.5% or less. The Treasury felt there were uncertainties about the old target – was it 2.5% or less than 2.5%, and if so how much less? So the new target was symmetrical. It was designed to give equal weight to circumstances in which inflation is higher or lower than the target rate. Inflation below the target was to be judged as being just as bad as inflation above the target. The first inflation target was set by the Chancellor of the Exchequer to be an annual inflation rate of 1%–4%, with an objective to be in the lower half of that range by the end of the 1992–97 parliament. The inflation target was subsequently revised to be 2.5% or less. Interest rates are set to ensure demand in the economy is kept at a level consistent with a certain level of inflation During this time, interest rate decisions were taken by the Chancellor of the Exchequer. However, the Bank of England was asked to publish its own economic appraisals in a quarterly Inflation Report and was given the task of deciding the timing of interest rate changes. Each month the then Chancellor – Kenneth Clarke – met the then Governor of the Bank of England – Eddie George – to discuss the level of interest rates. Although the Governor could offer the Bank’s advice about the level of interest rates necessary to meet the Government’s inflation target, the decision remained the Chancellor’s. These arrangements continued until May 1997 when the new Chancellor – Gordon Brown – announced a new policy framework. Bank of England and The Times Interest Rate Challenge 2014/15 The target was symmetrical – inflation below the target was to be viewed in the same way as inflation above it So the remit was not to achieve the lowest possible inflation rate – policy should not aim for an inflation rate below the target. Interest rates should be set to ensure the level of demand in the economy was consistent with meeting the inflation target. From RPIX inflation... Between 1992 and 2003, the inflation target was expressed in terms of an annual rate for a measure of retail price inflation that excludes mortgage interest payments. This is known as RPIX inflation – it is the annual change in the Retail Prices Index (RPI) but does not include one of the RPI's components – the interest paid on mortgages. Mortgage interest payments are an important Between 1992 and 2003, the inflation target was expressed in terms of RPIX – retail price inflation excluding mortgage interest payments Section C Monetary policy in the United Kingdom 33 part of household expenditure and so they are included in the RPI. But they will tend to rise if interest rates go up. So an increase in interest rates designed to reduce inflation would have the perverse effect of initially resulting in a rise in inflation. …to CPI inflation On 9 June 2003, the Chancellor announced that he planned to change the inflation target to one based on the Harmonised Index of Consumer Prices – the HICP – instead of RPIX. This would be the first major change to the monetary framework introduced since 1997. 2.0% on average Having a target for annual inflation of 2.0% does not mean that the Monetary Policy Committee is expected to hold inflation at 2.0% all the time. That would not be possible or, in fact, desirable. Inflation might change month to month for all kinds of reasons, many of which will only have a temporary influence. Stormy weather... The inflation rate might change, for example, because of the weather. If there had been a very wet or very dry summer, we might expect this to result in bad food harvests. Any resultant fall in the supply of food might push some food prices higher for a time, and raise the overall inflation rate. But we would not expect interest rates to be changed because of this. We do not want to force changes in demand and output across the economy to get inflation back to 2.0% every time it moves higher or lower. That would mean interest rates going up and down all the time. This would create great uncertainty and unnecessary volatility in the economy. And, by the time the effects had worked through the economy, inflation might well have changed again for another reason. Remember, when interest rates are changed, there is little immediate effect on inflation. It takes time. So we accept that the inflation rate will move up and down because the economy is subject to all sorts of influences and unexpected events. The aim is to set the degree of policy stimulus that we think gives the best chance of inflation being 2.0% in around two years’ time. But we know it will not always be exactly that rate. Bank of England and The Times Interest Rate Challenge 2014/15 When inflation does change, we need to understand why and assess whether the change is likely to persist or if the reasons for the change are likely to have a broader impact on the economy and future inflation. But we do not need to change interest rates every time this happens. In this sense, monetary policy is aiming to ensure the inflation rate is 2.0% on average over time. Why is the target positive? Why not have an inflation target of 0%? Although the objective of stable prices actually means no inflation, we do not aim for this. We prefer to have a moderate amount of inflation rather than zero inflation. There are a number of reasons for this, although economists debate which matter most. One consideration concerns the fact that interest rates cannot fall below zero – banks cannot charge negative interest rates. But what we call real interest rates – the interest rate minus the inflation rate – can be, and often are, negative. That is simply when the rate of inflation is higher than the actual rate of interest. We call the actual rate of interest – ie. what is paid in money terms – the nominal interest rate. When real interest rates are negative, there is a big incentive for people to spend and borrow rather than save. One hundred pounds might earn 5% interest if it was put in a bank account for a year. But if the inflation rate is 10% in that year, the cash will be worth less in a year’s time than it is now. The real rate of interest is minus 5%. In this situation, people are likely to prefer to spend more today rather than tomorrow. Having negative real interest rates – when the nominal rate of interest is below the rate of inflation – might be a useful policy option if demand in the economy is very weak, such as during a recession. Monetary policy is aiming to ensure that the inflation rate is 2.0% on average over time However, if we have zero inflation, then the policy option of having negative real interest rates is lost. Like nominal interest rates, real rates could not be lower than zero. Retaining this policy option is often cited as one of the reasons for having an inflation target above zero. Section C Monetary policy in the United Kingdom 34 Another reason that we do not have a target of zero inflation relates to our ability to measure inflation accurately. It is not possible or practical to record every single price in the country every day of the week. So we have to estimate inflation by taking a sample of prices. This sample tries to be representative but it is only ever an approximation of what people are spending their money on and what prices they are paying. It is generally recognised that the true level of inflation is usually below the rate of inflation recorded by a measure like the CPI – it overstates inflation to a small degree. Some price increases will reflect improvements in quality. For example, computers might include more features or have faster processors; cars might be more reliable. So, from year to year, prices might not be measured on an identical like-for-like basis. It is difficult to incorporate quality improvements in a price index although some adjustments can be made. But we need to acknowledge that some price increases will be due to quality improvements – in other words, consumers are getting more for their money. Having a positive inflation target allows real interest rates to be negative which might be a useful policy option when demand is weak Bank of England and The Times Interest Rate Challenge 2014/15 The measured rate of inflation tends to overstate the true inflation rate Because of this and other reasons, the measured rate of inflation tends to overstate the true rate of inflation to a small degree. So if we had a zero inflation target, we would be targeting falling prices. A general fall in prices – what we call deflation – could cause demand to fall if people expect prices to be lower in the future and consequently decide to delay their spending. Why not have an inflation target of 5% or 10%? Many of the costs of inflation are associated with its unpredictability. But if we could be sure that inflation could be held at 5% or 10% a year, then the costs of higher inflation might not be as great. However, it would be odd to be using money as a standard measure of value for goods and services if its value was going to decline by 5% or 10% every year. We would continually have to adjust the value of everything by 5% or 10%. Because having higher inflation would bring no lasting benefit – in terms of output and employment – we would have to ask why not aim for something lower, which was more consistent with stable prices? In practice, the higher inflation is, the more uncertain and volatile it tends to be. Having high and stable inflation might not be an option. Section C Monetary policy in the United Kingdom 35 Section C An independent Bank of England In 1997, the Government gave the Bank of England independence to set interest rates. This was a major change in the policy framework. It meant interest rates would no longer be set by politicians. The Bank would act independently of Government, though the inflation target would be set by the Chancellor. The Bank would be accountable to parliament and the wider public. The objective given to the Bank of England was initially explained in a letter from the Chancellor. This objective was then formalised in the 1998 Bank of England Act. The Bank has ‘to maintain price stability, and, subject to that, to support the economic policy of HM Government including its objectives for growth and employment’ (Bank of England Act 1998). The Bank’s remit recognises the role of price stability in achieving economic stability more generally, and in enabling sustainable growth in output and employment. It also recognises that the inflation target will not be achieved all the time and that, confronted with unexpected developments in the economy, striving to meet the target in all circumstances might cause undesirable volatility of output. The Chancellor restates the inflation target each year. From June 1997 to December 2003 the target was 2.5% for RPIX inflation. The Chancellor, on 10 December 2003 changed the target to 2.0% for CPI inflation. The most recent policy statement is reproduced on page 43. Dear Chancellor If the inflation target is missed by more than 1 percentage point on either side – in other words, if the annual rate of CPI inflation is more than 3.0%, or less than 1.0% – the Governor of the Bank, as Chairman of the MPC, 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. This does not mean that the Bank has a target of 1.0%–3.0%. The target is 2.0%. But if inflation varies by more than 1 percentage point from the target, the Bank has to explain why. So far the Governor has written fourteen open letters to Bank of England and The Times Interest Rate Challenge 2014/15 the Chancellor. CPI inflation on all of these occasions was more than 1 percentage point above the 2% target. In his letter of February 2012, the Governor said that the MPC’s best collective judgement was that CPI inflation would continue to fall back to around the target by the end of 2012. In coming months, that further moderation was likely to reflect the declining contributions from petrol prices and any remaining VAT impact, together with recently announced cuts to domestic energy prices. But the pace and extent of the fall in inflation remained highly uncertain. The Monetary Policy Committee The Chancellor instructed the Bank to create a new committee to set interest rates – the Monetary Policy Committee (MPC). The Committee consists of nine independent members – five from the Bank of England and four external members appointed by the Chancellor. The appointment of external members to the Committee is meant to ensure that the MPC benefits from thinking and expertise in addition to that gained inside the Bank of England. The membership of the MPC changes from time to time. The current members are: Mark Carney, Governor Ben Broadbent, Deputy Governor Sir John Cunliffe, Deputy Governor Nemat Shafik, Deputy Governor Kristin Forbes Andy Haldane Ian McCafferty David Miles Martin Weale Each member of the MPC has expertise in the field of economics and monetary policy. Members do not Section C An independent Bank of England 36 represent individual groups or areas. They are independent. Each member of the Committee has a vote to set interest rates at the level they believe is consistent with meeting the inflation target. The MPC’s decision is not a consensus of opinion. It reflects the votes of each individual member of the Committee. A representative from the Treasury also sits with the Committee at its meetings. The Treasury representative can discuss policy issues but is not allowed to vote. The purpose is to ensure that the MPC is fully briefed on fiscal policy developments and other aspects of the Government’s economic policies, and that the Chancellor is kept fully informed about monetary policy. MPC meetings The MPC meets every month to set monetary policy. Throughout the month, the MPC receives extensive briefing on the economy from Bank of England staff. This includes a half-day meeting – known as the pre-MPC meeting – which usually takes place on the Friday before the MPC’s interest rate setting meeting. The nine members of the Committee are made aware of all the latest data on the economy and hear explanations of recent trends and analysis of important issues. The Committee is also told about business conditions around the country from the Bank’s regionally-based Agents.The Agents’ role is to talk directly to business to gain intelligence and insight into current and future economic developments and prospects. differences of view. They also record the votes of the individual members of the Committee. The Committee has to explain its actions regularly to parliamentary committees, particularly the House of Commons’ Treasury Committee. MPC members also speak to audiences throughout the country, explaining the MPC’s policy decisions and thinking. This is a two-way dialogue. Regional visits also give members of the MPC a chance to gather first-hand intelligence about the economic situation from businesses and other organisations. In addition to the monthly MPC minutes, the Bank publishes its Inflation Report every quarter. This report gives an analysis of the UK economy and the factors influencing policy decisions. The Inflation Report also includes the MPC’s latest forecasts for inflation and output growth. Because monetary policy operates with a time lag of about two years, it is necessary for the MPC to form judgements about the outlook for output and inflation. The MPC uses a model of the economy to help produce its projections. The model provides a framework to organise thinking on how the economy works and how different economic developments might affect future inflation. But this is not a mechanical exercise – forecasts are not produced by feeding data into the model and pressing a computer button to get the answer. Given all the uncertainties and unknowns of the future, the MPC’s forecast has to involve a great deal of judgement about the economy. There are no crystal balls to tell the Committee what the future will be. Two days – one decision The monthly MPC meeting itself is a two-day affair. On the first day, the meeting starts with an update on the most recent economic data. A series of issues is then identified for discussion. On the following day, the Governor summarises the previous day’s discussions and the MPC members individually explain their views on what policy should be. The Governor then puts to the meeting the policy which he believes will command a majority and the Committee takes a vote. Any member in a minority is asked to say what level of interest rates he or she would have preferred, and this is recorded in the minutes of the meeting. The Committee’s decision on Bank Rate and the level of asset purchases is announced at 12 noon on the second day. We tell you more about the MPC’s projections for growth and inflation on pages 55–56. We do not want teams to produce forecasts and you do not need to understand how the MPC produces its projections. But we will tell you something about the factors that might affect inflation in one or two years’ time – so teams can form their own opinions and make their own judgements. The Bank of England is charged with the task of meeting the Government’s inflation target, which is 2.0% based on the CPI measure of inflation. The target is symmetrical – inflation below or above the target is viewed as equally undesirable. Inflation will not always be 2.0%. The aim is that it is 2.0% on average over time. Explaining the MPC’s views and decisions – public accountability The MPC goes to great lengths to explain its thinking and decisions. The minutes of the MPC meetings are published two weeks after the interest rate decision. The minutes give a full account of the policy discussion, including Bank of England and The Times Interest Rate Challenge 2014/15 Section C An independent Bank of England 37 Section C Quantitative easing – injecting money into the economy The Monetary Policy Committee announced in March 2009 that it would start to inject money directly into the economy to boost spending – a policy often known as quantitative easing. The Committee continues to set Bank Rate each month, and the objective of monetary policy is unchanged – to meet the government’s 2% inflation target. What is quantitative easing? In March 2009, the Bank’s Monetary Policy Committee (MPC) began purchasing financial assets funded by the creation of central bank reserves. These reserves are new money that the Bank creates electronically. Often known as quantitative easing (QE), the Bank’s asset purchases are designed to inject money directly into the economy to raise asset prices, boost spending and so keep inflation on track to meet the 2% target. The Bank has injected money into the economy to boost spending to meet the inflation target Once Bank Rate had reached 0.5%, the MPC considered this to be the practical limit to how far it could cut nominal interest rates. But the outlook for demand and inflation in March 2009 suggested the need for further monetary stimulus. So the MPC decided to inject additional money directly into the economy through a programme of financial asset purchases funded through the creation of central bank reserves. In 2009 money was not growing quickly enough to keep inflation close to the 2% target How does QE work? The Bank buys financial assets from banks who may be selling on their own behalf or, more likely, on behalf of their clients, such as insurance companies, pension funds and non-financial firms. The proceeds of the sale are credited to the seller’s bank account. Most of the assets purchased since the start of the programme in March 2009 have been British government bonds (gilts). Why was QE needed? Spending in the economy slowed very sharply in the latter part of 2008 and during 2009 as the global recession gathered pace. This threatened a downward spiral through a combination of contracting real output and price deflation. The MPC responded decisively, cutting Bank Rate from 5% to 0.5% – its lowest ever level – in just five months in order to support activity and thus reduce the risk of inflation falling below the 2% target in the medium term. Bank of England and The Times Interest Rate Challenge 2014/15 The MPC’s purchases of financial assets can boost nominal spending in the economy in a number of inter-related ways. The immediate effect of buying large quantities of gilts is to raise their prices and lower their yields relative to other assets. In response, investors are likely to adjust their portfolios, for example by buying other financial assets like shares or company bonds – the return on which is likely to be more attractive. This increased demand for those assets pushes up their prices, and lowers their yield. In this way, the effect of the MPC’s purchases of gilts spreads out across all other asset markets. At the same time, those selling assets to the Bank have more money in their bank accounts and commercial banks hold more deposits at the Bank of England. Section C Quantitative easing 38 As a result of QE, asset holders in general – including ordinary households and businesses – will have portfolios with higher value and more liquidity. If they feel wealthier and have more money immediately available, then they are likely to increase their spending which boosts the economy directly, or else to take on more risk by increasing their lending to consumers and businesses. In turn, consumers and businesses may be encouraged to take on more debt because lower yields on financial assets – lower interest rates in other words – bring down the cost of borrowing. But there are factors that may work to dampen the effects of QE. An obvious example lies in the banking sector. The boost to the value of banks’ asset holdings and their holdings of liquid assets as a result of QE, by itself, might be expected to make them more willing to lend. But in the wake of the financial crisis, banks are concerned about their financial health and as a result are wary of expanding their lending. For this reason, the MPC did not expect QE to result in a material expansion of bank lending. The Bank has acquired most of the assets from financial businesses other than banks. Charlie Bean – the Bank’s Deputy Governor for monetary policy at the time the policy was initiated – said that ‘the objective of QE is to work around an impaired banking system by stimulating activity in the capital markets’. As a result, companies, particularly larger companies, wishing to raise money have not had to depend as much on the banks as they might have done in the absence of QE, raising funds instead from bond and share issuance. How much QE is needed? There was a lot of uncertainty over the appropriate scale of asset purchases. When the MPC first discussed the scale of asset purchases in March 2009, the Committee noted that spending in the economy had grown each year by around 5% since 1997 and, over that period, inflation had been close to target. At that time, it appeared likely that spending would contract without additional policy stimulus. That suggested asset purchases needed to be large enough to boost spending growth back to around 5% a year, bearing in mind reductions in Bank Rate and other factors influencing the economic outlook. So at its meeting in March 2009, the MPC voted to reduce Bank Rate to 0.5% and to spend £75 billion on asset purchases. Subsequently, at its meeting in May that year, the outlook for the economy looked somewhat bleaker than in March. Consequently, the MPC voted to Bank of England and The Times Interest Rate Challenge 2014/15 keep Bank Rate at 0.5% and to undertake a further £50 billion of asset purchases – bringing total purchases to £125 billion. At its meeting in August 2009, there were still few signs of the fall in economic activity coming to an end. So the Committee again voted to keep Bank Rate at 0.5% and to make another £50 billion of asset purchases, so that total purchases increased to £175 billion. In November the MPC voted to increase total purchases to £200 billion, and to keep Bank Rate unchanged. Those purchases were completed early in 2010. The MPC kept the level of Bank Rate and asset purchases unchanged for almost two years after its meeting in November 2009. The Committee believed that the stock of past purchases, together with the low level of Bank Rate, continued to provide a substantial stimulus to the economy. This extended pause in monetary loosening did not necessarily mean that the MPC’s asset purchase programme had come to an end, but it gave the MPC the opportunity to take stock of the effects of QE so far. QE2 – a second round of asset purchases At its meeting in October 2011, the Committee decided that the outlook for output growth had weakened so that the margin of slack in the economy would probably be greater and more persistent than previously thought. This made it more likely than not that inflation would undershoot the 2% target without further monetary stimulus. Overall, the case for an expansion of the Committee’s programme of asset purchases was compelling and it voted unanimously to purchase a further £75 billion of gilts, bringing the stock of purchases since March 2009 to £275 billion. Subsequently, at its meeting in February 2012 the Committee voted to make an additional £50 billion in asset purchases, and in July it judged again that further stimulus was required to meet the inflation target and voted to buy another £50 billion in gilts to bring the total stock of asset purchases to £375 billion. Exiting QE as the economy recovers As the recovery in the economy becomes stronger and more enduring, the appropriate settings of monetary policy needed to deliver the inflation target will change. This means at some point