These are the monthly payments made by house owners to service their outstanding mortgage debt. The amount of the MIPs will depend on the size of the mortgage and the level of mortgage interest rates.
■ What do you think?
1. What is inflation? How is it usually measured in the UK?
2. What exactly is meant by the term ‘consumer price index’?
3. It is often argued that inflation is only a problem when it is unpredicted. Do you agree with this viewpoint? Outline why you agree or disagree.
4. Explain what is meant by the term ‘deflation’.
5. With reference to theFinancial Timesarticle why do the latest CPI data suggest that the Bank of England will find it difficult to make further cuts in interest rates in coming months?
6. What is meant by the term ‘core inflation’?
7. Take a look at the Federal Reserve’s website (www.federalreserve.gov) and then explain how the primary objective of the US central bank differs from that of the Bank of England.
8. It has become normal for central banks to set an inflation target. What are the argu- ments in favour of this development?
9. How might the weakness of the pound in foreign exchange markets affect the inflation rate?
■ Data exercise
Go to the Office for National Statistics official websitewww.statistics.gov.uk Find the latest consumer price index first release.
Now answer these questions.
1. What is the annual rate of the three main measures of inflation: CPI, RPI and RPIX?
2. Find the chart that shows a comparison of the 12-monthly percentage changes in the twelve main categories of the CPI (Food and non-alcoholic beverages to Miscellaneous goods and services). Write a short report on the current pattern of annual price infla- tion across these categories.
3. Using the Internet compare the annual rate of UK inflation with other major economies’?
■ The Web
Go to the Bank of England’s website atwww.bankofengland.co.uk.
Now go to the Monetary Policy section.
Select the Latest Inflation Report.
Based on this Report, you are required to prepare a short PowerPoint presentation:
Slide 1: Provide a short overview of the Bank’s inflation outlook.
Slide 2: What are the current trends in money and asset prices?
Slide 3: What are the current data showing in terms of the level of demand in the real economy?
Slide 4: Discuss output and supply pressures.
Slide 5: Set out the outlook for costs and prices.
Slide 6: Give an overview of prospects for inflation.
Slide 7: Based on this Report what are the prospects for short-term interest rates in the next year?
■ Research
Begg, D. and Ward, D., (2007)Economics for Business, 2nd edition, Maidenhead: McGraw-Hill.
You should look at Chapter 9 and 10. The costs of inflation are set out on page 226
Begg, D., Fischer, S. and Dornbusch, R., (2008)Economics, 9th edition, Maidenhead: McGraw- Hill. You should look at Chapters 25 and 26. You will see the macroeconomic models of inflation.
Gillespie, A., (2007)Foundations of Economics, 1st edition, Oxford: Oxford University Press. You should focus on Chapter 29. On page 385 you will see a good section entitled ‘Why does infla- tion matter?’
Sloman, J., (2007)Essentials of Economics, 4th edition, Harlow: Financial Times Prentice Hall. You should look at Chapter 9.
Sloman, J., (2008)Economics and the Business Environment, 2nd edition, Harlow: Financial Times Prentice Hall. This topic is covered on page 10.
Sloman, J. and Hinde, K., (2007)Economics for Business, 4th edition, Harlow: Financial Times Prentice Hall. You should look at Chapter 26, pages 585–592. The concept of deflation is dis- cussed on pages 590–591 (see Box 26.3).
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Article 16 Inflation jumps to 9-month high on data move
M A C R O E C O N O M IC P O L IC Y : U N E M P L O Y M E N T, IN F L A T IO N A N D G R O W T H
Economists who work in the financial markets spend much of their time analysing the various economic statistics published by governments across the world. There is one par- ticular economic release that is always the most eagerly awaited. That is the monthly US
‘Employment Situation Report’. This can in just a few seconds transform the market’s per- ception of where the US economy is heading. When these data hit the screens huge fortunes are made and lost in a few seconds. The skill of a City economist lies in being able to provide an instant assessment of the significance of this new release. The headlines on the news screen services are just the highlights from the full press release from the Bureau of Labor published at the same time. Economists must speed-read the full report and be able to pick out the full highlights to brief their traders, sales staff and clients. This is a skill that is highly valued and explains why City economists can command such massive financial rewards.
US economy heading into recession!
Escalating fears of a US recession and growing concerns about credit markets drove global equities sharply lower this week and kept the dollar under pressure, which in turn sent commodity prices to fresh records.
A week of increasingly gloomy news culminated on Friday with the worst US employment report for nearly five years and moves by the Federal Reserve to increase liquidity in the banking system.
Non-farm payrolls fell by 63,000 last month, the biggest monthly drop since March 2003. In particular, analysts noted that private sector payrolls shrank by 101,000, compared with a 26,000 drop in January.
‘A decline of that magnitude screams recession,’ said Paul Ashworth at Capital Economics.
The futures market moved to fully
price in a 75 basis point cut in the Fed funds rate to 2.25 per cent at the US central bank’s next policy meeting on March 18 – and raised the odds of a full percentage point easing to about 34 per cent.
The jobs data came hard on the heels of news that the Fed had increased 28-day funding under the bi-monthly Term Auction Facility from $60bn to $100bn, plus additional 28-day repos totalling up to a further $100bn.
‘The scale of the emergency liquidity funding is without precedent in modern times,’ said John Kemp, analyst at Sempra Metals.
