What will higher unemployment figures in NZ mean for monetary policy?

Although still low New Zealand’s unemployment figures today registered an increase of 0.1% to be at 3.4%. The labour market is still tight but there are signs that the reduction in job ads and monthly filled jobs are putting less pressure on the market. This may mean that the RBNZ, who sets monetary policy, sees that aggregate demand is starting to ease indicating a less aggressive stance with interest rates. With inflation at 7.2% and still well above the policy target agreement of 1-3%. the RBNZ might increase the OCR this February by 0.5% which is a reduction on the the previous increase of 0.75% on 23rd November. That would leave the OCR at a peak of 5.25% by May. However if high inflationary expectations become the norm the RBNZ might have to become more aggressive in its policy. Below is a mindmap on monetary policy which might be useful for revision purposes.

Source: ANZ Research 1st February 2023

Adapted from: A Level Economics Revision – Susan Grant.

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How well do we understand inflationary expectations?

In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.

Higher wages = Higher labour costs = Higher prices

Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:

“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.

How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?

Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:

  • a sharp increase in crude oil prices
  • a rise in income taxes,
  • a federal government spending increase,
  • a rise in the Federal Reserve’s target interest rate.

All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:

higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑

Experts take the view that it is a demand-side issue:

higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓

Central Banks look to make communication more accessible

Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.

Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.

Source: Hall of Mirrors: How Consumers Think about Inflation by Carlo Pizzinelli
IMF F&D September 2022

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Globalisation to regionalisation and its impact.

With the global economy experiencing supply chain pressures, inflationary problems, higher interest and geopolitical tensions are we seeing a move to more regionalisation rather than globalisation?

Part of this change has come about from the decoupling of the American, European and Japanese economies from China. This ultimately alters trade and investment flows around the global economy and will mean lower economic growth and less liquidity. For instance consider the restrictions on technology including complex microchips being placed by the US on China. Janet Yellen the US Treasury secretary referred to ‘friendshoring’ which means relocating production to countries that fall within the US economic sphere of influence. Apple’s recent announcement that it would begin sourcing sophisticated chips from North America is the signal that many global firms have been waiting for to begin reducing their exposure to China.

Furthermore as well as the impact of decoupling of trade with China, a shortage of labour will also add to production costs and will result in slower rates of growth. Labour force participation rates have dropped as there have been less migrant workers coming into countries. This scarcity of labour will put further pressure on wages and ultimately inflation. To counteract the latter interest rates will continue to climb and this will lead to further problems:

  • The cost of financing economic expansion will become more expensive.
  • Firms that have lived off 0% interest rates and negative real rates (nominal interest rate – inflation) will face increasing problems on their balance sheets

In the medium term interest rates are determined by inflationary expectations and rates tend to move lower in periods of disinflation and higher in periods of inflation. The risk for all central banks and policymakers is if the rate of inflation goes above that of expectations there can be a further tightening cycle.

Response to shocks – GFC and COVID-19

The GFC and COVID-19 saw the primary policy response of an expansionary monetary policy (near 0% interest) due to insufficient aggregate demand. The result of this policy has changed the economic landscape. Today things are quite different:

  • insufficient aggregate supply,
  • persistent supply shocks,
  • higher inflation,
  • higher interest rates
  • slow growth.

After years of loose fiscal, monetary, and credit policies and major negative supply shocks, stagflationary pressures are now putting the squeeze on a massive mountain of public- and private-sector debt. Recession (negative GDP for two consecutive quarters) seems on the cards.

Source: The Real Economy Blog

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US dollar strength a problem in fighting inflation

The US dollar hasn’t been stronger since 2000 – it has appreciated:

  • 22% – Yen,
  • 13% – Euro,
  • 6% – emerging market economies.

The dominance of the US$ has serious implications for the macroeconomy of almost all countries. Although US share of world trade has declined from 12% to 8% the US$ share of world exports has remained around 40%. Therefore imports denominated in US$ into countries have become more expensive and it is estimated that for every 10% US$ appreciation adds 1% to the country’s inflation figure. For developing countries with a high dependency on US$ denominated imports this is particularly worrisome.
Furthermore almost 50% of cross-border loans and international debt securities are in US$ and although emerging market governments have made progress in issuing debt in their own currency, their private corporate sectors have high levels of dollar-denominated debt. As the US Fed continue to raise interest rates with a fourth consecutive 75 basis points rise on 2nd November financial conditions have tightened and the strong US$ only compounds these pressures especially for many low income countries that are close to defaulting on their debt.