the MPC will begin to tighten Section C Quantitative easing 39 policy by increasing Bank Rate and, later, by selling assets. In its May 2014 Inflation Report, the MPC said that it is likely to defer asset sales at least until Bank Rate has been increased to a level from which it could be cut materially, were more stimulus required. Has QE worked? Monetary policy affects inflation with a long and variable time lag. So asset purchases – like changes in Bank Rate – take their time to work through the economy to have their full effect on inflation. But what impact has the Bank’s asset purchases had to date? QE is untried previously in the UK, so there’s little past experience to go by. The economic circumstances that necessitated the use of QE were also unprecedented. The evidence suggests that the first round of QE in 2009 raised the level of real GDP by 11/@% to 2% and increased inflation by 3/$ to 11/@ percentage points. The Bank’s forecasting model suggests that a 1 percentage point cut in Bank Rate increases CPI inflation by about 1/@ a percentage point, so that the effect of the first round of QE in 2009 was equivalent to a 11/@ to 3 percentage point cut in official interest rates. Taking the MPC’s current plan for asset purchases as its starting point, the team can decide to maintain or increase the stock of asset purchases, or to make asset sales. It is difficult to offer precise guidelines about how much money needs to be injected into – or withdrawn from – the economy to keep inflation on track to meet the target. For instance, if you think that growth in the economy could be very low and inflation is set to fall below 2%, you might decide that justifies more asset purchases. If you think economic recovery is likely to be strong and enduring with upward pressure on inflation, that might suggest asset sales. But there is no right answer. Deciding on the level of asset purchases or of Bank Rate is a matter of judgement and, like the real policymakers, team members may disagree. So the team may choose to vote on Bank Rate and on quantitative easing. If this results in a tie, the team captain will have the casting vote. If there is a split decision, both sides of the argument must be explained in the presentation to the judges. Key resources for the team’s decision Teams may vote on Bank Rate and the level of asset purchases The team’s policy decision In each round, the team should take the MPC’s interest rate on the day of its presentation as its starting point, and decide whether to change Bank Rate and, if so, whether to increase it or decrease it, and by how much. In addition to setting Bank Rate, teams may – like the MPC – wish to consider the option of injecting or withdrawing money from the economy to meet the inflation target. Bank of England and The Times Interest Rate Challenge 2014/15 • Watch the Bank’s short animated film, ‘Quantitative easing – How it works’. www.bankofengland.co.uk/education/Pages/ inflation/qe/video.aspx. • Read ‘The impact of asset purchases in the MPC’s projections’ on page 41 of the May 2014 Inflation Report www.bankofengland.co.uk/publications/Documents /inflationreport/2014/ir14may5.pdf. Section C Quantitative easing 40 Section C Monetary policy as the economy recovers The financial crisis and the deep recession that followed prompted exceptionally loose monetary policy. Now that the economy has begun to recover, the MPC has provided ‘forward guidance’ on how it will adjust monetary policy to keep inflation close to the 2% target. Forward guidance is a statement by the MPC on the future path of monetary policy. It’s designed to help people understand how the MPC sets interest rates, so that households and businesses can spend and invest with more confidence. Forward guidance is a statement by the MPC on the future path of monetary policy The MPC first provided forward guidance on monetary policy in August 2013. At that time, there were early signs of recovery, but the degree of spare capacity or ‘slack’ in the economy remained large. The Committee framed its guidance in terms of the unemployment rate. It said it would leave interest rates and the stock of asset purchases unchanged, at least until the unemployment rate had fallen to 7% – provided this didn’t pose risks to the outlook for inflation or financial stability. The MPC’s forward guidance has prompted companies to bring forward spending and increase hiring Although not a comprehensive measure of slack, the Committee selected the unemployment rate because it’s less volatile and prone to revision than other measures, and is widely understood. Bank of England and The Times Interest Rate Challenge 2014/15 When it provided its policy guidance, the MPC said that once unemployment had fallen to 7%, it would assess the state of the economy more broadly, drawing on a wide array of indicators. Evidence collected from business surveys shows that the MPC’s forward guidance has prompted companies to bring forward spending and increase hiring. Fresh guidance By February 2014, unemployment had fallen close to 7% and the MPC decided to offer further guidance on future monetary policy. The Committee believed there remained spare capacity in the economy equal to about 1%–1½% of GDP. On that basis the MPC judged there was scope to absorb more spare capacity before raising Bank Rate. And the Committee would maintain the stock of asset purchases at £375 billion, at least until Bank Rate had begun to rise from 0.5%. The Committee said that once it begins to raise Bank Rate, it expects it will do so only gradually. And when the economy has finally returned to normal capacity and inflation is close to target, the appropriate level of Bank Rate is likely to be materially below the 5% level set on average by the Committee prior to the crisis. The Committee said that once it begins to raise Bank Rate, it expects it will do so only gradually Section C Monetary policy as the economy recovers 41 An expectation, not a promise In its August 2014 Inflation Report the MPC said that the central message in its previous guidance remained: given the headwinds holding the economy back, Bank Rate would rise only gradually and was expected to remain below historical levels for some time to come. The Committee’s guidance on the likely pace and extent of increases in Bank Rate ‘was an expectation, not a promise’. However, the actual path for monetary policy would depend on economic conditions. In other words, the Committee’s guidance on the likely pace and extent of increases in Bank Rate ‘was an expectation, not a promise’. Recovery and the stock of purchased assets A factor influencing increases in Bank Rate will be the speed and timing at which the MPC sells its stock of purchased assets. Sales of assets represent a tightening of monetary policy because they withdraw money from the economy. Therefore asset sales are likely to be associated with a lower path of Bank Rate than would otherwise be the case. Bank of England and The Times Interest Rate Challenge 2014/15 The MPC has said it is likely to defer sales of assets at least until Bank Rate has reached a level from which it could be cut materially, were more stimulus required. Bank Rate will be the ‘active marginal instrument’ for monetary policy. This means that once asset sales have begun, the Committee will loosen policy by cuts in Bank Rate, rather than through new purchases of assets. Recent Bank publications on monetary policy guidance • ‘Influences on policy in the medium term’, pages 42–43 in the August 2014 Inflation Report. See www.bankofengland.co.uk/publications/ Documents/inflationreport/2014/ir14aug5.pdf. • ‘Monetary policy as the economy recovers’, pages 8–9 in the February 2014 Inflation Report. See www.bankofengland.co.uk/publications/ Documents/inflationreport/2014/ir14febo.pdf. • ‘The impact of asset purchases in the MPC’s projections’, page 41 in the May 2014 Inflation Report. See www.bankofengland.co.uk/publications/ Documents/inflationreport/2014/ir14may5.pdf. Section C Monetary policy as the economy recovers 42 Section D Assessing economic conditions and the inflation outlook This section discusses how teams might think about their assessment of economic conditions and the inflation outlook – building on the material covered in Section B. It provides more background for the task of setting interest rates, and will help teams to work through the different parts of Section F. Assessing economic conditions 51 Demand and supply...again 51 Assessing demand 51 Assessing inflationary pressure 52 Judging the inflation outlook 55 Economic growth 55 Inflation 55 The MPC’s growth and inflation forecasts – judgement and uncertainty 56 Bank of England and The Times Interest Rate Challenge 2014/15 Section D Assessing economic conditions and the inflation outlook 49 Section D Assessing economic conditions By now, you should be clear about your task – to assess economic conditions and judge whether future inflation is likely to be above, below or in line with the Government’s inflation target, and then decide what interest rate might best achieve the target. There is no unique way to go about building up your team’s assessment of the economic situation and outlook. You should decide what you want to cover and how. But you need to keep a close eye on the economic principles that underpin monetary policy and the inflation process. Demand and supply…again Assessing demand In Section B, we explained that the amount of demand in the economy relative to overall supply is an important consideration for policymakers. The level of spending, in money terms, relative to the economy’s ability to produce will determine the extent of inflationary pressure in the economy. Assessing the level of demand, whether it is growing more or less quickly than the economy’s ability to supply goods and services, and whether this is likely to continue into the future, are key issues for monetary policy. Interest rates are set to try to ensure that the level of demand, in money terms, is consistent with the inflation target. Teams will need to build an overall picture of the current and future level of demand in the economy. Teams need to assess whether the level of demand is exceeding the supply of goods and services We explained how rising demand might result in output growing at a rate that leads to upward pressure on costs and prices. Teams need to assess whether there are signs that the level of demand is beginning to exceed the economy’s potential to supply goods and services. The task can be divided into two related parts: • monitoring and assessing demand conditions across the economy; and • monitoring and assessing the extent of inflationary pressure in the economy. Bank of England and The Times Interest Rate Challenge 2014/15 Components of demand Looking at the different components of demand will help teams to interpret and understand changes in overall demand. The main components are: • Consumers’ expenditure – spending on goods and services by households in the United Kingdom; • Capital expenditure – investment in buildings and new equipment; • Expenditure on stocks of goods – spending by firms on increasing their inventories of goods and materials; • Government expenditure – spending by central and local government on health, education and other public services; • Expenditure on exports – spending by foreigners on UK goods and services; and • Expenditure on imports – spending by UK residents on foreign goods and services. Each of the main components of aggregate demand is likely to be growing at a different rate at any point in time, not least because they are influenced by different factors. For example, consumers’ expenditure might be rising strongly because of the growth in wages and other earnings or because people are confident about the future. Section D Assessing economic conditions 51 But exports might be falling because demand in overseas economies is declining or the exchange rate is rising. And investment might be weak because company profitability is low. The extent of inflationary pressure in the economy will depend on the overall level of demand There are also links between different components of demand – for example, strong growth in consumer spending is likely to increase import demand, or perhaps make it more attractive to increase investment in consumer goods industries. A large amount of the economic data that teams will come across relate to one or another of these components of demand. Consumer spending is by far the largest component of total demand in the economy. So it is important to track this particularly closely. Section F explains more about the different components of demand. Whether firms are producing output for one component of demand or another is unlikely to affect the way they use resources. The pressure on costs and prices will be similar if output is rising too fast. The extent of inflationary pressure in the economy will depend on the overall level of demand. Money The amount of money in the economy is the key determinant of the level of prices. It also provides important indications about demand conditions. Monetary statistics, such as narrow and broad money, as well as consumer credit and mortgage lending data, can provide information about whether spending is likely to rise. In addition to total output, information is available covering the output of different sectors of the economy, such as manufacturing and services. This can help to build evidence on economic conditions and how they might be changing. Similarly, data on activity in the labour market – such as the change in the number of people in employment and unemployment – will also tend to reflect how quickly the economy is growing. All these aspects of the economy are covered further in Section F. Assessing inflationary pressure Teams can monitor the growth of money, demand and output using all the economic data and information at their disposal. But remember it is when the level of spending in money terms starts to exceed what can be produced normally or comfortably with existing resources that prices tend to start rising more quickly. Ultimately, excess demand will be reflected in higher prices, not higher output. The problem is that it cannot be known with any certainty by how much the economy can grow before it starts to generate inflationary pressure. There is no simple rule to follow. The pressure on capacity depends ultimately on the level of demand rather than its growth: an economy with plenty of spare capacity can grow more quickly than an economy where resources are fully utilised. But it is not possible to estimate with much precision how close the current level of output might be to the point at which producers start to reach capacity limits. It is not something that can be observed directly. The box on page 54 discusses the long-term trend in the growth of output and the concept of the output gap. Spotting signs of inflation Output Teams can also look at information that reflects the growth of output in the economy. We explained in Section B that the rate at which the economy can grow over the long term depends on factors that increase the supply potential of the economy, ie. the capacity of the economy to produce goods and services. But, in the short term, output (and employment) can rise and fall in response to changes in demand. Higher demand might be met by an increase in imports or from firms’ stocks. But, in the short run, changes in output are likely to reflect changes in demand. Bank of England and The Times Interest Rate Challenge 2014/15 In order to monitor how close the economy might be to operating at or beyond its normal capacity, evidence has to be gathered that might indicate production bottlenecks and pressure on resources within the production process, particularly in the labour market. This includes data on wages and other costs and prices. Cost and prices data can help to tell us how close the economy might be to operating at full capacity by providing signs that inflationary pressure is building. But it is always necessary to understand what factors are driving higher or lower prices before we draw conclusions. Section D Assessing economic conditions 52 Rising raw material prices might, for example, reflect strong world demand and be a sign of wider or pending worldwide inflationary pressure. But, alternatively, higher prices could be due to factors affecting supply in particular sectors – for example, poor crop harvests can raise food prices, or output restrictions by oil producers can increase oil prices. In these instances, rising material prices might temporarily lead to more inflation as higher costs work through the supply chain and into retail prices. But they are less likely to be a signal of general inflationary pressure than if prices were rising because of excess demand. Evidence of inflationary pressure in the supply chain and labour market can indicate that the economy is operating close to full capacity Similarly, if manufacturers’ product prices start rising more quickly, you need to assess whether or not this reflects strong demand and pressures on capacity, allowing firms to pass on cost increases. Higher prices might reflect temporary or one-off influences such as a change in taxes or duties. These factors might influence the inflation rate for a period. But, unless this results in higher inflation expectations more generally – which then feed into wage negotiations and other prices – these effects should not have a lasting influence on inflation. This was explained in Section B. Bank of England and The Times Interest Rate Challenge 2014/15 The labour market The labour market is an important area for monitoring inflationary pressure. Employment levels might reach a point where there is likely to be upward pressure on wages and other earnings. Wage costs are a major part of total costs and so can have a significant influence on retail prices. Rising wage costs not matched by higher productivity, may reflect pressures in the labour market, perhaps due to a shortage of skills and recruitment difficulties. Costs, profits and prices It is also necessary to judge whether any increase in prices within the supply chain is likely to be passed on to consumers. Cost increases might mean lower profit margins for firms rather than higher prices for consumers, at least in the short run. For example, faced with higher costs, retailers might either take a cut in their profits, make offsetting cost savings elsewhere, or pass the cost increases on to consumers by charging higher prices. The extent to which firms are able to pass on cost increases is likely to be influenced by demand conditions – when demand conditions are buoyant, retailers are more likely to be able to pass on cost increases to the consumer, and perhaps also boost their profit margins. Competitive conditions will also be important. If some retailers try to increase their prices and profits, other retailers might enter the market and eventually force prices down. These are the kinds of issue that teams will have to consider. Section D Assessing economic conditions 53 Sustainable growth and the output gap The economic cycle Over time, though not over the past few years, the UK economy has grown at an average rate of about 2.5% a year. This is a useful guide to how much of an increase in output can be sustained over time, ie. without generating inflationary pressure. The answer will partly depend on the stage of the economic cycle. After a recession, output might grow quickly without any signs of inflation rising. That is because there is spare capacity in the economy – the actual level of output has been growing below its potential level. This is generally associated with a reduction in inflationary pressure. As spare capacity in the economy is used up, there is an increasing likelihood that continued growth will result in rising inflation. Long periods of rising demand can take the level of output above its potential or sustainable level and are generally associated with rising inflationary pressure. The UK economy has grown on average by around 2.5% a year – a guide to its sustainable growth rate You will see this referred to as the trend or sustainable rate of growth. This reflects the rate of growth in the labour force and in productivity. Such things as investment in new equipment and technology, improved methods of production and distribution, and the development of skills have enabled productivity to rise. Productivity increases and the growth of the labour force determine the growth in what is referred to as the economy’s potential output. As we explained in Section B, potential output is the ‘normal capacity’ level of output at which there is no upward or downward inflationary pressure in the economy. We said that actual output might grow by more than its sustainable rate in some periods and by less in other periods as the growth in demand fluctuates. Strong growth, such as that experienced in the late 1980s, has often been followed by falls in output – negative growth. When growth is above or below its sustainable rate, you need to ask whether inflation is likely to move above or below the inflation target in the period ahead. Bank of England and The Times Interest Rate Challenge 2014/15 Economists refer to the difference between the actual level of output and the potential level of output as the ‘output gap’. It can be positive – here defined as actual output above potential output – or negative. The output gap cannot be measured with any precision. No two economic cycles are alike and the rate of growth that the economy might be able to achieve through productivity increases can vary over time. Growth above or below its sustainable rate is a guide to potential inflationary pressure So it is not possible to have hard and fast rules about the output gap and its implications for future inflationary pressure. But this is still a helpful concept for assessing the balance of demand and supply in the economy as a whole. Section D Assessing economic conditions 54 Section D Judging the inflation outlook Much of the information the MPC studies tells it something about the economic outlook as well as current economic conditions. The MPC looks at a range of indicators of the growth in money, demand and output, and the extent of inflationary pressure in the economy in order to judge, as best it can, future inflation. Section B explained that monetary policy has to be forward-looking because interest rate decisions taken today only have their full impact on inflation around two years ahead. The MPC is, therefore, interested in the prospects for both economic growth and inflation. Like the MPC, teams will need to form judgements about future trends in the economy and how these are most likely to impact on inflation. Teams will have to judge future trends and how these might impact on inflation Economic growth If the growth in demand and output is currently strong or weak, teams will have to judge whether the recent trend is likely to continue or not. They will need to ask whether the current strength or weakness reflects temporary factors or more fundamental and lasting influences. In the case of consumer spending, for example, teams might look at information in the labour market – such as employment levels and wage increases – in order to judge the extent to which incomes are likely to rise and support future growth in spending. Are there factors which are likely to change recent trends in employment and the growth in incomes? This reveals something about the amount of spending power consumers will have at their disposal in the period ahead. Survey evidence might also help teams to assess likely trends in future spending. Some surveys reveal how confident consumers are about economic prospects. And teams can look at how much money people are borrowing from banks and other financial institutions as an indicator of future spending. Bank of England and The Times Interest Rate Challenge 2014/15 In a similar way, developments in overseas economies, together with exchange rate developments, will largely determine the outlook for export demand. And future investment demand will be determined by factors such as company profitability and the outlook for the sales of firms’ goods and services, as well as the cost of raising finance. Teams will have to look at trends in variables that tend to influence future demand in the economy. Has the MPC already acted? Of course, the MPC may have already responded to strong or weak demand growth and the expected effect on future inflation, by changing Bank Rate or through other policies, such as ‘forward guidance’. These changes will take time to affect demand and output. Teams will need to assess whether it is necessary to adjust monetary policy further or whether enough has already been done. Demand may have been rising quickly up to the period for which the latest data are available. But growth may already be moderating to the extent that another change may lead to even slower growth, with the result that inflation might fall below its target in the future. Teams need to assess the impact of any recent changes in monetary policy Inflation Assessing the trend in inflation will depend both on current and future trends in economic growth and how these relate to the amount of spare capacity in the economy. Current demand conditions will tell us something about the likely future path of inflation. And much of the information that we monitor to tell us about current inflationary pressure in the economy is relevant to Section D Judging the inflation