Lena Komileva, economist at Tullet Prebon, said: ‘Rising tensions in the euro and sterling term money markets increase pressures on the European monetary authorities to follow in the Fed’s footsteps
Overview: recession fears rise after US employment fall
Dave Shellock
Financial Times, 7 March 2008
Article 17
■ The analysis
This FT article reported on the latest US Labor Report for February, published on Friday 7 March 2008 at 1.30p.m. London time. The news wires across Wall Street confirmed the financial market’s worst fears. The employment data showed a 63,000 fall in non-farm payrolls which was particularly worrying as it was the biggest monthly decline for five years. The detail behind the headlines was just as gloomy. There was a particularly sharp fall of 101,000 in private-sector payrolls. This was not that surprising as the private sector tends to be the first to react to lower spending by reducing its labour force. The public- sector job cuts would be expected to follow in coming months. These data led an analyst at Capital Economics to conclude that ‘a decline of that magnitude screams recession’.
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Article 17 Overview: recession fears rise after US employment fall
M A C R O E C O N O M IC P O L IC Y : U N E M P L O Y M E N T, IN F L A T IO N A N D G R O W T H
and step up efforts to inject liquidity in domestic markets.’
Signs of stress in the money markets were evident as three-month sterling and euro interbank lending rates spent much of the week at levels not seen since January.
Credit spreads ballooned and equity markets sank as uncertainty about bond insurers, forced selling and margin calls at hedge funds, and record US mortgage delinquencies heightened concerns about further problems in the financial sector.
Ben Bernanke, Fed chairman, urged banks to write down more mortgage prin- cipal to help borrowers.
Larry Hatheway, chief economist at UBS, said he believed the changing tenor of US policy discussions marked an important third stage in the evolution of the financial crisis.
‘Specifically, policy may now have to move beyond liquidity provision and rate cuts to minimise the risk of market failure,’ he said.
Investment-grade credit indices in the US, Europe and Japan hit record levels, while in equity markets the S&P 500 touched its lowest level since September 2006.
Over the week, the US benchmark fell 2.8 per cent, the pan-European FTSE Eurofirst 300 shed 3.5 per cent and the Nikkei 225 in Tokyo tumbled 6 per cent.
Government bonds had a volatile week
as the spread between the two- and 10- year US Treasury yields, watched as a measure of risk aversion, touched its highest level since June 2004.
The spread between 30-year agency mortgage bonds and 10-year Treasuries widened to more than 200bp this week, the highest since 1986.
Divergent interest rate expectations between the US and eurozone meant that the two-year US Treasury yield fell 12bp to 1.52 per cent but the two-year Schatz yield rose 12bp to 3.26 per cent.
In the currency markets, all eyes were on the dollar as speculation of aggressive Fed easing and expectations that euro- zone rates would be on hold for some time paved the way for the greenback’s slide to record lows against the euro. Jean-Claude Trichet, the European Central Bank pres- ident, adopted a hawkish tone after eurozone interest rates were left on hold on Thursday.
Sterling regained the $2 level as the Bank of England opted to hold rates steady.
Commodity prices continued to climb as the dollar sank, with oil, gold and copper all hitting record highs.
April West Texas Intermediate, the US crude benchmark, hit $106.54 a barrel, with additional support coming from Opec’s decision not to increase supplies.
Gold rose as high as $991.90 an ounce and copper touched $8,820 a tonne.
Financial markets reacted instantly to the data. The US money markets took an immediate bet that the Fed would reduce it key short-term interest rate, the Fed Funds Rate, to 2.25% at its next meeting on 18 March. This prediction proved to be correct just a few days later. The Fed was also clearly concerned about the vulnerability of the US banking system as it announced plans to increase two key injections of liquidity in the money markets. The 28-day term auction facility was raised to $100bn and the normal repo operations increased to a further $100bn. When the large US investment bank Bear Stearns was forced into a dramatic rescue by JPMorgan a few days later it could hardly blame the Fed for a lack of intervention. The US central bank was doing all it could to save the financial institutions and mitigate the worst effects of the economic downturn.
Not surprisingly the US equity markets reacted very badly to the data. The S&P 500 stock market index fell nearly 3% to its lowest level since September 2006. There were also sharp falls in European and Japanese share prices. The weaker-than-expected economic data was terrible news for equity prices as any slowdown would translate into lower cor- porate profits, lower dividends and lower share values. The stock market would remain in the doldrums until it could start to see the first signs of economic recovery in the distant future.
The banks were also desperate to secure some additional liquidity from the money markets. This resulted in a sharp rise in the 3-month interbank rates in both the US and European markets. The bonds markets were not immune to these pressures either. The article notes that ‘credit spreads ballooned’. This means the relative yield on more risky bonds increased sharply. In times of uncertainty it is always to be expected that there will be a ‘flight to quality’ with bond investors preferring the relative safety of high quality including US, German and UK government bonds rather than the more risky alternatives.
The unease in financial markets also caused major problems for the beleaguered hedge funds. They were reliant on massive loans taken out from the banks to enable them to take huge trading positions. When the banks started to recall these loans the hedge funds did not have enough available cash so they had to liquidate their investments, often incurring massive losses. Some hedge funds had taken huge gambles and this time they lost. One such casualty was the private equity giant The Carlyle Group which saw its hedge fund fail in mid-March 2008.
The article ends with an intriguing final paragraph; this refers to the spread between the two-year Treasury note yield and the 10-year US Treasury bond yield. It has long been recognised by bond and stock market traders that this spread (the difference in yield between the 2-year US Treasury notes and the 10-year Treasury bonds) was a crucial indi- cator of the financial market’s expectations about future moves in the Fed’s interest rate policy and inflationary expectations in the economy. The steepening in this spread at this time was caused by the strong expectation of further cuts in the Fed Funds Rate. This cut caused the decrease in 2-year yields and at the same time the continued risk of inflation produced the increase in 10-year bond yields, because the risk of higher inflation caused investors to demand a higher rate of return on bonds. This especially applies to long-term investors as the uncertainty of their purchasing power is even greater.
■ Key terms