What should countries do?
Some countries and intervening in the foreign exchange buying their own currency with US$ reserves – foreign reserves fell by over 6% in the first half of this year to support their currency. Intervention should not be a permanent policy as it could mean a loss of foreign reserves as well as alerting markets to your intentions which could play into the hand of foreign exchange dealers. Monetary policy needs to keep inflation close to its target rate and the higher price of imports should reduce demand and therefore prices but a lot depends on the elasticity of demand for a country’s imports – if inelastic there is increasing pressure on inflation. Fiscal policy should provide some support to those that are most vulnerable without jeopardising the inflation target.

Source: IMF Blog – How Countries Should Respond to the Strong Dollar.

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New Zealand and Global Economy update.

New Zealand Economy

As we approach the external exam season it is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question. Indicators that you might want to mention are below.

  • New Zealand’s gross domestic product (GDP) expanded by 1.7 percent in the June 2022 quarter, above market expectations.
  • Coming from record low interest rates the RBNZ has recently increased the OCR by 50 basis points (0.5%). They did consider 75 basis points.
  • A current account deficit of $7.1 billion was recorded in the June 2022 quarter, compared with a deficit of $8.8 billion in the previous quarter (in seasonally adjusted terms)
  • Annual inflation remains high globally, with annual inflation within the OECD averaging 10.3 percent in August.

Global Economy – October 2022

Notice that global interest rates are on the rise as the countries tackle the current inflationary problem. Within OECD member countries, annual inflation ranged from 3% in Japan to 80.2% in Turkey. Global inflation is expected to moderate next year but likely to remain above inflation targets in many economies – RBNZ 1-3%. However with the tight monetary conditions expected to remain in place until mid 2023 GDP growth will be subdued.


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UK Pound slumps as IMF advises against tax cuts

Below is a very good video from Al Jazeera that explains the Bank of England’s emergency intervention to calm the market after the UK’s government’s tax cut plans. Once these plans were announced the GB Pound slumped to it lowest level $1.035 against the US Dollar since 1985. The BoE announced it is buying up long-dated UK government bonds to bring stability to financial markets but even higher interest rates are still likely and that is worrying news for the country’s property market. Good coverage of this below from Al Jazeera.

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

Central Bank Interest Rates – more increases in the horizon

Jerome Powell US Fed Chair increased the Fed Funds Rate by 0.75% last week to 3.25% and has signalled that he will do what is required to get the inflation rate down to the 2% target. Policy rates are still negative almost everywhere, the main exceptions being China, Brazil, Hong Kong, and Saudi Arabia. Mexico and Indonesia are almost there, too.

Thoughts from the Frontline – Mauldin Economics.

If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate. If the interest rate is 2% and the inflation rate is 10%, then the borrower would gain 8% of every dollar borrowed per year. In the early 1970s, the US and UK both reduced their debt burden by about 30% to 40% of GDP by taking advantage of negative real interest rates.

It is possible to control inflation while keeping real rates well below zero but it is more likely that reducing demand will require raising real rates at least to 0%, and probably a bit higher. Higher interest rates globally are on the horizon as at present they aren’t high enough to significantly reduce inflation pressure in most countries. Central banks have work to do.

Source: Mauldin Economics

Shrinkflation

From the PBS NewsHour Paul Solman looks at shrinkflation with some great examples. Shrinkflation is a rise in the general price of goods per unit of weight or volume, brought about by a reduction in the weight or size of the item sold. One of the most famous was in 2016 when the Toblerone reduced a 170g bar to 150g, while the 400g bar shrunk to 360g. This was done by enlarging the gap between the chocolate triangles.

Inflation and potential drivers

Interesting set of charts here that I picked up from Mauldin Economics. The left hand chart shows annually from 2019 and 2021 inflation change against the change in government disbursements. Countries with larger stimulus packages tended to experience greater inflation acceleration. Compared to other countries New Zealand had the largest fiscal stimulus with a disbursements gap of approximately 19% indicating that government spending and transfers increased sharply relative to pre-pandemic trends.

The right panel of that graphic plots inflation vs. the change in employment. A positive
unemployment gap implies that a country’s labour market has yet to recover from the pandemic recession. Across countries, the size of the inflation acceleration is negatively correlated with the unemployment gap, suggesting that differences in labour market slack account for a significant part of the cross-country variation in inflation acceleration.

Source: Mauldin Economics

Is there stagflation in the global economy?

Below is an interesting graphic from the FT which shows GDP and Inflation over the last couple of years in New Zealand – you can select other countries as well and it is good to compare different parts of the world. Note that NZ’s inflation and GDP is lower than the global average. You would normally experience stagflation when the stagnant growth is accompanied by high levels of unemployment – NZ has 3.3% unemployment. However the labour markets globally are very tight with just today British Airways cancelling 10,000 flights due to labour shortages.