outlook 55 assessing the outlook for inflation. The aim is to spot early warning signals of higher or lower inflation within the production process and labour market, and evidence of spending exceeding the supply capacity of the economy. These considerations provide clues about future inflation in relation to developments in the domestic economy. But the inflation outlook can also be influenced by changes in the exchange rate, particularly in the short run. The exchange rate The exchange rate is a key factor affecting inflation prospects, although it is very difficult to predict. There is, however, no mechanical link between a change in exchange rates and inflation. A change in the value of sterling can have a direct influence on inflation through changes in import prices. An appreciation of sterling will tend to lead to a fall in inflation. But this is primarily a one-off impact on prices and so a temporary influence on the inflation rate. The exchange rate is also likely to affect prices indirectly, through its impact on the demand for exports and imports and, in turn, output. Importantly, the size of these effects will depend on why the exchange rate has appreciated or depreciated, not least because that will determine whether any change is likely to be sustained. The exchange rate is discussed further in Section F. There is no mechanical link between a change in exchange rates and inflation Current inflation Although monetary policy is the dominant determinant of the inflation rate in the long run, there are many other influences on the measured inflation rate over shorter time periods. This was discussed in Section B. Teams will have to monitor the current rate of consumer price inflation and judge to what extent movements reflect temporary influences or more fundamental factors, ie. whether the current rate of inflation is a guide to the future rate of inflation. The current rate may be above or below the inflation target but that may tell us little about its future direction. In July 2003, the MPC reduced the official Bank Rate when RPIX inflation was above the then 2.5% target; the MPC increased the Bank Rate in June 2004 when CPI inflation was below the current 2.0% target. Bank of England and The Times Interest Rate Challenge 2014/15 Even the likely path of inflation in the immediate future may not be a good guide to its path further ahead. The immediate outlook might be for inflation to rise or fall, perhaps due to one-off factors such as a change in VAT and duties or a rise or fall in the exchange rate. But demand conditions might indicate that the underlying picture differs from this short-term prospect. The immediate outlook for inflation may not be a good guide to its trend over the medium term You will want to judge whether inflationary pressures are building or diluting over the two-year period, and whether inflation is likely to be rising or falling once any short-term influences on the measured inflation rate have dissipated. It is not possible to do this with much precision. We cannot say inflation will be 2.0% in one year’s time and 2.5% in two years’ time. This kind of statement assigns too much certainty to what is always a judgement about possible future outcomes. The MPC’s growth and inflation forecasts – judgement and uncertainty The MPC thinks about the economic outlook and future inflation with the help of an economic forecast. The MPC’s forecast brings together into a quantitative framework all the key information on the economy and an understanding of how the economy tends to work. The future will always be different in some way from the past Although teams will not have the MPC’s forecasting framework, the task, in many respects, will not be so different. The MPC’s forecasts involve judgements about a wide range of considerations. The Committee does not just plug in a series of numbers and wait for the forecast models to produce a mechanical answer. Economic models are part of the monetary policy tool kit, but they do not provide all the answers. Given the size and complexity of the economy and the ever-changing nature of the economic situation, economic models cannot possibly incorporate all the factors that matter to monetary policy. Most economic models are Section D Judging the inflation outlook 56 The MPC’s ‘fan’ charts One important characteristic of the MPC’s forecasts is worth explaining. You will see that the forecasts are not presented in terms of a single number for economic growth and inflation in one or two years’ time. The only certainty about this kind of ‘single-point’ forecast is that it will be wrong. The probability of inflation being a particular number in two years’ time is almost zero. Judgements about the future involve a great deal of uncertainty – there are only ever probable outcomes So it is better to present a forecast as a range of likelihoods or possible outcomes – what we call a probability distribution. The MPC tries to judge the most likely outcome for inflation and economic based on an understanding and an estimation of what has happened in the past. Although this is often a good starting-point for thinking about the future, the future is never an exact repeat of the past. Forming judgements and assessing their implications for monetary policy are part of the job of the MPC. So do not be put off by some of the more technical aspects of the MPC’s work. Teams will have to use their judgement about future trends to help make their policy decisions. growth over a two-year period. But it acknowledges that inflation might be higher or lower. This uncertainty is reflected by the presentation of the forecasts as ‘fan charts’. These are shown in the Inflation Report*. The central bands within the fans represent what the MPC thinks is the most likely outcome for growth and inflation over the forecast period. The outer bands represent other possible outcomes. The MPC’s forecasts explicitly acknowledge that judgements about economic growth and inflation in the future involve a great deal of uncertainty. So teams should not feel they need to be too precise or exact. Like the MPC, they need to make judgements about what is most likely to happen. And, like the MPC, teams should acknowledge that those judgements will involve uncertainty. In addition, you can look in the newspapers and other places to see what other organisations and economists are forecasting for the economy. This section has discussed, in general terms, the task of forming judgements about demand conditions and inflationary pressure in the economy. It has provided a foundation for thinking about the task of setting interest rates to control inflation. *Teams can look at the MPC’s latest forecasts for economic growth and inflation in the Inflation Report, which is on the Bank’s website at www.bankofengland.co.uk/publications/Pages /inflationreport/default.aspx Bank of England and The Times Interest Rate Challenge 2014/15 Section D Judging the inflation outlook 57 Section E Using economic information This section provides general guidance on the main types of economic information that are available. It describes some of the common features of economic statistics. The aim is to prepare the ground for teams to be able to use the data series discussed in Section F. Building up the economic picture 61 Official statistics 62 Definitions and coverage 62 Aggregated versus disaggregated data 63 Accuracy and timeliness 63 Values and volumes; current prices and chained volume measures; nominal and real values 64 Index numbers 65 Seasonal adjustment 65 Data volatility 65 Which growth rate? 66 Surveys and business intelligence 67 The nature of survey information 67 Using survey information – survey balances 67 Business intelligence 68 The economic jigsaw – how many pieces of data should you use? 69 Organising economic information Bank of England and The Times Interest Rate Challenge 2014/15 70 Section E Using economic information 59 Section E Building up the economic picture Economic statistics are published almost every day. A steady stream of new figures arrives on the desks of economists at the Bank of England each month. And on most days of the week the newspapers carry reports covering the latest information, often including comments about what the figures might mean for the MPC’s next decision on Bank Rate and quantitative easing. New information does not necessarily change the MPC’s assessment of the economy. It adds to the current body of evidence. The latest figures might support an existing view or establish a clearer trend. But, equally, they might contradict other information and perhaps suggest that a trend is changing. The data rarely present a uniform or unambiguous picture. Each new piece of information adds to the existing body of evidence Whether new data clarify or complicate matters, no one piece of information can ever provide a complete picture of economic conditions. And the MPC never makes its decisions on the basis of a single piece of data. It uses different types of information and many data series to form its views. A wide range of official statistics and other information is reviewed and analysed in the Bank of England’s quarterly Inflation Report and in the minutes of the monthly MPC meetings. The MPC uses a range of different types of information and many different pieces of data to form its views Teams will also be able to read the Monetary Policy Committee’s own economic assessment in the minutes of the monthly MPC meetings. These are published two weeks after each meeting. You can also read regular commentaries on the latest figures and economic situation in The Times and other publications. The following pages of this section should give teams a better feel for the kinds of data that are available. We do not expect teams to cover everything. The Bank of England is providing teams with a selection of the key data relevant to interest rate decisions. These are described in Section F. The first set of datasheets will be available from 5 September 2014. The Bank will produce data updates immediately prior to the regional heats, area and national finals. The datasheets will be updated monthly. The datasheets and data updates will be posted on the Bank’s website. You can, of course, look at any information you feel is relevant to your assessment of economic conditions. You might want to use information from newspapers and other reports. It is entirely up to you. Bank of England and The Times Interest Rate Challenge 2014/15 Section E Building up the economic picture 61 Section E Official statistics Official statistics are the backbone of the MPC’s assessment of the economy – an essential guide and tool. They provide a framework for analysing economic developments and the inflation outlook. The main official data series on the UK economy are provided by the Office for National Statistics and the Bank of England. The data measure such things as: • the amount of money in circulation and level of borrowing from banks and building societies; • output from different sectors of the economy eg. manufacturing, retailing, business services, construction; • expenditure by different groups eg. consumers, firms; • activity in the labour market eg. employment, earnings; • the costs and prices of goods and services; • government finances; and • overseas trade. Official statistics are the backbone of the MPC’s economic assessment Statistics are never perfect, but without them we would be largely ignorant of how the economy is performing, and unable to judge where it might be heading. The official statistics have a variety of characteristics of which teams should be aware in order to use them effectively. These are discussed in this section. Examples, often referring to retail sales, ie. spending in the shops, are used to illustrate points. You might want to refer back to this information once you have started looking at the data. Definitions and coverage All official statistics have definitions explaining what they cover and the basis on which they are constructed. Whatever data series you are using, it is important to have a good general idea about its coverage. The numbers may not always be what you think they are, and definitions can Bank of England and The Times Interest Rate Challenge 2014/15 change from time to time. You should familiarise yourself with the short descriptions provided in the datasheets. You also need to be aware of specific details, such as whether data are seasonally adjusted, or are in current or constant prices. These and other features are discussed later in this section. Always have a good idea of the definition and coverage of the data you are using Teams also need to understand that the statistical coverage of the economy is not uniform. Some sectors and activities are better measured than others. In particular, there is a relative lack of data covering some parts of the service sector. This is because some activities are genuinely difficult to measure. You need to bear this in mind so your economic assessment is not too heavily based on data that relate to just part of the economy. GDP – a key economic statistic There is one official statistical series with which teams need to be thoroughly familiar – Gross Domestic Product (GDP). GDP measures the size of the economy – the amount of economic activity. It does this in a number of different ways, one of which is to measure total output over a specified period. We tell you more about GDP and its components in Section F. You also need to be aware that the coverage of some data series is more comprehensive than others. For example, retail sales data do not cover all types of spending by consumers. They measure primarily spending on goods that are bought in shops. They do not include spending on cars or services such as restaurants, electricity supply and Section E Official statistics 62 transport. Services account for over half of total consumer spending, so it would be misleading to draw firm conclusions about total consumer spending from retail sales data alone. Nonetheless, we would expect the trends in retail sales data to be closely related to trends in total consumer spending. They will tend to be determined by the same factors. But we have to acknowledge that, at any particular point in time, an indicator like retail sales may give a wrong impression of the wider situation. We often pay attention to such data because they are available more frequently and sooner than the more comprehensive pieces of data. Retail sales data, for example, are available every month and are released about two to three weeks after the end of the month. Data on total consumer spending are only available quarterly – every three months – and are first released some seven weeks after the end of the relevant quarter. So although total consumer spending gives a more complete guide to the economic picture, earlier additional clues provided by other data are helpful. Some data provide more timely information but they need to be used with care Some data are likely to provide more reliable indications about the wider economy than others. The number of people eating out in your local restaurant or pub might be an indicator of the trend in consumer spending across the economy as a whole. But we have little means of knowing how reliable an indicator it is. Generally speaking, the smaller and less representative the sample, the less reliable a guide it is likely to be. Aggregated versus disaggregated data You will tend to read most about the aggregate or ‘headline’ figures on the economy, ie. data that cover either the whole economy or a broad sector or aspect of economic activity. GDP figures cover the economy as a whole; the Consumer Prices Index covers the prices of a very wide range of goods and services. When the MPC is setting interest rates, it concentrates in the main on aggregate data series of this type. That is because it needs to consider the overall economic picture rather than every individual component within it. But to understand the data, it is often useful to look at some of the components that make up the ‘headline’ series – the disaggregated data. This may provide clues about the current economic situation and enable us to make a better judgement about whether or not trends are Bank of England and The Times Interest Rate Challenge 2014/15 likely to continue. We might want to know, for instance, if the latest figures reflect special or temporary factors which might be revealed by looking at the disaggregated data. For example, total output can sometimes be affected by large falls or rises in energy output, ie. electricity, gas and oil. These changes are often weather-related and so have only a temporary influence on output. Similarly, if the money supply is growing fast, you will need to assess what factors might be behind the growth and whether they are likely to be continuing or temporary influences. Teams will need to concentrate on aggregate data but individual components can provide useful clues How much digging? Teams will have to judge how much digging beneath the aggregate data they need to do. That might depend on the numbers themselves. If new data are surprisingly strong or weak, you might want to look at the underlying components. Remember that you will be trying to build up an overall assessment of inflationary pressures in the economy. You will need to concentrate your efforts on data that shed light on the prospects for inflation. Too much detail might make it hard to see the wood for the trees! Accuracy and timeliness The economy is large and complex. Trying to measure its size and structure, and by how much it is changing, is a difficult task. Official statistics are usually based on large samples of firms and individuals, and they are systematically checked and reviewed to ensure that they meet high standards. But any statistic can only be an approximate guide to reality. There is often a trade-off between the timeliness of data and its accuracy In fact, official statistics provide us with an indication of what has happened rather than what is happening. There is always a time lag between the data being available and the period they cover. GDP data are first released around three to four weeks after the end of the quarter. A more detailed second estimate is released one month later. This means that policymakers are always looking at data relating to the past rather than the present. That adds to the challenge of using the data to judge what is happening in the economy now, and how it will develop in the months and years ahead. Section E Official statistics 63 Data that are published soon after the period to which they relate play a key role in the decisions taken by the MPC. Interest rate decisions need to be based on the most up-to-date picture of the economy possible. But there is often a trade-off between the timeliness of data and its accuracy. Revisions – do not overlook them! Data that are released shortly after the end of the period to which they relate are often based on less complete information than is eventually available. These data are initial estimates. As more information becomes available, the original estimates may be revised. Revisions may be trivial, but they can sometimes be substantial. And data can continue to be revised a long time after they are first released. Over time, the data series underlying the aggregate figures are reviewed and re-estimated. Quarterly estimates of, say, investment expenditure are often based on smaller samples or less detailed information than is available on an annual basis. Estimates of GDP are not finalised for some years. One major exception is the Consumer Prices Index – it has had only one set of revisions since it began in 1996. Because of the time it takes for a change in interest rates to have an impact on inflation, policymakers cannot wait for later estimates or finalised data. They have to base their decisions on the best information that is available at the time. It is because individual pieces of data are only ever best estimates of what has happened, and are often revised, that monetary policy decisions need to be based on a wide range of information rather than just a handful of statistics. Official statistics are always measuring what has happened rather than what is happening The Bank will provide new data to teams during the course of the Challenge. This will often include revisions to earlier data. The revised data might cause you to change your view about what has been happening in the economy. Revisions to existing data can be just as important as new data. Bank of England and The Times Interest Rate Challenge 2014/15 Values and volumes; current prices and chained volume measures; nominal and real values Raw data need to be adjusted in various ways to make them useful. An important piece of data is the measure of total output in the economy. But the value of output is made up of two components – volume and price. A rise in the value of GDP may be due to a rise in prices rather than any increase in the amount of goods or services produced. But we often want to know about volumes, not least to assess the balance between demand in the economy and the available supply of goods and services. So statisticians remove the price change element, ie. values are adjusted for any change in prices. They deflate values using price data, which are collected separately, to derive volumes. So, if the value of sales for a particular product has risen by 5% over a period, and prices have risen by, say, 4%, we can deduce that the volume of sales must have increased by 1%. Statisticians take value figures measured in today’s prices – termed current prices – and deflate them by the change in prices since a particular year, called the reference year. This gives a value in chained volume measures. The price is held constant over time in order to identify the change in volume. You will often see data described as ‘in chained volume measures (reference year 2010)’. This means that the level of prices in one year – in this case 2010 – is held the same for all years. You do not need to know the details but, if you are interested, this is explained in more detail in the May 2003 Inflation Report. Values measured in constant prices allow us to track changes in volumes Expressing variables – for example, manufacturing output – in chained volume measures means that the numbers will show changes in quantity, ie. volumes. You will sometimes see this referred to as being in ‘real’ terms – for example, ‘in real terms manufacturing output grew by 2%’. This means that it is free of the influence of any change in prices. When we are observing data in current prices, they are sometimes referred to as being in ‘nominal’ terms. GDP is usually presented in real terms, though nominal values, ie. in current prices, are also available. Data on wage earnings are expressed in nominal terms. You should watch this distinction carefully when using data. Section E Official statistics 64 Index numbers Seasonal adjustment Some data are presented in terms of actual amounts of money – for example, £100 million – either in chained volume measures or current prices, or as a figure such as the change in the number of people unemployed. But other data are presented in the form of index numbers. For example, you might see manufacturing output recorded as, say, 110 in a particular month rather than an amount. Most official data are seasonally adjusted. This means they take account of normal seasonal variations in such things as the amount of spending or production. This is a necessary step. When trying to assess economic conditions, it is not sensible to look at changes in the data that reflect, more than anything else, the time of year. Removing the seasonality from data is an attempt to remove variations in the figures that reveal little about the underlying economic situation. A good example is the large increase in retail sales in the period leading up to Christmas. Measuring and removing the seasonal element can be difficult, especially when seasonal patterns themselves might be changing over time. An index number is an arithmetical conversion of the raw data. Statisticians usually take the value of something in a particular period and assign it a value of 100. This becomes the reference year value. For example, if retail sales volumes were, say, £316 billion in 2010 and that year is the reference year, then it is assigned the index number 100. If sales volumes rise to £326 billion in 2011, ie. 3% higher than in 2010, the index number for 2011 would be 103. The reference year value should always be shown on the data series, for example, 2010=100 or 2009=100. The use of index numbers allows easier comparisons of different things over time. The Consumer Prices Index The Consumer Prices Index is not seasonally adjusted. For this reason, we usually look at the annual rate of change in the CPI – the change in prices over the year. As long as the seasonal pattern of price changes is fairly consistent from year to year, then annual inflation rates should reflect the non-seasonal element of the change in prices over the year. For example, the annual rate of inflation in January will reflect the change in prices between January this year and last year. The fact that prices always tend to fall in January because of the winter ‘sales’ will not distort the year-on-year comparison. Of course, price discounting might be greater this year than last so the rate of inflation might fall. In this instance, we would need to judge the reasons for this – it might, for example, be due to lower demand – and whether it was likely to be a temporary influence on the inflation rate or not. Bank of England and The Times Interest Rate Challenge 2014/15 We do not want to focus on changes in the data that just reflect the time of year Data volatility Seasonal adjustment removes some of the variation in the figures. But even when this is done the data rarely follow a smooth path from month to month or quarter to quarter. Figures often jump up and down, making an assessment of the overall trend difficult. Some series are more volatile than others. Data may be displaying an overall trend, but there can be a lot of variation around the trend. Month-to-month movements in retail sales volumes, for example, tend to be very volatile. If spending in the shops is very high one month, it can often fall sharply the following month. This variation can be due to factors such as the weather or the timing of particular events such as public holidays. Such factors can affect the timing and amount of spending in a particular period. But, over time, factors like the weather do not determine the overall amount consumers spend. So rather than focus on month-to-month movements in data, it is sometimes better to look at changes over longer periods to get a feel for what is going on. Section E Official statistics 65 Different annual growth rates • the annual growth rate in, say, retail sales in March 2014 will reflect the change in sales between March 2014 and March 2013; • for monthly data, the annual three-month growth rate in March 2014 will reflect the change in the average level of sales in January to March 2014 compared with January to March 2013; and • for quarterly data, the annual growth rate in the first quarter of 2014 will reflect the change in sales between 2014 Q1 and 2013 Q1. Which growth rate? You will see that most of the discussion of economic data in the Inflation Report and minutes of the MPC’s meetings is framed around growth rates of different variables – money, consumer spending, output, employment, wages, exports etc. In tracking economic developments and the extent of inflationary pressure in the economy, the movements in variables over time – their growth – is often important, in addition to their level. Statistics rarely follow a smooth path – it can help to identify the trend by smoothing out short-term volatility Quarterly growth, annual growth, annual three-monthly growth...? The data that we provide to teams are expressed in a variety of different ways. For monthly data, we often look at the average growth rate over the latest three months compared with the previous three months. This averaging irons out some of the volatility between individual months in many data series. But three-month growth rates can themselves move up and down. A large rise in, say, retail sales in one particular month will initially increase the three-month growth rate. But it will then fall back as the large monthly rise moves from being in the latest three months to the previous three months. You can work this out with some numbers. The trend in growth will be somewhere in between these swings. Bank of England and The Times Interest Rate Challenge 2014/15 Some data are volatile even when measured on a quarterly basis, for example investment. In this and many other cases, it is common to look at the annual rate of growth and to track this quarter by quarter. Annual growth rates can be expressed in a number of different ways – as a monthly rate, a three-month rate, a quarterly rate or even a half-yearly rate. Again, have a look at the data to become familiar with this. and annualised growth! You may also see references to ‘annualised’ growth rates. These are the growth rates over a particular period – say three or six months – expressed as an equivalent growth rate for a full year. In other words, it is the growth rate that would be achieved if growth over a particular period continued over twelve months. For example, if GDP increased by 1% in the first quarter of the year, the quarterly annualised rate would be 4.06%. If it increased by 3% over the first half of the year, the six-month annualised rate would be 6.09%. In the second case, the annualised rate is not simply double the six-month growth rate – we will let you work out why...but it is to do with compounding! The risk in trying to observe the trend in the data by averaging monthly or quarterly changes, is that changes in the trend might be missed by underplaying the latest figure. Again, by looking at a variety of growth rates and understanding what is going on beneath the aggregate data, you can keep alert to indications that trends might be changing. There are other features of official statistics, but what has been covered here should give you enough grounding to start using official data. Some of it might seem confusing initially. The best way to understand the data is to use them. You will learn by asking questions as you go along. We give you specific definitions for each of the data series in the datasheets. Section E Official statistics 66 Section E Surveys and business intelligence In addition to official statistics, the MPC considers a range of surveys provided by business organisations such as the Confederation of British Industry (CBI) and the British Chambers of Commerce (BCC). These surveys can provide additional indications of business trends and conditions. Surveys can be useful in supplementing the information from official data sources. They often provide an independent check on the current situation and trends. In addition, some survey responses provide forward-looking information. In many cases, survey information is very timely, providing indications of economic conditions before other data are available. The nature of survey information Strictly speaking, most official statistical series are surveys. They are based on samples of firms or individuals, rather than a full population census. But official data are normally based on quantitative information – for example, sales in company A were £100 million in a particular period. ‘State of trade’ type surveys ask firms for their views rather than numbers and so are qualitative in nature – for example, sales in company B were ‘above’ or ‘below’ normal in a particular period, or were ‘higher’ or ‘lower’ than in a previous period. A typical survey will ask companies or individuals a range of questions relating to current economic and business conditions – for example, questions on a firm’s output, orders, employment and prices – or about confidence in the future in a more general sense. Responses are often in the form of whether something like output or prices is higher or lower than at the time of the previous survey. For example, a firm might be asked ‘compared with the situation three months ago, are the prices you charge higher, lower or about the same?’ We are interested in how these responses alter over time, ie. how the total number of firms responding ‘higher’, ‘lower’ or ‘same’ is changing. For example, if a larger number of firms report that output is now higher than at the time of the previous survey, this might be a sign that the growth in output is increasing. Bank of England and The Times Interest Rate Challenge 2014/15 Some survey responses cover the same ground as the official data – for example, they provide information on output, exports and employment. Others provide additional information that complements official data – for example, on orders, skill shortages and confidence. Survey responses that correspond directly with official data are useful because they are often available sooner than the official data and they can be a helpful cross-check. Survey responses that give additional information may be useful if they provide a guide to something that is either not well measured statistically or is not directly observable – for example, capacity utilisation or skill shortages. Surveys can provide an independent check on current trends, and information about possible future trends Survey responses may also provide forward-looking information. For example, answers to questions about order books may tell us something about future output, and responses about investment intentions may tell us about future investment spending. Similarly, firms’ expectations of prices, employment and output in the near future can be a useful indication of short-term prospects. Using survey information – survey balances The way survey information is used depends on its timeliness, track record and coverage. Some surveys cover particular sectors of the economy. The MPC tends to look closely at surveys with a broad coverage – for example, those covering the manufacturing or service sector as a whole. It also looks at surveys covering activity and behaviour in the labour market. Section E Surveys and business intelligence 67 Most surveys do not provide hard data and so the information has to be interpreted in some way. A typical approach is to look at survey responses over time and try to assess the significance of recent changes. It is usual to look at the ‘balance’ of responses – the difference between the number of firms reporting a rise in, say, output or prices and those reporting a fall. Most of the survey data that we provide will be in this format. We typically look at the difference between the ‘up’ and ‘down’ responses to survey questions over time Large movements in survey balances might warrant closer examination, by comparing the latest observation with, for example, the average over time, or perhaps the same point in previous economic cycles. But it helps to know whether a survey has tended to be a good guide to trends in official data in the past. There is an example of using survey information in the box below. Simply observing the latest data and the changes and patterns in survey responses can be very useful. At the same time, we have to remember that many surveys are based on smaller and less representative samples than the official statistics. They may not always be an accurate guide to what is happening in the economy or a particular sector. Surveys are not a substitute for official statistics. But used in a complementary way, they can help us to interpret economic conditions and resolve some of the puzzles and uncertainties about the economic outlook. The CBI Industrial Trends Survey The CBI Industrial Trends Survey asks manufacturing firms how optimistic they are. The balance of responses from firms saying they are ‘more’ or ‘less’ optimistic about the future than previously has tended to have a fairly good relationship in the past with the annual growth of GDP. This relationship seemed to have broken down during the past decade. In 1997 and 2001 the CBI balance declined sharply, but GDP growth slowed only a little. However, the CBI survey only covers the manufacturing sector, and both these declines in the balance reflected shocks concentrated in this sector. In 1997 sterling’s depreciation, combined with the crises in East Asia and other regions, were likely to impact more strongly on the confidence of manufacturers, and particularly of exporters. Similarly in 2001, the bursting of the ‘dot-com’ bubble was most likely to affect Bank of England and The Times Interest Rate Challenge 2014/15 Business intelligence It is important for the MPC to understand what lies behind the economic data. In addition to formal economic research, information can be gleaned by talking directly to firms, individuals and experts in particular fields. Each month the MPC receives information from hundreds of businesses through the reports provided by the Bank’s twelve regional Agencies, which are located throughout the United Kingdom. The Agencies speak to companies in all sectors of the economy and cover topics such as demand, employment, investment, and costs and prices. They are able to form an overall view of business conditions in their areas. Each month the MPC discusses economic conditions with a number of the Bank of England’s Agents at the pre-MPC meeting. The Agents also provide information on topics of particular interest to the MPC. This information often adds flavour to the statistics. It might help to distinguish between different interpretations, perhaps when official data are giving unclear or conflicting signals. The aim is to provide the MPC with a better understanding of the circumstances underlying recent trends. Teams can look at a summary of the information provided by the Agencies in the Agents’ Summary of Business Conditions, which is available on the Bank of England’s website. manufacturers of ICT equipment. Therefore, in both cases, there were good reasons to believe that the fall in optimism might not be representative of the wider economy. During 2007, and continuing into 2008, the CBI optimism balance fell sharply and was a better indicator of GDP growth. The increasing concerns over the global financial system, related to the extent of losses on sub-prime mortgages in the USA, affected confidence across the economy. In the event, GDP growth slowed sharply at the end of 2007 and the economy fell into recession by mid-2008. These examples highlight the importance of interpreting movements in the confidence balance carefully, and of bearing in mind which specific sectors they refer to, and whether developments in those sectors are likely to be representative of the whole economy. Section E Surveys and business intelligence 68 Section E The economic jigsaw – how many pieces of data should you use? Building up your assessment of economic conditions will be a little like assembling a jigsaw – except that the pieces of evidence will not always fit neatly together and it is likely that some of them may be missing. Given the vast amount of data available on the economy, the obvious question is how much should you use? That is a matter of judgement. But given what is available on both the economy as a whole and different sectors, it is easy to become over-burdened with information. It is always tempting to seek one more number to try to add comfort to your thinking and conclusions. Part of the Challenge is to decide as a team what you want to look at and where to draw the line to avoid information overload. data might be relevant to issues that are important at a particular time. At all times you will need to ask yourself how a piece of information influences your view of current and future economic conditions. And you need to ask and decide how it influences your judgement about inflation. Data on money, consumer spending, exports, jobs, wages, investment or output all need to be considered with that in mind. Information has to be pieced together to give a picture of the economy as a whole. Faced with potentially hundreds of different data series on the economy, you will need to prioritise your effort and choose a focus. Some data are essential to follow; other Bank of England and The Times Interest Rate Challenge 2014/15 Section E The economic jigsaw 69 Section E Organising economic information In view of the large amount of data available, it is sensible to organise the information in some way. The Bank of England’s Inflation Report and the minutes of the MPC meetings are organised around different aspects of the economy. The Inflation Report is organised under headings that reflect different elements of the inflation process – from the money supply, exchange rates and interest rates, to the amount being spent in the economy and the rate of output growth, to the effects on activity in the labour market and costs and prices. These are the various stages of the links between interest rates and inflation – the transmission mechanism – outlined in Section B. This basic structure is followed in Section F. The headings are: • money and financial markets; • demand and output; • the labour market; and • costs and prices. Bank of England and The Times Interest Rate Challenge 2014/15 Teams will want to look through Section F and familiarise themselves with each of these areas of the economy. Of course, the way that teams structure and organise their presentations need not follow these headings. The judges will be looking for imaginative formats. For the purposes of working through the economic information, this is a logical way of thinking about inflation and interest rates. But you should still base your decision on Bank Rate and quantitative easing on an assessment of the outlook for the economy as a whole, not of particular aspects of it – such as the labour market. This section has given some general guidance to prepare you for using the economic information included in Section F and the data that we are providing. It is important to understand the nature of the information that you will be dealing with. Section E Organising economic information 70 Section F The economy – from money to prices This section covers different aspects of the economy and the inflation process, building on the material in Sections B and D. It explains why we look at particular areas of the economy and why they are important. We will provide many of the statistics discussed under the various headings. The section is divided into five main parts. We start by looking at money and financial markets and then go on to consider demand and output, the labour market and costs and prices. The different aspects of the economy are not independent of each other – everything in the economy is inter-related. But there is a great deal of material here so each member of the team might want to concentrate on a particular part. You should not feel that you have to be familiar with everything. The section is intended to be a comprehensive reference source for teams to use as they come across different issues and data. It will also help you to understand the minutes of the MPC meetings and the Bank of England’s Inflation Report where there are further data and charts. Recap The transmission mechanism of monetary policy 73 74 Money and financial markets 75 The amount of money and credit 75 Financial market interest rates 77 The exchange rate 78 Other asset prices 79 Demand and output 80 GDP – three measures in one 80 Total output of goods and services – GDP(O) 80 Total expenditure on goods and services – GDP(E) 82 Domestic demand and the balance of trade 82 Consumer spending 82 Investment 85 Inventories (stocks) 85 Public spending 86 External demand 86 Total income from goods and services – GDP(I) 88 Bank of England and The Times Interest Rate Challenge 2014/15 Section F The economy 71 The labour market 89 Employment and unemployment 89 Labour costs 91 Costs and prices 93 Consumer prices 93 Producer output prices 94 Producer input and commodity prices 95 Import and export prices 96 Guidance for using the datasheets 97 Note: The datasheets are only up-to-date at the time of publication. The first set of datasheets will be available from 5 September 2014. Additionally, the Bank will produce data updates immediately prior to the regional heats, area and national finals. These will cover key data released since the most recent datasheet. The datasheets and the updates will be available on the Bank of England’s website: www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx Bank of England and The Times Interest Rate Challenge 2014/15 Section F The economy 72 Section F Recap In Section B we set out in general terms how a change in Bank Rate affects inflation over a period of time. We discussed how it leads to changes in spending and how this influences output and, in turn, the rate of inflation. Section D expanded on this discussion. This section will add to this material by looking at different aspects of the economy and how we monitor developments to judge the future path of inflation. The diagram on the next page illustrates the basic features of the transmission mechanism – the route by which an interest rate decision influences the rate of inflation. It portrays how the rate of inflation is the product of the degree of inflationary pressure within the UK economy, Key points • Bank Rate affects other interest rates – such as mortgage rates and bank deposit rates. At the same time, policy actions and announcements affect expectations and confidence about the future course of the economy. They also affect asset prices and the exchange rate. • These changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. Higher interest rates will tend to encourage saving rather than spending, and a higher value of sterling in foreign exchange markets – which makes foreign goods less expensive relative to goods produced at home. Bank of England and The Times Interest Rate Challenge 2014/15 and the influence on domestic prices from import prices. The diagram will refresh your understanding of what has been discussed earlier and provide a quick reference point as you are looking at the material in this section and the data that accompany it. • The level of demand in money terms relative to the supply capacity of the economy – in the labour market and in product markets – determines inflationary pressure in the economy. If the demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some firms might pass through into higher prices charged to consumers. • Exchange rate movements have a direct, though often delayed, effect on the prices of imported goods and services, and an indirect effect on the prices of domestic goods and services that compete with imports and use imported materials and other inputs. Section F Recap 73 Bank of England and The Times Interest Rate Challenge 2014/15 Section F Recap 74 Exchange rate Expectations/ confidence External demand Domestic demand Total demand Import prices Domestic inflationary pressure Inflation Having a good feel for the transmission mechanism will help the teams to identify how information and signals from different aspects of the economy might influence future inflation. Official Bank Rate Asset prices Market rates The transmission mechanism of monetary policy Section F Money and financial markets The amount of money and credit An old song has it that ‘money makes the world go round’. It certainly turns the wheels of the economy and it is central to thinking about inflation. As Section B explained, inflation represents the rate of decline in the value of money. Without money, there would be no inflation. As we explained in Section C, the UK authorities no longer attempt to target the growth in the money supply as a means of controlling inflation. But the money supply does play an important role in the transmission mechanism and as an indicator of economic conditions. And, ultimately, the control of inflation implies the control of monetary growth. The box on the next page discusses this. Narrow money – notes and coin Notes and coin in circulation in the economy are referred to as ‘narrow money’. Growth in the amount of notes and coin in the economy provides one indication of how much household spending might be rising. That is because notes and coin are still an important means of payment, despite the growth in the use of debit and credit cards. If people withdraw notes from cash machines, they are likely to use them for spending in the near future. An increase in notes and coin in circulation in a particular month might signal a rise in the value of retail sales. Data for notes and coin are released ahead of retail sales data. Note that we have said the value of retail sales, not the volume. Money will reflect the value of expenditure, ie. the price and the volume. It is a nominal variable, in the way we explained in Section E. Broad money – money in bank and building society accounts Notes and coin only represent a small part of what we call ‘money’. Money in a wider sense largely consists of what is held in bank and building society accounts. ‘Broad money’ is the term used to describe the amount of money held in these accounts plus notes and coin in circulation. Bank of England and The Times Interest Rate Challenge 2014/15 The measure of money that captures this definition is called M4. As well as aggregate M4, data are also available for the money held by different sectors of the economy – households, companies and financial institutions other than banks. Alongside the amount of money deposited, there are also data for the amount of lending undertaken by banks and building societies. Again, these are available for the economy as a whole – known as M4 lending – and for individual sectors. In particular, there are data covering lending to households. These are divided into secured lending, ie. lending backed by assets such as housing, and unsecured lending, such as credit card debt. Loans secured on housing represent around 84% of personal debt. We can look at the growth of bank deposits and lending both for the whole economy and for different sectors, to see if they provide any indications about future demand. Households Household spending power is likely to be related to the size of individuals’ bank and building society accounts. Higher growth in household deposits might reflect an increase in savings. But it could also signal a future rise in consumer spending growth. On the borrowing side, households can borrow from banks and building societies to supplement their income in order to help finance spending or to buy a house. Data on household borrowing can provide information about current and future consumer spending. Private non-financial corporations (PNFCs) Companies’ deposits and borrowing data can provide similar insights into their investment behaviour. For example, companies may build up bank deposits or increase borrowing to finance investment