If you look at Japan you will see very little difference between GDP and Inflation and you could say they may be eventually coming out of a deflationary period.

The site is very good and has various interactive graphs – Global Inflation Tracker

Global supply-side pressures starting to ease

At the heart of the rise in inflation over the past year has been supply-chain issues as well as the war in the Ukraine. However there are signs that this inflationary pressure is starting to subside with the cost of transportation coming down as well as improved delivery times for produce. The major concern was the COVID lockdown in China and now that restrictions have eased production and the transportation network have returned to some sort of normality. Oil and a number of other commodity prices have declined in recent months due to easing supply-side pressures and expectations of lower global demand, although prices remain elevated.

RBNZ – August Monetary Policy Statement

Global interest rates in sync

Below is a graphic from the IMF showing both developing and developed countries interest rate movements. Obviously during the the COVID pandemic interest rates were lowered to stimulate aggregate demand and reduce the debt burden on consumers and businesses. However with inflation now being well above the 2% threshold that most countries have as their target, interest rates have been on the rise. Central banks need to act resolutely to bring inflation back to their target, avoiding a de-anchoring of inflation expectations that would damage credibility built over the past decades. Although the war in Ukraine and the supply chain disruptions can’t be resolved by central banks, higher interest rates can slow aggregate demand and therefore reduce inflationary pressure.

IMF – Central Banks Hike Interest Rates in Sync to Tame Inflation Pressures – 10th August 2022

Causes of recessions and how do you manipulate the economy for a ‘soft landing’?

Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.

“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.

Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Will inflation stay above pre-pandemic levels?

With inflation above double figures in many economies and central banks tightening monetary policy will consumer prices fall? Some economists believed that the inflation figure is transitory and that the surge in prices would quickly decline with the increases in commodity prices falling out of the year-on-year comparison. The US Fed expects inflation to fall from 5.2% at the end of this year to 2.6% by the end of 2023. Predicting the effects of shocks and monetary policy on the inflation rate has become very difficult.

Alternative Macro Signals construct a “news inflation pressure index” which measures how frequently price pressures are mentioned in the news media. In the US and EU the index is still well above 50, indicating that inflationary pressures are continuing to rack up. There are those who believe that inflation will not return to pre-pandemic norm of low stable price growth – 3 indicators suggest this:

  1. Rising wage growth: Bank of Spain suggest that half of the collective-bargaining deals signed have clauses which tie wages to the level of inflation. Other examples of high pay demands include IG Metal in Germany and rail workers in Britain. The G10 group of countries has had a very steep rise in wages increases from the previous year. Minimum wages are increasing in both Germany and the Netherlands. Australia’s industrial-relations agency has increased the minimum wage by 5.2%.
  2. Public expectations: with higher wages there is an expectations of higher prices – Canadians are predicting 7% inflation whilst Japan 20% (previously 8%) believe prices will go up significantly.
  3. Company expectations: retailer inflationary expectations are on the rise. Bank of England suggest clothes prices will be 7-10% higher than a year ago but are customers willing to accept such price increases.

However there is some hope with supply chain pressures easing – cost of shipping from Shanghai to Los Angeles has fallen by 25% since March. Retailers have stocked up on inventory and cutting prices to sell stock. In the US car production has increased which should ease the pressure on the highly inflated used vehicle market.

Source: The Economist – Why inflation looks likely to stay above the pre-pandemic norm. July 2nd 2022.

Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about expectations”
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

  • a sharp increase in crude oil prices as a result of falling world supply,
  • a rise in income taxes,
  • an increase in government spending,
  • a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

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Interest rates and controlling inflation

Excellent video from The Economist. It goes through the impact of raising interest rates in an economy – mortgages, spending patterns, inflationary expectations. Also looks at when interest rates in the US went to 19.5% during the 1980’s. There is a fine line between increasing interest rates too quickly and tipping the economy into a recession or being too slow with the tightening process and letting inflation spiral upwards. The video discusses all these points – great revision for the Inflation topic at NCEA, IB and CIE.

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Turkish inflation hits 73.5% but not surprising.

Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.

The Turkish lira dropped by 17% this year with three cuts in interest rates since September. This comes as inflation has climbed to 73.5%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.

Source: FT4th June 2022

The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.

So with inflation now at 73.5% and and interest rates at 14% this makes real interest rates = – 59.5%. The central bank kept its benchmark interest rate at 14% at its May meeting, extending a pause that followed 5% of cuts last year. This has led to the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very good video clip from Deutsche Welle (German World Service) outlining the crisis that Turkey face and how a policy of cutting interest rates has backfired.