in new equipment and buildings. Section F Money and financial markets 75 Money and inflation The amount of money in the economy and the level of prices are positively related in the long run. Without money, inflation could not exist. And, across many countries, persistently high rates of money growth have usually been associated with high inflation. money growth of 4.5% per year would be broadly consistent with annual growth in economic activity of 2.5% – around the historical average in the United Kingdom – plus inflation of 2.0% per year, in line with the inflation target. Excess demand is likely to be accompanied by strong growth in the amount of money deposited in banks and building societies, and the amount of lending undertaken by banks and building societies. Consider, for example, what happens if Bank Rate is reduced. Banks are likely to reduce the interest rates they charge on their loans to individuals and businesses. In addition to boosting spending directly, this is also likely to lead to increased demand for loans which, if met, will increase the amount of money in bank deposits. So a change in Bank Rate is likely to result in a change in both bank deposits and bank lending. In practice, however, the relationship between money and inflation has not been stable. Money growth has been influenced by many other factors, including financial innovations – such as the introduction of credit cards – changes in banking regulations, and developments in international capital markets. The effects of these changes have not always been easy to predict accurately. So rules of thumb like the one above have not usually been useful guides for policy. Although money and inflation are clearly linked over the longer term, the usefulness of money as an indicator of inflationary pressures in the short to medium term depends on there being a predictable relationship between money and the value of spending. For example, suppose money grew at the same rate as the value of spending over time. Then Nonetheless, data on bank deposits, bank lending and cash are helpful in providing indications about both current and future spending in the economy. They can corroborate other data or sometimes give leading indications of spending behaviour since the figures are released earlier than GDP data. In particular, data on deposits and lending to households and companies can provide useful clues about consumer spending and company investment. Other financial corporations (OFCs) Credit conditions Financial institutions other than banks and building societies – such as life assurance and pension funds – also have bank deposits. The deposits of OFCs may rise or fall in response to their financial market activities – for example, financial institutions might switch to holding money rather than other assets in order to carry out financial transactions such as purchasing company shares. Such changes might influence asset prices, but often they may have little to do with future spending and investment in the wider economy. Whatever the reason, because the behaviour of financial institutions can cause large movements in the aggregate measure of M4, it is necessary to monitor the data for OFCs before drawing conclusions about the significance of the growth in broad money more generally. In addition to providing indications about future spending and investment, monetary data can also be used to assess conditions in the banking sector. There may be circumstances in which the banking sector reduces or increases the amount of lending it undertakes. For example, losses on bad loans either in the United Kingdom or overseas might restrict the ability of the banks to lend. This is what happened in 2008 when the turmoil in financial markets that originated in the US mortgage market disrupted the supply of bank credit to households and firms in the United Kingdom. This is sometimes referred to as a ‘credit crunch’, which can reduce spending and investment and lead to lower inflation. The opposite is a ‘credit boom’, which might result in an increase in spending and investment, and lead to higher inflation. The Bank of England’s quarterly Credit Conditions Survey gives up-to-date information on lending developments in the United Kingdom. Bank of England and The Times Interest Rate Challenge 2014/15 Section F Money and financial markets 76 Key data: money and credit – – – – Notes and coin M4 M4 lending Consumer credit Financial market interest rates Interest rates – the cost of borrowing – are important determinants of both the demand for, and the availability of money and credit. By examining interest rates on savings, such as deposit account rates, and the cost of borrowing, such as mortgage rates, you can better understand how Bank Rate decisions made by the MPC might be affecting spending and saving behaviour in the economy. Market interest rates may not change immediately or by the same amount as changes in Bank Rate. At any point in time, other factors might be influencing interest rates. For example, increased competition amongst financial institutions might result in lower mortgage or credit card interest rates. The speed and extent of the pass-through from Bank Rate to market rates will affect the impact of MPC policy decisions. The amount by which some market interest rates change following a change in Bank Rate will also depend on the extent to which a policy change is anticipated by financial markets, and how the change affects market expectations of future policy. If a change in Bank Rate is expected, market interest rates might change beforehand. It is possible to observe interest rate expectations by looking at different financial market prices. Newspaper articles about MPC interest rate decisions usually refer to what financial markets expect to happen, and the MPC discusses market expectations at its meetings. Short-term interest rates When Bank Rate changes, this is quickly transmitted to other short-term interest rates in the money markets – such as the rates charged by banks when they lend to other banks. Short-term market interest rates are important as they tell us about the cost to financial institutions of obtaining funds that can then be used to provide loans to customers such as mortgages and overdrafts. An alternative source of funds for banks is savings deposits placed with them by customers. The rate on these deposits will typically move with Bank Rate set by the MPC. So movements in Bank Rate set by the MPC are important for both savers and borrowers. Long-term interest rates Households and firms in the economy often want to borrow money for long periods of time. One way to borrow in this way is to take out a sequence of short-term loans at short-term interest rates. Alternatively, borrowers might want to fix the cost of borrowing in advance. Fixed borrowing rates for long-term loans are called long-term interest rates. These interest rates matter most to individuals taking out fixed-rate mortgages or firms looking to raise long-term finance for investment. One way of observing changes in long-term market interest rates is to look at the returns – or ‘yields’– offered on government and corporate bonds which extend over long time periods – for example five, ten or fifteen years. Key data: interest rates – Bank of England official Bank Rate – money market rates (short rates) – bond yields (long rates) Bank Rate The MPC sets the interest rate that is paid on deposits held at the Bank of England by commercial banks and building societies. This interest rate is known as Bank Rate. Bank of England and The Times Interest Rate Challenge 2014/15 Section F Money and financial markets 77 Changes in long rates Long-term interest rates tell us about financial market expectations of future inflation and interest rates. As such, they provide an indication of the credibility of monetary policy, ie. the extent to which financial markets believe that the MPC will achieve its target. In practice, short and long-term interest rates are likely to be closely related, with long-term rates being an average of expected short-term rates over the period of the loan. So if the MPC is expected to raise short-term interest rates in the future, the current rate for long-term borrowing might be higher than the current short-term rate to reflect the expected higher future cost of funds. And if short-term rates are expected to fall in the future, long-term interest rates might be lower than short-term rates. The exchange rate Exchange rates are particularly important financial prices. They measure the price of one country’s money in terms of another. Consequently, they depend on factors both at home and abroad, including domestic and foreign interest rates. Changes in interest rates in the United Kingdom may affect the exchange rate between sterling and, say, the euro. But so may changes in interest rates set by the European Central Bank. It is important to bear in mind, however, that interest rates are not the only influence on exchange rates. They will also reflect the demand for, and supply of, goods and services, and any other factors affecting international transactions in goods, services or assets. Although monetary policy does not aim to achieve a particular level for the exchange rate, it has to take into account how changes in the exchange rate impact on inflation prospects. In Section D, we explained that a change in the value of sterling can have a direct influence on inflation through changes in import prices, and an indirect effect through its impact on demand for exports and imports. But the nature and size of these effects will depend on the reasons for a change in the exchange rate. This means that, while short-term rates largely depend on the MPC’s interest rate decisions, long-term interest rates also depend on market expectations of economic developments and monetary policy in the future. So long-term interest rates can and do vary without any change in current Bank Rate, as financial markets continuously revise their expectations about future Bank Rate and other variables, including inflation. A rise in Bank Rate could generate an expectation of lower future interest rates, in which case long-term rates might fall. Although a change in Bank Rate almost always moves other short-term interest rates in the same direction – even if some are slow to adjust – the impact on long-term rates can go either way. UK goods, it might be a reflection of rising demand. It is, of course, often difficult to know what has caused the exchange rate to change. But it is important not to view changes in exchange rates and interest rates in terms of a simple mechanical relationship. Some of the possible effects on import prices and the composition of demand are discussed in the box on the next page. Bilateral and effective exchange rates You can look at the pound’s exchange rate on what is termed a ‘bilateral’ basis – the exchange rate between two currencies, such as the pound relative to the US dollar – and what is termed an ‘effective’ basis. An effective exchange rate is an average of different bilateral exchange rates, weighted according to the importance of each one to a country’s trade. The sterling effective exchange rate index (ERI) reflects the pattern of UK trade with its 48 main trading partners. The sterling-euro exchange rate has a weight of 46.2% in the ERI. For example, an appreciation of sterling might reflect an increase in demand for UK goods and services. So rather than a higher exchange rate reducing demand for Bank of England and The Times Interest Rate Challenge 2014/15 Section F Money and financial markets 78 You can also look at other exchange rates to shed light on movements in sterling. For example, you can see if a change in the rate between the pound and the euro has been similar to the exchange rate movements between the dollar and the euro. This might help to explain what has caused exchange rate changes. Other exchange rates also help us to assess future economic conditions in the United Kingdom’s main trading partners. Key data: asset prices – – – – – – £/$ exchange rate £/€ exchange rate $/€ exchange rate sterling ERI FTSE all-share index FTSE 100 index Other asset prices Asset prices – such as share prices and house prices – can also provide information about future developments in economic activity and inflation. Rising house prices might reflect how confident consumers are feeling about the future. Falling house prices might indicate the opposite. The housing market is discussed under ‘Demand and output’. Share prices will reflect investors’ expectations of companies’ future profits. In this way, they can provide a useful barometer of expectations and confidence in future economic developments. You can monitor UK share prices by looking at the Financial Times Stock Exchange (FTSE) indices. The exchange rate and import prices Import prices are an important component of many firms’ costs and of final consumer prices. An appreciation of sterling – a rise in its value relative to other currencies – will tend to lower the prices of imported goods and services, and a depreciation will tend to increase them. The effects may take many months to work their way through the supply chain and into retail prices. Import prices are discussed under ‘Costs and prices’. The exchange rate and demand Depending on the reasons for a change in the exchange rate and whether it is sustained, a lower exchange rate will tend to make foreign goods more expensive relative to goods produced at home. This can affect the composition of total demand in the economy, which could have implications for output Bank of England and The Times Interest Rate Challenge 2014/15 growth and inflation. A fall in the relative prices of UK output might encourage a switch of spending towards home-produced goods and services away from those produced overseas. For any level of overall demand, domestic production will be higher and imports lower. This may therefore increase inflationary pressure relative to what it would otherwise have been. The exchange rate has its biggest impact on the manufacturing sector, which accounts for around 45% of UK exports. But other sectors, such as agriculture and service industries like tourism and consultancy, are also affected – for example, foreign holidays can become more expensive and UK holidays relatively cheaper if the pound falls in value. Exports and imports are considered under ‘Demand and output’. Section F Money and financial markets 79 Section F Demand and output We have already said a great deal about demand and output in earlier sections. Section D explained why it is important to look at aggregate demand and output in the economy. This part of Section F looks in more detail at the main components of demand and output, and some relevant data series. It does this by working though the different measures of total economic activity – Gross Domestic Product (GDP). GDP – three measures in one The rate of growth of the economy is a key piece of information that the MPC considers when it is setting interest rates. GDP data provide the most comprehensive measure of economic growth. They capture different aspects of economic activity – such as how much is produced in the economy and how much is spent. Most of the time you will see references to GDP as a single measure of economic activity, but there are in fact three approaches: one for total output – GDP(O); one for total expenditure – GDP(E); and one for total income – GDP(I). Each provides a different way of arriving at the same figure – GDP. The three measures of GDP are equal in principle. GDP(O) is the total output of goods and services; GDP(E) is the total expenditure on that output; and GDP(I) is the total income generated by producing that output. But, in practice, the measures always differ to some degree. This happens because it is not possible to measure everything perfectly, and different information is used to construct each measure. And, for initial estimates, data sources are often incomplete. The published measure of GDP combines information from the output, expenditure and income measures. For the initial estimates of GDP, the output measure tends to have the largest influence. Output data are thought to provide the most accurate initial indication of economic activity. So, for early estimates of GDP, adjustments are often made to the expenditure and income measures. If the latest data show GDP rising by 0.5% in the most recent quarter, that will tend to reflect the measured growth of output. Bank of England and The Times Interest Rate Challenge 2014/15 But, in terms of assessing demand conditions in the economy, most attention is devoted to the expenditure measure and its components. The main components of expenditure provide the framework for assessing demand conditions and most economic forecasts, including the MPC’s, are organised around them. The income measure receives less attention, though some parts of it provide important information. GDP is most commonly expressed in chained volume measures, ie. in real terms. It is normal to measure output in chained volume measures. Expenditure, which is measured in current prices, can be deflated to provide expenditure in chained volume measures. Income is usually presented in current prices, ie. nominal terms, though for the purposes of producing an average measure of GDP, it is also deflated to provide a measure in chained volume measures. Once you are using the data, all this should become clearer. Total output of goods and services – GDP(O) The output measure of GDP – GDP(O) – measures everything that is produced in the economy. This is not simply the value of every firm’s production added together. This would result in counting some output more than once because many goods and services are incorporated as inputs into other goods and services – for example, part of the output of firms producing tyres will be included in the value of the output of car producers. GDP(O) aims to measure what is called ‘value added’. Section F Demand and output 80 GDP releases Each quarter the MPC receives three sets of data releases for GDP. Each successive one gives more accurate and detailed information about economic activity and its make-up. • The first release is called the ‘GDP preliminary estimate’, available around three weeks after the end of the latest quarter. This provides an estimate of GDP growth and output growth in the production industries and the service sector. Because this estimate is produced quickly, it is usually subject to revision as more information becomes available. • The second release is called ‘Second estimate of GDP’. It is available about a month later, some seven weeks after the end of the relevant quarter. It includes a revised estimate of GDP growth for the quarter and a breakdown of total output by sector. It also provides estimates of total expenditure in chained volume measures and current prices, along with the main components of spending, as well as total income in current prices, along with its main components. • The third release is called ‘Quarterly National Accounts’. It provides details of any further revisions to the previously released estimates and a lot more detail about the different components of GDP. For example, it includes a breakdown of consumers’ expenditure into a number of categories, a breakdown of investment and inventories, and information about personal and corporate income. This is the difference between the value of what firms purchase, ie. their inputs, and their output. Value added measures each firm’s contribution to total output. But measuring this from quarter to quarter is a difficult task and so it often has to be approximated using sales and other information. Industrial production Sectoral output Surveys The change in total output in each quarter is estimated by combining the volume of output in each of the different sectors of the economy. Manufacturing output accounts for around 10% of the economy. Services output accounts for around 78%. Other sectors include agriculture, energy and construction. A variety of surveys provide information about trends in output. These include surveys from the Confederation of British Industry (CBI), the British Chambers of Commerce (BCC) and the Chartered Institute of Purchasing and Supply (CIPS). Collectively, these and other surveys cover all sectors of the economy, although there tend to be more surveys for the manufacturing sector. Each quarter, there are usually differences in the growth rates of different sectors. Even average growth rates tend to vary from sector to sector. For example, manufacturing output has grown by less than other sectors over recent decades. It is often important to look at output in different sectors to assess whether a change in total output reflects lasting or temporary influences. Energy output, for example, is often volatile from quarter to quarter because of the weather. So it may be useful to consider the underlying situation by excluding temporary effects. You might also be interested in the balance of overall growth in the economy. Different economic conditions affect sectors differently. For example, manufacturing is more export intensive, therefore factors such as the exchange rate or foreign demand will affect manufacturers more than they will construction or services output. Bank of England and The Times Interest Rate Challenge 2014/15 Data covering the production industries are published more frequently than GDP data. The Index of Production is published monthly, consisting of output data for the manufacturing, energy and water sectors. Industrial production represents just under a fifth of total output. Key data: output – – – – – – GDP Index of Production CBI Industrial Trends Survey CIPS Report on Manufacturing CIPS Report on Service BCC Quarterly Economic Survey Section F Demand and output 81 In addition to information about recent output, many surveys ask companies about their orders and what they expect output to be in the near future. This can give us some idea about future trends in output and whether the current situation is likely to continue or change. A selection of survey data is included in the datasheets. Total expenditure on goods and services – GDP(E) You’ll see the following identity or similar versions in many textbooks: GDP = C + I + G + (X-M) where C is consumer spending (or consumption) I is investment (including stockbuilding) G is government consumption The expenditure measure of GDP – GDP(E) – measures total spending on UK produced goods and services. Spending in the economy is made up of consumers’ expenditure, investment expenditure and spending on stocks of goods by companies, government spending on goods and services, and spending on imports and exports. GDP(E) excludes spending on imported goods and services as they are produced outside the United Kingdom, but includes spending on exports by overseas firms and consumers. X is exports M is imports demand plus exports minus imports. The difference between exports and imports is called the balance of trade. GDP(E) is equal to domestic demand plus or minus the balance of trade. Final domestic demand The proportion of GDP accounted for by each category varies from year to year. Spending on some categories is particularly variable – for example, investment spending tends to fall as a proportion of total spending in economic downturns. Generally, spending by consumers accounts for around 65% of GDP. Government spending – both central and local government accounts for just over 20%, and investment accounts for 14%. The value of imports is equivalent to about a third of GDP and the value of exports about 30% of GDP. The amount spent on stocks of goods can vary greatly from year to year, but tends to be small on average. Domestic demand and the balance of trade Combining consumer and government spending, investment expenditure and spending on stocks gives domestic demand. You will often see references to the growth of domestic demand. This tells us about spending in the domestic economy. Some spending by consumers and firms will be on imports, ie. not UK produced goods and services. Exports might also include some spending on imported goods – such as materials and components. Imports are therefore subtracted from total spending. So total expenditure on UK goods and services – GDP(E) – is equal to domestic Bank of England and The Times Interest Rate Challenge 2014/15 You will also see references to final domestic demand. This is domestic demand minus what is spent on inventories (or stocks). Expenditure on inventories is not final demand – rather it is intermediate demand by companies, such as manufacturers and retailers. Changes in the level of stocks can reflect changes in other components of demand and also firms’ expectations of future demand. They can also be large and volatile from quarter to quarter, making changes difficult to interpret. Each of the components of total spending is now considered in turn, along with some of the factors that influence them. Consumer spending In 2012, consumers spent over £1 trillion, in current prices. The fortunes of the economy are therefore very much tied up with consumer demand. Small percentage changes can amount to billions of pounds. Consumer spending largely depends upon household income and wealth. It can also be affected by confidence – how optimistic or pessimistic consumers are feeling – and by interest rates, as we discussed in Section B. It is possible to build up an impression of potential future trends in consumer spending by looking at these factors. Section F Demand and output 82 Income and spending What people earn is the main determinant of what they spend and so changes in income are an important part of any assessment of demand conditions. Total spending in the economy will be affected by wage increases and other earnings, and the levels of employment and unemployment. These data are considered under ‘The labour market’. Consumers are unlikely to make spending decisions based solely on their current income. They probably take into account their likely income over time – their expectations of future income as well as current income. So changes to current income might only impact on spending insofar as the changes are viewed as permanent or long-lasting. Wealth in financial assets, like shares and bonds, largely consists of what is held in pension funds and life assurance policies. Higher share prices might reflect expectations of higher future income from company profits. This might boost current spending, though the implications for inflation will depend on why share prices have risen. For example, investors might expect higher company profits in the future because firms are investing more and increasing the economy’s productive capacity. House prices are slightly different. A rise in house prices increases the value of home owners’ existing houses. But it also increases the cost of future house moves, for which households might need to save. So rising house prices do not necessarily result in higher consumer spending. Spending and tax Of course, consumers will spend out of their incomes after taxes and other deductions have been paid. This is referred to as disposable income. In this sense, changes in the amount of tax paid are also relevant to consumer spending. If the Chancellor increases income tax, this is likely to reduce consumer spending, though the extra tax revenues might be used to finance higher public spending, so the overall impact on demand need not change. Spending and saving Consumers do not spend everything they earn – some part of their disposable income will be saved. What part of income is spent and what part is saved are important economic decisions. It is possible to look at past trends to get some feel for the average proportions of income that are spent and saved, and to see how these have changed. It is often useful to look at the balance between household income and spending. This is provided by a statistic called the saving ratio. If consumers seem to be saving relatively little as a proportion of their income compared with the past, you might conclude that spending in the future will moderate as consumers rebuild their savings. Alternatively, if saving appears high, this might mean that spending will rise in the future. Wealth Developments in household wealth – the value of the assets that people own – also have a bearing on the prospects for consumer spending. Most household wealth consists of financial assets and housing. Bank of England and The Times Interest Rate Challenge 2014/15 The saving ratio Saving is what is left from personal disposable income after spending. The difference between income and spending is measured by the saving ratio. It is the proportion of income that is saved in a particular period. It is published alongside estimates of personal income and expenditure as part of the third release of GDP. If household income is £150 billion in a quarter and spending is £142.5 billion, then the saving ratio would be 5%, ie. £7.5 billion as a proportion of £150 billion. Because the saving ratio is the difference between two very large totals, it is sometimes revised quite substantially. Nonetheless, it can provide indications about consumers’ current and future spending behaviour. But rising house prices might be accompanied by higher spending insofar as they are influenced by the same factors, such as confidence and expectations about future income. If people are optimistic about the future, they may increase their demand for houses as well as goods and services. And higher house prices might also allow households to increase the amounts they borrow, secured on the increased value of their homes. The box on the next page discusses some of the data the MPC considers to assess housing market developments. Section F Demand and output 83 Housing market turnover The MPC regularly reviews a range of measures of housing market activity and house price inflation from official sources and surveys. This includes information from different stages of the house-buying process – such as estate agent enquiries, mortgage lending and Land Registry details. Data on estate agent enquiries from the Royal Institution of Chartered Surveyors (RICS) and the numbers of people reserving new houses from the House Builders’ Federation (HBF) can provide information about future housing market activity, and may be useful in giving an early indication of changes in trends. Data on mortgage loan approvals by banks and building societies provide information about future lending for house purchase. They also give an indication of housing transactions, measured ultimately by Land Registry ‘land transaction returns’ data when house moves are completed. House prices The MPC also reviews a number of measures of house price inflation such as those from the Halifax and Nationwide. House price data are also available on a regional basis. This can provide useful information on regional conditions in the housing market, and help to assess the picture in the United Kingdom as a whole. Categories of consumer spending Total consumer spending is split 45:55 between spending on goods and services. Goods spending is divided into what are called non-durable goods like foods and petrol, and durable goods, like cars and computers. We tend to concentrate on total spending but, as with other data, it is sometimes beneficial to look at the underlying components. Retail sales In addition to quarterly estimates of consumer spending growth, monthly data are available for retail sales. Retail sales data consist of spending on goods in shops and through mail-order companies. The data measure spending in different types of stores. These include stores that sell mainly food, clothing, footwear or household goods (which includes electrical retailers), and those that sell a range of goods (such as department stores). Retail sales volumes data are closely related to the goods component of consumer spending in the quarterly GDP data, and so they can provide an indication of changes in spending month by month, in between the quarterly estimates. In addition to the official data, the CBI Distributive Trades Survey provides information from retailers and wholesalers about their sales, sales expectations, prices and stocks. This is published ahead of the official retail sales data. Bank of England and The Times Interest Rate Challenge 2014/15 Variations in spending Spending on different goods and services will be changing all the time, depending on prices, consumer tastes and other factors. But spending on some items will vary to a greater degree than others over the course of an economic cycle. For example, spending on durable goods and some services, such as eating out, tends to vary more as economic conditions change than spending on non-durable goods. Spending on essential items like food varies less – we eat roughly the same whatever the economic conditions! So changes in overall consumer spending are likely to be driven more by spending on durable goods and other discretionary items than by spending on essential items. Consumer confidence How optimistic or pessimistic consumers are feeling about their own situation and that of the wider economy can be an influence on their spending behaviour. Changes in confidence are likely to reflect sentiment about factors that affect spending, such as income and wealth. They may also provide indications about what consumers think about their future income, something that we cannot observe directly. The MPC regularly considers data from the GfK and YouGov surveys of consumer confidence. Section F Demand and output 84 Investment The amount of spending on new equipment and buildings matters for both an assessment of demand conditions and the economy’s supply capacity. Investment that increases firms’ capacity will raise the economy’s potential output – for example, a new piece of equipment might produce more output in less time. This is one of the main ways in which the economy grows over time. So if total demand is growing strongly due to increasing investment rather than, say, consumer spending, there might be less concern about inflationary pressure because the capacity of the economy would also be rising. However, the extra demand could still put upward pressure on prices in the short to medium term. As ever, it is necessary to judge all these considerations together and take an overall view based on the information available. Total investment in the economy does not just consist of spending undertaken by companies, ie business investment. It also includes investment by government and by individuals. Investment by individuals largely consists of what is invested in housing. This accounts for a quarter of total investment. Business investment accounts for 56% of the total. Investment data are available each quarter, initially as part of the second release of GDP. More detailed data for business investment are also published. Changes in the amount of investment tend to be quite volatile from quarter to quarter. This is often because capital expenditure tends to occur in large ‘lumps’. For What drives investment? Firms invest so that they have the capital equipment they need to allow them to produce goods and services in a profitable way. How much they invest will be affected by a variety of factors, such as their use of existing capacity – their capacity utilisation – and expected future demand and profits. Firms are more likely to install new equipment and add to their capacity when they are optimistic that they can increase sales profitably. Investment takes time so firms need to be confident about future demand. Rising investment tends to be associated with favourable economic conditions, when the prospects for demand are good and a high proportion of companies are operating at, or close to, full capacity. Bank of England and The Times Interest Rate Challenge 2014/15 example, an airline might purchase a number of aircraft in one quarter but then nothing else over the rest of the year. Investment data are also prone to large revisions as new information becomes available, often from annual statistical inquiries. It is also useful to look at other data to assess current and future trends in investment, including information about company profitability and borrowing. Surveys also provide information about firms’ investment intentions and capacity utilisation, as well as business confidence. Inventories (stocks) Inventories are stocks of goods held by companies, either as materials and components for future production or as finished goods for future sales. They can be seen as a form of investment – spending today for revenue tomorrow. Output can be thought of as sales plus or minus the change in stocks. Changes in the level of stocks have important implications for the pattern of both current and future economic growth. Firms will have some desired level of stock that they want to hold relative to their output or sales. Better management and control of both stocks and production has meant that stocks as a proportion of output – what is called the stock-output ratio – have been falling over recent decades. But changes in stock levels from quarter to quarter can be volatile and large. Such changes often reflect temporary imbalances between demand and output. Changes in technology are also likely to influence the amount that firms invest. New technology might enable more efficient, lower-cost production. And the availability of finance within a company and the cost of borrowing or raising external finance will also affect investment. High levels of company debt and high interest rates will tend to constrain investment. Changes in investment tend to be more strongly cyclical than GDP as a whole. Firms tend to cut back their investment plans when economic activity is weak – investment can fall sharply in recessions – and increase spending when the economy is more buoyant. Section F Demand and output 85 What can cause the level of stocks to change? A rise or fall in stocks might reflect unexpected changes in demand. If demand is higher than expected, companies might run down stocks ahead of increasing their output. If demand is lower than expected, firms might see their stock levels rise. Alternatively, firms might deliberately build up stock levels by increasing output in anticipation of higher future demand, or reduce stocks if they expect demand to fall. In a recession, reductions in the level of stocks can exacerbate falls in output. If companies have reduced what they are holding in stock to excessively low levels, it is likely they will want to increase stock levels in the future. This will add to the future growth in output. Alternatively, if stocks have risen to high levels, firms are likely to want to reduce them at some point. Data on changes in the level of stocks for the economy as a whole and the main sectors are included in the second release of GDP. Rather than expressing these changes as a growth rate, they are recorded in terms of millions of pounds, from which the contribution of the change in stocks to the change in overall GDP is calculated. This contribution can be positive or negative. It is often difficult to explain changes in the level of stocks in any particular quarter and to judge the likely implications for future demand and output. Public spending Government and other public sector spending on goods and services is an important component of total demand. Like any other part of demand, how much the government is spending and plans to spend on goods and services will affect the overall balance between demand and supply in the economy. MPC projections of public spending are based on the government's published spending plans, and the MPC monitors how actual spending compares with these plans over time. The overall total for public spending on goods and services is the most important consideration, rather than the particular ways in which the money is spent, although this can also be of significance. Estimates are provided with the second GDP release. In addition, monthly figures are also available on the public finances. Bank of England and The Times Interest Rate Challenge 2014/15 A large proportion of all the stocks in the economy is held by manufacturers and distributors. Distributors – retailers and wholesalers – hold stock ahead of sales to customers, either as goods on the shelves in shops or in warehouses. Manufacturers hold stocks of materials and finished goods, and will also have unfinished goods at different stages of the production process – what is called work-in-progress. They might want to hold stocks of raw materials in case of shortages or disruptions to future supply, or in case they need to increase production at short notice. They might hold stocks of finished goods to meet short-term or temporary fluctuations in demand rather than keep changing output. The cost of holding stocks will also be a consideration. For example, if interest rates are high companies might prefer to lower stock levels to reduce their borrowing or increase their bank deposits. Public finances Each month, figures are published showing how much the government has received in revenue – for example, from income tax and VAT – and how much has been spent by the different areas of government – such as health and education. These data provide a check on the extent to which government spending plans are being achieved. The difference between expenditure and revenue will determine the amount of borrowing the government has to undertake. This is called the Public Sector Net Cash Requirement (PSNCR). This will be negative, ie. in surplus, when revenue is greater than expenditure. Monthly movements in public spending and revenue can be volatile, reflecting the timing of spending by government departments and the receipt of revenue. Low spending in one month might be reversed the following month. Over time, however, the monthly public finance data do provide an indication of trends in government spending and whether it is growing more or less than envisaged by the MPC. External demand The balance of trade The balance of trade in goods and services – the difference between exports and imports – is an important indicator of economic activity. Total spending in the economy will include what is spent on imports; and total output will include what is produced for export. So the balance of trade measures the difference between domestic production and domestic spending. Section F Demand and output 86 When the balance of trade is negative, ie. imports are greater than exports, the United Kingdom is purchasing more from other countries than it is selling to them. A more negative or less positive trade balance could indicate that domestic demand is too high relative to supply, which draws in more imports. But it could indicate that growth prospects in the United Kingdom are considered to be good and so investment spending is high, drawing in imports of machinery and other capital goods. If the balance of trade is becoming less negative or more positive, that could indicate that demand overseas is strong, enabling UK exports to rise. Changes in the balance of trade therefore reflect both domestic and external demand conditions. Exports and imports Although the balance of trade is a useful summary measure, it is often more informative to look at trends in exports and imports separately. They may provide clues about different aspects of the economy. For example, strong growth in export volumes might reflect growth in the world economy, whereas strong growth in import volumes might signal strong domestic demand growth. Growth in exports and imports might also reveal something about the competitiveness of UK producers, both in domestic and overseas markets. Data on the volume of exports and imports are available on a monthly and quarterly basis. The monthly data releases focus on exports and imports of goods. These data are broken down into trade with EU and non-EU countries. Trade with EU countries accounts for a large part of the United Kingdom’s total trade, for example, goods exports to the EU are 50% of UK goods exports. The second GDP release provides details of total trade in goods and services. Key data: expenditure – – – – – – – – – GDP retail sales volumes CBI Distributive Trades Survey housing market turnover house prices GfK consumer confidence PSNCR import volumes export volumes The world economy The exchange rate and competitiveness The prospects for growth in the world economy are an important consideration for monetary policy, particularly growth in the United Kingdom’s main export markets. Demand for UK exports is an important component of overall demand. The level of UK exports and imports will also be affected by the exchange rate. It will influence the competitiveness of UK exports and foreign imports – a depreciation of the pound tends to make UK goods cheaper abroad and imports more expensive; an appreciation has the opposite effect. The MPC looks particularly closely at the economies of the euro area, United States, China and Japan. These are the world’s largest economies. The MPC has to be alert to any developments in the world economy that influence demand for UK goods and services and the prospects for the wider world economy. The MPC considers a range of data on the main overseas economies to provide indications about current and future growth in demand for UK exports. A key indicator in many countries is the growth in GDP. But, additionally, labour market indicators are also useful, and prices in overseas markets will be the main determinant of UK export prices. Bank of England and The Times Interest Rate Challenge 2014/15 Changes in the exchange rate are likely to take time to influence prices and, in turn, exports and imports. And the reasons for a change in the exchange rate and whether it is likely to be a temporary or sustained change will also influence the impact on prices and demand. Of course, many other factors will affect the competitiveness of UK exporters and firms that compete in the domestic market with imports, including wage costs and product quality. But the exchange rate is certainly important, as exporters will tell you. The exchange rate is discussed under ‘Money and financial markets’. Section F Demand and output 87 Total income from goods and services – GDP(I) The income measure of GDP – GDP(I) – measures the incomes paid in the process of producing goods and services. This includes incomes paid to employees and profits retained by firms. It does not include incomes such as unemployment benefits or interest payments because these are transfers between different parts of the economy, ie. they are not additional income. Key data: income – – – – – GDP household post-tax income wages and salaries personal disposable income saving ratio Wages and salaries The main source of income is that paid to employees. This is referred to as ‘employee compensation’, estimates of which are available with the second release of GDP. The data are based on the monthly earnings data that are discussed under ‘The labour market’. The largest part of employee compensation is in the form of wages and salaries. These data are published with the third release of GDP along with estimates of post-tax disposable income and the saving ratio. The relationship between income, spending and saving was discussed earlier under ‘consumer spending’. Bank of England and The Times Interest Rate Challenge 2014/15 Section F Demand and output 88 Section F The labour market Conditions in the labour market are another important influence on interest rate decisions. They provide information about the balance between demand and supply, and the extent of inflationary pressures in the economy. Like other markets, conditions in the labour market depend on the demand for labour relative to the available supply – in other words, how many people firms want to employ and how many people are available to work. Firms will tend to demand more workers when wages are lower, and more individuals will be inclined to seek employment when wages are higher. This interaction will determine, in a broad sense, the number of people in employment across the economy as a whole. Many factors will influence the demand for, and supply of, labour. So it is necessary to keep abreast of all developments in the labour market. An example is the Government’s New Deal programme, which aims to reduce unemployment. Month by month, the MPC considers the levels and changes in employment and unemployment, and the rate of increase in wages and other earnings. Teams will need to monitor these data closely. Employment and unemployment The numbers of people in work and out of work provide important indications of the level and growth of economic activity, and of the level of pressure on the supply of labour and, in turn, wage increases and prices. Unemployment The unemployment rate is a key measure of the balance between labour demand and labour supply. It can be thought of as the number of people available and looking for work, expressed as a proportion of the working population. The LFS measure is based on a survey of households and reflects the number of people who are looking for, and available to start, work. They need not be claiming social security benefits, so the LFS measure and the claimant count measure tend to be different. Claimant count and LFS data are available on a regional basis as well as nationally. This gives the MPC a guide to economic activity and labour market conditions in each region, and helps them to judge the extent to which changes in unemployment are broadly based or concentrated on particular parts of the country. Unemployment and inflation As we stressed in Section B, there is no permanent trade-off between inflation and output, and the same is true for inflation and unemployment. But, again, there are important trade-offs in the short term. Unemployment will vary with output growth in response to changes in demand. When the unemployment rate is low, firms are likely to find it more difficult to recruit new staff and retain existing staff, who will find it relatively easy to find other jobs. Consequently, firms may need to offer higher wages to attract and retain labour. Low rates of unemployment can be associated with higher inflation and vice versa. But there is no particular rate of unemployment below which inflation will always tend to rise. It is necessary to monitor all the information available to determine when labour is relatively scarce or relatively abundant, and make judgements about the likely impact on wages and other earnings. Inactivity Unemployment is measured in two main ways – the ‘claimant count’ measure and the Labour Force Survey (LFS) measure. The claimant count is the number of people eligible for, and claiming, social security payments as a registered unemployed person. Bank of England and The Times Interest Rate Challenge 2014/15 The number of people potentially available to become employed is likely to be greater than the numbers measured as unemployed. Unemployment does not include some groups of people such as those registered sick or other people who are not currently seeking work – Section F The labour market 89 The ‘NAIRU’ Economists use a concept called the ‘non-accelerating inflation rate of unemployment’ – the NAIRU – as a guide to thinking about the relationship between inflation and unemployment. This is similar to the output gap concept discussed in Section D. But, rather than output reaching a certain level beyond which inflation starts to rise, the idea is that unemployment falls to a level below which inflation starts to rise. The level of the NAIRU cannot be determined with any precision for the purposes of setting monetary policy. Like the output gap, it is a useful conceptual tool. It is easier to construct plausible estimates after the event – ie. once we have observed inflation – rather than in anticipation of it. And the rate of unemployment at which inflation is likely to start rising can vary over time. For example, if unemployment benefits are reduced or the skills of the unemployed are improved, the NAIRU might fall as more people are drawn into employment. Changes in labour market legislation over recent decades, and greater flexibility in employment conditions, such as more part-time working, might have reduced the NAIRU. But the level is a matter of inconclusive debate. Consequently, monitoring wage pressures is especially important. for example, retired people or parents who look after young children. These groups are not in employment or measured as unemployed. But they might enter the labour market at some point, perhaps as their own circumstances change or if changes in the labour market make working more attractive or achievable. Some groups are, of course, more likely to enter the labour market than others. Hours worked We describe this pool of people as economically ‘inactive’. Inactivity is measured as the size of the adult population minus the number employed and unemployed. The number of inactive people is another measure of the pool of people who are potentially employable. The participation of women in the labour market has grown considerably over recent decades. This is one of the reasons why we have seen the growth in employment exceed the fall in unemployment. Another factor is population growth, which will be affected by migration flows in and out of the United Kingdom. It is also possible to look at data on the number of hours worked, provided by the Labour Force Survey. This might be more closely related to changes in demand and output than the numbers employed. As demand rises, firms might initially increase overtime working rather than recruit extra people. And if demand falls, firms might be reluctant to reduce the size of their workforce until they are certain about the level of demand. Given the costs of recruitment and redundancy, firms might want to retain staff during periods of lower output growth and instead reduce the number of hours worked. Equally, they might delay recruitment until the need for it is clearly established. So a rise in employment will not necessarily be matched by a fall in unemployment if people are drawn into the labour market from ‘inactivity’. It is therefore necessary to look at unemployment and employment separately. Employment There are also two principal measures of employment in the economy – a measure called ‘Workforce Jobs’ and the Labour Force Survey (LFS) measure. Workforce Jobs data are obtained from firms. They record the number of jobs so the measure may overstate the number of people employed because some people have more than one job. The data are available both for the whole economy and for individual sectors. Data on the manufacturing sector Bank of England and The Times Interest Rate Challenge 2014/15 are published more frequently than other sectors. The LFS data are based on responses from households and measure the number of people employed rather than the number of jobs. Figures are available for both full-time and part-time employment. Employment intentions, vacancies, skill shortages and recruitment difficulties In addition to the official statistics, we can also look at survey information on labour market activity, such as that from the British Chambers of Commerce (BCC), Confederation of British Industry (CBI) and Manpower. Business surveys provide information about firms’ employment intentions – whether they intend to increase or reduce the number of employees in the future. This might tell us something about labour market activity in the future and about firms’ expectations of future demand – if they expect demand to rise or remain at a higher level, firms are more likely to want to recruit extra people. Section F The labour market 90 Employment and output We would expect changes in employment to be related to changes in firms’ output. As firms produce more, they might need to recruit extra people. But the growth in employment is unlikely to match the growth in output, in terms of its timing or extent. Extra output might be produced with relatively more equipment and machinery rather than people, so we might see a larger rise in investment relative to employment. Over time, labour productivity tends to rise – less labour is needed to produce a given amount of output. Whether employment rises with higher output will also depend on the amount of spare capacity available. If firms are operating with spare capacity, they will be able to produce higher levels of output without We can also learn about the extent to which firms are experiencing difficulties filling job vacancies. This might tell us something about the balance between the demand for labour and its supply, and therefore whether there is likely to be upward or downward pressure on wage increases. Firms often have difficulty recruiting people with the right skills for available jobs. Some surveys ask firms whether or not they are experiencing skill shortages. These data can be considered, along with data on job vacancies, to help build a picture of the demand for labour and the extent of pressures in the labour market. Key data: employment and unemployment – – – – – – claimant count LFS unemployment inactivity Workforce Jobs LFS employment LFS hours worked Bank of England and The Times Interest Rate Challenge 2014/15 necessarily recruiting additional people. More output can be produced with the same number of people. Again the productivity of labour increases. But even when higher output requires more labour, employment might not initially rise. Increases in output might be gradual. Firms might wait for output to increase by a certain amount before they decide that it is worthwhile employing additional people. Furthermore, firms might be uncertain about whether demand will remain strong and whether the higher level of output will be sustainable. Of course, some firms are able to plan increased production, in which case employment might rise ahead of output. But, generally speaking, employment growth is likely to lag behind growth in output. Labour costs Labour costs – which include wages and non-wage costs such as pensions and national insurance contributions – are a major component of firms’ total costs and are an important influence on prices. The actual proportion will vary depending on the activities of each business. For example, in parts of the service sector, the proportion is likely to be higher than in the manufacturing sector. If demand for goods and services is rising strongly, firms are likely to need to recruit more employees to increase production. If their extra demand for labour exceeds the supply available, firms may need to increase wages. Wages are also the main source of income for most people and therefore a key determinant of the amount that they can spend. So the rate of increase in wages provides a good indication of consumer spending in the economy. Wages, unit costs and productivity Higher wages will be an additional cost to firms. But, even with higher wages, if each employee produces more, ie. if productivity is rising, then the cost of producing each unit of output may still fall. And higher wage costs might also be offset by lower costs elsewhere in their business. In short, output might rise more than costs, thereby lowering the unit costs of production. Section F The labour market 91 But if wage increases add to firms’ unit costs and demand conditions are favourable, some firms are likely to seek to pass these increases on to customers as higher prices. In this way, higher wages lead to higher inflation. It is not possible to know what rate of increase in wages will lead to higher or lower inflation. Productivity growth will vary over the course of the economic cycle – output might be rising strongly, lowering unit costs even if wages are rising. Its trend rate of growth may also vary over time, for example, in response to factors such as the increased use of computers and the spread of information technology. But it is difficult to separate the trend from cyclical influences on productivity growth. You can observe the current rate of productivity by looking at the ratio of output to employment, but only informed guesses can be made about the future. Earnings and wage settlements The main measure of the growth in wages is the Average Weekly Earnings (AWE). Earnings include basic wages and other earnings such as overtime and bonus payments. We can look at data for total earnings and the contribution made by bonuses and, separately, wage settlements. Average earnings data are published each month, both in terms of an annual growth rate and a three-month moving average of the annual growth rate. The latter is referred to as ‘headline’ earnings growth. The growth in average earnings for the whole economy is also broken down by sector – such as manufacturing and services – and by industry. This allows us to compare sectoral earnings data with other sectoral data, such as output and employment, to judge the nature of demand and inflationary pressure across the economy as a whole. Data on wage settlements are available for both the private and public sectors of the economy. By far the most important months for wage settlements are January and April because this is when most annual adjustments to wage rates are implemented. However, compiling data for these months is often delayed as wage negotiations can take time to conclude. Changes in the annual growth of earnings in individual months can sometimes reflect a small number of significant wage settlements, such as those for large firms or public sector bodies; and bonus payments which can vary considerably from year to year, both in terms of amount and timing. Individual wage settlements and Bank of England and The Times Interest Rate Challenge 2014/15 bonus payments will, of course, reflect specific company circumstances as well as wider labour market conditions. So you need to be careful before drawing conclusions from the data. The ‘headline’ AWE figures smooth the effect of month to month volatility in earnings growth. Key data: wages and earnings – – – – – Average Weekly Earnings headline AWE wage settlements productivity unit wage costs Wage drift Over the course of the economic cycle, the rate of increase in basic wages relative to total earnings is likely to vary. As demand and output rise, elements of total earnings such as overtime and bonus payments tend to increase more quickly than basic pay. In other words, overtime and bonus payments increase as a proportion of total earnings. The gap between total earnings growth and wage settlements is referred to as wage drift. The extent of wage drift is likely to be affected by the demand for labour. Firms might find that some elements of wage drift, such as overtime payments, are easier to change than basic pay as economic conditions change. It is also useful to consider the nature of bonus payments. Bonuses paid to staff for good performance or the profitability of a firm over the previous year might tell us more about the past strength of demand in the economy. Bonuses paid to retain staff might tell us more about firms’ expectations of continued or rising demand in the future. Of course, it might be difficult to separate these explanations. And, whatever the reason for bonuses, they add to the potential spending power of employees, though some of the money might of course be saved rather than spent. Overall, earnings are an important part of the MPC’s assessment of economic conditions – signalling both the strength of future demand and inflation. Teams should monitor the growth of earnings and their composition as a key input into their overall judgement about the economy and the inflation outlook. Section F The labour market 92 Section F Costs and prices The MPC looks at the prices of goods and services at different stages of the production process to help it assess the inflation outlook. Information on commodity, producer and retail prices can tell us both about general inflationary pressure in the economy and specific developments that might influence retail price inflation in the future. The prices ‘pipeline’ Consumer prices represent the final price paid by the consumer. They can be thought of as the end of a ‘pipeline’ of costs and prices. The final price will be made up of many different components of cost as well as the retailer’s profit or margin. For retailers, the price of an item will have to cover the cost of buying the goods from the producer, paying staff their wages and paying for other services required such as delivery, rents and electricity. A similar breakdown applies to producers. This will include the cost of materials and components that they purchase from other firms. Prices at one stage of the pipeline become costs for the next stage – for example, oil prices are a cost for petrol producers; petrol prices are a cost for haulage companies; haulage prices are a cost for retailers. The idea is a simplification and it is not meant to imply that consumer prices are just the sum of all the various costs in the pipeline. Prices are determined by the Consumer prices We have already said a great deal about consumer prices. We explained in Section C that the Government’s inflation target is currently specified in terms of the annual rate of change in the Consumer Prices Index. We said that monetary policy is not aiming to keep inflation exactly in line with the inflation target every single month. Month to month, the actual rate of inflation will tend to move up and down. In Section D, we discussed how the current rate of inflation might be a poor guide to prospects for the rate of inflation over the next two years or so. Bank of England and The Times Interest Rate Challenge 2014/15 interaction of supply and demand. If the cost of raw materials rises, for example, producers or retailers might accept lower profit margins rather than raise their prices. They are more likely to do this if demand is weak or because of competition. The degree of competition in markets can affect how much cost increases are passed on to consumers. The effects of prices in the pipeline do not work in just one direction. For example, an increase in oil prices might show up first as an increase in producers’ material prices and then feed through to consumer prices. But an increase in demand, perhaps due to a rise in government spending, might first result in higher consumer prices before higher demand puts pressure on resources further down the pipeline, resulting in a rise in oil and other material prices. The MPC monitors price developments at all stages of the ‘pipeline’ to spot signals and clues about demand and future inflation. Components of the CPI Although we are interested in the overall rate of inflation, there may be instances when price changes in individual, or groups of, components of the inflation index contain useful information. In order to understand movements in current consumer price inflation and to assess the likely path of inflation in the future, the MPC regularly monitors developments in the inflation rates of different components. For example, some food prices can be volatile, often reflecting factors like the weather. These effects are usually temporary in nature, so they can obscure the underlying trend in inflation from month to month. Section F Costs and prices 93 We might even want to look at the price changes of individual components of the CPI if the inflation rate rises or falls in a particular month due to specific price movements. The Office for National Statistics often draws attention to particular items that have had a significant influence on inflation in a particular month. You then need to decide whether the reasons are specific to the item or items, or indicative of some wider influence that may affect other prices over time. More generally, the MPC pays particular attention to trends in inflation rates for the ‘goods’ and the ‘services’ components of the CPI. rate of growth of productivity in goods markets relative to services markets. Goods are traded internationally to a greater extent than services and capital equipment tends to replace labour to a greater degree in the production of goods compared with services. So, if inflation is around 2.0%, we might expect to see goods prices inflation below this rate and services prices inflation above it. Of course, at any specific point in time, goods prices inflation might be higher than services prices inflation. Domestically generated and imported inflation Some prices go up – some prices go down Individual prices are going up and down all the time. If we were to look at the prices of every item within the CPI then we probably would not glean very much information about the overall situation. Rather, we would learn more about the specific characteristics relevant to the markets for each product, and changes in consumer tastes. Computer prices have tended to fall over time as new technology has made new models better and cheaper. Computer prices might fall whether overall inflation is 2.0% or 5.0%. Conversely, some prices such as those for education services, like university and school fees, have tended to rise more quickly than the overall rate of inflation. These observations do not add much to our assessment of the inflation outlook. But if there was a change in these established patterns – which might change the inflation rate for a period – we would need to consider them more closely and assess their significance. Goods and services prices inflation Looking at the inflation rates for goods and services prices can often tell us about the nature of the forces underlying the current rate of inflation, and provide clues about the inflation outlook. Consumer goods prices account for around 55% of the Consumer Prices Index and services prices account for around 45%. The goods component includes much of what is sold in shops, and other items, such as cars and petrol. The services component includes things like bus fares, insurance premiums, cinema ticket prices, electricity and hairdressers’ prices. On average, goods prices inflation has tended to be lower than services prices inflation. This mainly reflects a higher Bank of England and The Times Interest Rate Challenge 2014/15 Prices will reflect both domestic economic conditions and also international influences, such as the exchange rate and demand conditions in overseas economies, which can affect the price of goods imported into the United Kingdom. One way of thinking about overall inflation is as a combination of domestic inflation and imported inflation. The UK economy is very open to international trade and so domestically generated inflation corresponds to the rate of inflation that would prevail in the absence of changes in prices that are influenced by external factors. Goods prices will be influenced by changes in the exchange rate to a greater extent than services prices. A fall in the exchange rate – a depreciation – will tend to increase the level of prices, at least relative to what they would otherwise be. This might mean that any downward pressure on prices from weak demand could be offset to some extent, or upward pressure from strong demand could be exacerbated. An appreciation of sterling is likely to have the opposite impact – reducing the level of prices. So if changes in the exchange rate are influencing inflation, we would need to assess what inflation might be once these effects had worn off. This goes for any temporary influence on inflation, although if changes in inflation affect inflation expectations and, in turn, wage demands, these influences can prove more persistent. It is the job of monetary policy to ensure that this does not happen. Producer output prices The prices charged by producers for finished products are an important influence on consumer prices. They will be influenced by the costs of production, including wages, and also the prices of imports that feed into the production process. They will reflect the balance between demand and supply in the same way as consumer prices. There is a close relationship between changes in producer price Section F Costs and prices 94 inflation and consumer price inflation, and particularly consumer goods prices, though this will vary depending on factors such as the level of demand. We can monitor producer prices by looking at the Producer Prices Index. Producer output prices reflect the prices charged by manufacturers to other sectors such as retailing, business services and construction. They will also include any taxes and duties levied on manufacturers’ prices, for example those on fuels like petrol. Changes in duties set by the Chancellor in the annual Budget can have an influence on the rate of inflation for producer prices, as well as consumer prices. So we sometimes also look at producer prices excluding tax effects to get a better view of the underlying situation. Producer input and commodity prices Price indices are also available for the materials used by manufacturers — what are called producer input prices. Inputs are materials such as timber, fuels, metals, and food materials. Of course, one firm’s input is another firm’s output, so the producer input price index also includes items like steel and plastics. The producer input price index weights materials and components according to their use as inputs by manufacturing firms. Many basic materials are also included in indices of commodity prices. Commodity price indices consist of what we call primary products, such as oil and timber. Producer input and commodity prices can rise and fall by large amounts. Trends in material and commodity prices are usually more volatile than the prices charged by manufacturers and retailers. This has been particularly noticeable in the recent past when consumer price inflation has been relatively low and stable. Raw materials are only a part of manufacturers’ total costs, so large changes in these prices do not tend to lead to changes in manufacturers’ output prices of the same magnitude. They are likely to have some impact, particularly if price changes are large and manufacturers think they will be permanent. Large one-off changes in prices of commodities like oil can have temporary effects on consumer price inflation. But only if these effects resulted in higher inflation expectations might any rise in inflation be more persistent. Changes in commodity and material prices Commodity and material prices are sensitive to changes in demand and expectations about future demand. In the short term, supply tends to be fairly fixed, particularly for commodities which are grown – for example, rubber and wheat. If demand growth is expected to rise, this might put upward pressure on prices unless there are large stocks of commodities available to increase supply in the short term. Similarly, if demand grows more slowly, there will be excess supply and lower prices. Changes in commodity and material prices can also reflect movements in exchange rates. Many commodities that are traded Bank of England and The Times Interest Rate Challenge 2014/15 internationally are priced in US dollars so the price in pounds will reflect the £/$ exchange rate. Large price changes for individual materials and commodities can often reflect specific events, such as crop failures or processing problems in particular markets or countries that are important suppliers – for example, Brazil produces a large part of the world’s total coffee crop. The oil price is affected by the amount that major oil producers agree to produce under arrangements set by OPEC (the Organisation of the Petroleum Exporting Countries). Section F Costs and prices 95 Import and export prices Key data: costs and prices The MPC also looks at import and export price indices to track the effects of exchange rate changes and demand pressures in both the United Kingdom and abroad, and how these might affect consumer prices in the future. Exchange rate changes will lead to changes in sterling import and export prices. If prices in foreign currency terms do not change, then an appreciation of the exchange rate will lower sterling prices. – – – – – – – consumer prices producer output prices producer input prices commodity prices oil prices export prices import prices The timing and extent of any fall in import and export prices might depend on the strength of demand. If demand is strong, importers might choose to increase their profit margins and perhaps sacrifice some sales rather than reduce their prices in sterling terms. Similarly, exporters might hold their prices and sacrifice sales. If, on the other hand, demand is weak, importers might reduce sterling prices instantly in order to boost their sales. The MPC monitors export and import prices alongside data on export and import volumes. Bank of England and The Times Interest Rate Challenge 2014/15 Section F Costs and prices 96 Section F Guidance for using the datasheets The first set of datasheets will be available from 5 September 2014 on the Bank of England website: www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx Monthly datasheets Data updates The datasheets will provide you with some of the statistics that have been mentioned in the discussion of different aspects of the economy. They cover: In addition to the monthly datasheets, the Bank will produce Target Two Point Zero data updates immediately prior to the regional heats, area and national finals. These will cover key data released since the most recent datasheet. • • • • • money and financial markets; demand and output; the labour market; costs and prices; the international economy. Some of the data are more important than others. You should not feel that you have to use all the data. You will need to decide which data you think are important for your assessment of economic conditions and your interest rates and quantitative easing decision. The datasheets contain tables of the latest available data so that teams can monitor the recent economic picture. In addition, long-runs of data are available for a selected number of key statistics. These will enable teams to compare recent changes in data with previous experience. The datasheets will be updated monthly as new data become available, so the first set should only be used as a starting-point. Teams will need to follow new data and revisions to existing data as they become available. The tables in the datasheets are in PDF format. The long-runs of data are in Microsoft Excel format. You will be able to download and use the long-runs of data if you wish. Always make sure that you are using the latest available data and do not forget revisions. Many of the features of these data were discussed in Section E but we did not provide individual descriptions of the data series. Short descriptions accompany each of the tables provided in the datasheets. Teams should make sure that they understand what the data are before they start drawing conclusions from them. Bank of England and The Times Interest Rate Challenge 2014/15 All the data, including the long-run series and the updates, will be available on the Bank of England’s website: www.bankofengland.co.uk/education/Pages/ targettwopointzero/default.aspx When you make your policy decision, data for the most recent quarter or month will not necessarily have been published for every data series. That is one of the realities of setting interest rates. You have to make the best of what is available. Teams are welcome and encouraged to use whatever other data and information they think will be useful and relevant to their presentation and interest rate decision. Pick up The Times and other publications to get some pointers about the current situation. There are plenty of people offering opinions on the economy and interest rates. Visit the websites of the organisations that publish statistics. The Office for National Statistics has much of its data on-line. You can obtain the latest releases and briefings from their website: www.statistics.gov.uk Links to the key data releases can be found in the Data section of the Target website. For ONS data, select the data release you want to look at click on statistical bulletin and then download pdf. You may also want to look at some of the data and charts included in the relevant parts of the minutes of the MPC meetings and the Bank of England’s Inflation Report. Section F Guidance for using the datasheets 97 Section G Making your presentation This section provides some guidance on how to go about developing your presentation and some tips on how to present well. Developing your presentation 101 The objectives 101 Planning your approach 101 Managing your workload 101 Thinking about your presentation 102 Reaching your decision 102 Thinking about the judges’ questions 102 Delivering your presentation 103 Style of delivery 103 Overcoming nerves 103 Visual aids 103 Length 104 Answering the judges’ questions 104 Equipment 104 Technology 105 And now... over to you 106 Bank of England and The Times Interest Rate Challenge 2014/15 Section G Making your presentation 99 Section G Developing your presentation The objectives Before you begin, make sure you are clear about the objectives of the Challenge, so you have a good idea of what you are aiming to achieve and what, in general terms, the judges will be expecting from your team’s presentation. How you go about the task is up to you but remember that the broad objectives are: want to rely entirely on the information provided by the Bank of England, or do you want to use other data and information that are available? It might help to draw up a checklist of questions that you want to answer such as: – is the economy slowing down or speeding up? • to assess the balance between demand and output, and the extent of inflationary pressure in the economy; – what areas of demand are strong or weak? • to assess the future outlook for the economy in general, and the outlook for inflation in particular – in other words, you need to look ahead; – what are the money supply data showing? • to judge whether interest rates should be changed or left at the current rate set by the MPC in order to meet the inflation target; – what is the outlook for demand? – what is happening in the world economy? – in which direction does employment appear to be moving? – how close is the economy to operating at full capacity? • to make an interest rate recommendation and offer supporting arguments and evidence; and – are wage pressures and other costs rising or falling? • to deliver an interesting and effective presentation. – is the current rate of inflation likely to rise or fall? Teams may consider if appropriate to make additional policy recommendations beyond that for interest rates. Again, the decision making process and presentation of these is entirely at the team’s discretion. Managing your workload Planning your approach You will want to spend a fair amount of time considering the resource material, familiarising yourselves with the data on the economy, and thinking about the issues that are most likely to be relevant to your decision on Bank Rate and quantitative easing. You can then decide how you want to go about your work. You might want to start with an interest rate discussion and vote to establish what each member of the team thinks about the economic situation and inflation outlook, and then decide the main issues that the team wants to cover. Alternatively, you might want to start by understanding the background to the latest MPC decision and discuss areas where team members agree and disagree. You will also need to decide how you want to undertake your assessment and analysis of the economy. Do you Bank of England and The Times Interest Rate Challenge 2014/15 – how has the exchange rate changed? However you decide to get the ball rolling, you will need to keep the workload manageable. Do not start by visiting a library and taking out a collection of textbooks. The aim of the Challenge is not to cover a course in economics in a few months. You will have to become comfortable with some basic ideas – such as why inflation rises and falls – and be familiar with some of the language that is used. But the resource manual and newspaper articles should be sufficient for this. It might be a good idea to establish how much time you can devote to the Challenge, and how much help you can expect from others in your class or group. Design your efforts around this and be realistic. You could also think about prioritising what you want to do. You could establish a list of the data and issues you think it will be essential to cover, and perhaps have a second list of things to do if time allows. A polished and well-argued presentation that focuses on a limited number of themes will work better than one that Section G Developing your presentation 101 attempts to cover everything but lacks coherence. The Challenge is not about which team can assemble the most information. Remember, your presentation should be no longer than fifteen minutes. Cramming everything in will not allow you to focus on the issues you think are central to your decision. And the judges might not spot your main lines of argument if they are weighed down by too much information, delivered at high speed. You will also need to decide how you want to divide the material amongst team members – do not forget the Challenge rules say that each person must make a significant oral contribution to the presentation. Establish who is responsible for different elements of the work – such as collecting new data, reading newspapers, and overseeing the overall progress of the team in relation to an agreed timetable. You might want to divide the material on the basis of the different aspects of the economy covered in Section F. But, if you adopt this approach, you should still base your policy decision on an assessment of the outlook for the economy as a whole, not of particular aspects of it – such as the labour market. Thinking about your presentation As there are only two months between the start of the Challenge and the regional heats in November, teams will need to think about their presentations quite early on. They will need to decide what kind of presentation to give and how it might be structured. For example, do you want to start with your policy decision or conclude with it? How do you want to cover current economic conditions and your thoughts about the economic outlook? Do you want to focus on a small number of key points, perhaps those which are central to your interest rate decision? Or do you want to cover different aspects of your economic assessment in a more comprehensive way? Some teams might want to work through the material in the same way as the minutes of the MPC meetings or Inflation Report; other teams might want to present in an entirely different way. These are all questions for your team to consider – that is part of the Challenge. You should assume that the judges are familiar with textbook theories and the workings of monetary policy – they will all have had first-hand experience of the Monetary Policy Committee and its decisions. So there is no need to give them background information or to discuss economic theories. But you might want to make it clear why you are looking at a particular issue or piece of data. This will help to demonstrate your understanding Bank of England and The Times Interest Rate Challenge 2014/15 – for example, ‘data on the growth in wages tell us something about how much consumers might have to spend’. You will want to demonstrate in your presentation that you have reached your policy decision in a thoughtful way. You do not want to give the impression that you thought about it the day before, or have only considered a few pieces of information – your decision will be based on uncertain judgements, but that is not to say that you should arrive at it casually. After all, you are deciding how much interest everyone in the country should pay on their borrowings and receive from their savings! Reaching your decision To reach your decision, you might find it useful to list all the factors that you think suggest lower interest rates, higher interest rates and no change in interest rates. This might help you to organise your thinking and allow you to form an overall judgement. Alternatively, you could list factors as being either inflationary or deflationary. Once you have identified all the relevant factors, you can decide where the balance of evidence lies, and make your decision. Do not forget that teams are not required to reach a unanimous decision about interest rates. But if there is a difference of opinion within the team, you will have to explain this. You could let each member of the team explain their own vote. But each team member should still base their decision on the whole picture not just the aspects of the economy they have covered. And remember that your team’s interest rate decision must relate to the level of Bank Rate set by the MPC at the time of your presentation. So you will need to be flexible and keep in touch with developments as you approach the regional heats. If you build all your thinking and work around the need to raise or reduce interest rates, and the MPC does just that at its meeting in early November, you might have to re-think your approach and presentation. Do not put all your eggs in one basket! Thinking about the judges’ questions You should think about the questions that your presentation and decision might prompt. You might find it helpful to get someone to ask you some questions. What questions flow from your key points? What areas might the judges be uncertain about? How might the judges challenge your conclusions and interest rate decision? Rehearse your answers with your teachers and friends. Section G Developing your presentation 102 Section G Delivering your presentation One aspect of good communication is being able to present information in a clear and interesting way. The Challenge gives you the chance to develop and demonstrate these skills. Here we offer you some guidance on how to go about it. Style of delivery Clarity of argument and familiarity with your material will take you a long way, but your audience will be more receptive if you can present it in a relaxed and confident style. • Do not read Spontaneous speech is much more lively and interesting to listen to than a text being read. Referring to short notes on cards is acceptable but make sure that you use your notes only as prompts and that you look at the audience as much as possible. Teams who read verbatim from scripts, laptop screens or visual aids or rely exceptionally heavily on notes will not automatically be disqualified from winning but they will be marked down by the judges. This does not mean that you have to memorise your presentation. The rules permit teams to refer to notes and visual aids. Try to look at the audience as much as possible and try to believe in what you are saying – if you are convinced, then you are more likely to convince your audience. • Speak loudly and clearly Speak loudly enough so that the person furthest away from you can hear, and speak more slowly than usual. Try to avoid sounding hesitant with expressions such as ‘um’ and ‘er’. • Establish a relationship with your audience Try to establish eye contact with as many members of the audience as you can. Wherever possible face the audience and not your visual aids. It might be helpful to include some humour but the overall impression you must give is of a serious and thoughtful analysis. • Pause When you are making a point, pauses can give you authority and they give the audience time to get to grips with your arguments. Bank of England and The Times Interest Rate Challenge 2014/15 • Gesture You may be feeling too nervous to gesture spontaneously, but gesturing can help to reinforce your points and to liven up your talk. But make sure that it does not distract the audience from what you are saying. • Practise Practising will improve the flow of your presentation and give you confidence and poise. It will also provide an opportunity to make improvements and spot any errors or inconsistencies in what you are saying. Good speakers practise everything, including not only what they will say, but also their style and using their visual aids. Overcoming nerves Nerves are to be expected. Knowing your subject thoroughly and practising aloud with your visual aids will help. Even regular speakers are nervous, but there are some tricks of the trade to overcome the symptoms. A glass of water can help with a dry mouth. Trembling hands can be calmed by resting them on the table or by making gestures. Try not to put them in your pockets. And do not use a pointer as this draws attention to the shaking. Butterflies or a thumping heart can be soothed by taking deep, steady breaths to relax. Overall, try to enjoy the event. Visual aids Listening to a talk is very different from reading the same words. When a member of the audience’s attention wanders momentarily, there is no written word to remind them what was being said, and they cannot re-read the argument – the speaker will already have moved on to the next subject. Visual aids provide a useful reminder and an opportunity to recap. Section G Delivering your presentation 103 Whiteboards, overhead projector slides, flip charts and computer-generated graphics can all keep the audience’s attention. And you do not have to create all your visual aids from scratch – simple yet powerful visual aids such as charts on many aspects of the economy can easily be found in major newspapers, business journals and the publications of financial institutions. They can also be found, of course, in the Bank of England’s own publications, particularly the Inflation Report, which is available on our website. When giving your presentation, you should describe to the audience precisely what is on each visual. For example, if you decide to show a graph of inflation you might say: ‘This slide shows the annual rate of inflation over the past two years’. If it is not obvious, you might need to explain things in more detail – for example, what the axes on a graph show. Once the audience understand what they are seeing, they will be more receptive to your explanation of it, for example ‘As you can see from this slide, investment appears to be increasing more slowly than before’. Aim to finish in under 15 minutes. The real thing usually takes longer than practice runs. Answering the judges’ questions After the presentation, the judges will ask each team a series of questions. You may confer before answering the judges’ questions but you will be pressed for an answer if you take too long. There are several ways to answer the questions. You should agree on which method you are going to use and practise it as part of your preparation. The approach used is at the discretion of teams. The key point is that the judges will want to see all team members making a significant contribution to the answers. Answers should not be dominated by one or two team members. You could consider using one or more of the following approaches. • Team members could specialise in certain topics and field any questions on their specialism. It is important not to cram too much into your slides, otherwise it becomes confusing. Too few points are always better than too many. And you could vary the number to add interest. Occasionally putting only one point on a slide will change the pace of the presentation and help to keep the audience alert. • Team members could agree that, after conferring, a team spokesperson or the team captain will answer. • Text is the most widely used form of visual aid. It is usual to set out key ideas as bullet points. But keep the bullet points simple. Whatever you do, be sure to leave lots of space so your points are easy to read. Teams will also have to consider how they handle questions if there has been a split decision on Bank Rate and quantitative easing . Answers may differ depending on what view the individual team members took of the outlook for the economy and inflation. • Graphs are useful for showing how variables change over time, or for showing how one variable relates to another. Beware of including more than three variables on one graph as they may confuse. Too many charts might diminish your main points, so be selective. • Teams could select whoever is best placed to answer. Perhaps the team captain might make the choice, particularly if more than one team member wishes to make a contribution. • Tables might be useful to draw attention to the latest data. You may want to think in advance of questions that the judges might ask, and to prepare answers. You might also consider how you will respond if you do not know the answers. You might find it helpful to get teachers and friends to ask you a few difficult questions, to give you practice in answering in a formal setting. Length Equipment The Challenge rules specify that your presentation should be no more than 15 minutes long. You may decide that you can present a well-argued case which covers all the relevant points in less than 15 minutes. It is the quality of your arguments and your ability to put your case across in a clear and convincing way that matters, rather than the length of your presentation. In the regional heats and area finals, your presentation can be in any format. The Bank will provide the presentation equipment listed below at all the venues for the regional heats and area finals: Bank of England and The Times Interest Rate Challenge 2014/15 • PowerPoint equipment – laptop or PC, projection equipment and screen. Section G Delivering your presentation 104 Teams are required to use PowerPoint in the national final in London. PowerPoint presentations should be in Microsoft PowerPoint 2010 format. They should be stored on a USB memory stick but should not be compressed ie. no zip files. Speakers for the laptop or PC will not be provided. If your presentation is dependent on equipment that is not mentioned above, you will need to ask us to provide it (see page 18 for contact details) or bring your own. If you intend to bring your own, please notify us as soon as possible so that we can make any special arrangements for you to deliver and set up your equipment. Technology PowerPoint has the advantage of enabling teams to present to a professional standard, in colour and with a variety of graphics and special effects. But using technology has its drawbacks. The more sophisticated the presentation, the greater the risk that something will go wrong, either with the presentation itself or with the equipment. The risks can be minimised by: Bank of England and The Times Interest Rate Challenge 2014/15 • Rehearsing your presentation with technology Practising your presentation before the event in front of friends will not only help you to familiarise yourselves with your visual aids but will also enable you to identify any problems. For example, you should ensure that the visual aids are sufficiently large and clear for the audience to read. If you have incorporated graphics you should ensure that they appear where and when you expect them to. • Rehearse your presentation without technology Since you cannot plan for every eventuality, it is advisable to have a back-up presentation that is not dependent on technology and to have practised with them in advance. This will enable you to perform to a high standard if something unforeseen happens on the day – for example software incompatibility or equipment or power failure. But do not be discouraged if you are not masters of the technological wizardry – judges will always think more highly of a carefully reasoned argument than of a colourful display. Section G Delivering your presentation 105 Section G And now... over to you The Target Two Point Zero resource manual provides teams with the foundations for their policy decision on Bank Rate and quantitative easing. It explains the main ingredients of monetary policy and has provided teams with a framework for thinking about the economy and inflation outlook. It will have given you many things to think about – too much for one person, so it will be important for team members to work together. The resource manual does not cover everything that is potentially relevant to interest rate decisions, and it is not a blueprint for setting interest rates. But if your team became the Monetary Policy Committee tomorrow, it would hopefully give you enough of an idea of how to go about the job. You can, of course, approach the task from whatever angle you wish and investigate anything that you believe is important and relevant. You might not agree with the way the MPC goes about its job and the issues it identifies as being the most important. So how you undertake the task – the Challenge is up to each team. We look forward to plenty of imagination and variety in the presentations. But even if your team does not progress to the next stage, we believe every student taking part will find the experience rewarding, both in terms of their immediate studies and further ahead. Participating will provide you with a greater understanding of the economy and, we hope, some appreciation of what it is like to make a major decision that affects nearly everyone in the country in some way or another. You might even discover skills you did not think you had. Good luck to everyone. We hope that all those people taking part will find the Challenge as stimulating and rewarding as the members of the MPC find it when they are setting interest rates. Like them, you will discover that there are areas where it will be difficult to make a judgement and, in some cases, you will have to settle for not knowing enough or not being able to reach a concrete conclusion. That is all part of real-life decision-making. But you must take a decision – there is no escaping that. If your team’s presentation is imaginative and well argued, you may well win a regional heat and revisit your policy decision – like the MPC – in an area final in February 2015. Bank of England and The Times Interest Rate Challenge 2014/15 Section G And now... over to you 106
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