George O Receives Cash back

George Osbourne has decided to do what his colleagues in America and Japan have been doing for quite a while now, and has asked to receive the receipts from the profits that the Bank of England has received from quantitative easing (QE). But QE has cost the Bank £375 billion I hear you say? Well it hasn't cost the bank £375 billion, it simply printed the money, but this debt - in the form of gilts - pays interest, and Mr O has asked for that interest back.

Now this is no small matter. As Richard Murphy says, this is the equivalent of about £40 billion pounds a year given the current size of the scheme, or £30 billion in total since the scheme started. As Murphy also says, that is £30 billion we no longer need to cut. 


So to recap in case you missed it: the Bank of England has bought UK government debt (which the bank issued on behalf of the government) and in return it receives interest on this debt, paid by the UK government. In return the government is now asking the bank to tranfer the proceeds from this debt (back) to the UK government. I feel a bit like I am in a washing machine.

PS. as the TUC point out, maybe this has just been done by Osbourne to ensure that he can say that debt is falling rather than rising in December when he makes the Autumn Statement? 

Btw, if you owed yourself £375 billion, wouldn't you just cancel that debt?

 

Does the headline rate of inflation misrepresent the impact of inflation in the economy? Taking into account past inflation as a predictor of economic behaviour

As the latest monthly inflation figures were released today, showing that the retail price index (RPI) had dropped from a high of 5.6 per cent in September 2011 to 2.8 per cent in June 2012 this got me thinking about the interplay between past inflation rates and the current rate of inflation. But first, let me put this into a little bit of context: RPI did not drop below 4 per cent for 22 consecutive months between March 2010 and January 2012, and spent the entire of 2011 barring December above 5 per cent. Why is this relevant? Well primarily because inflation has been outstripping average earnings growth for the past two years. This has meant that real wages have actually fallen significantly across the economy (by more than 10 per cent since the credit crunch). This has had a knock on effect on consumer spending, and is one of the important reasons aside from the most important (this man and this man), why economic growth has been so low recently.

(And by the way, on the topic of inflation, when this man increased VAT from 15 per cent to 20 per cent, 0.5 per cent was added to the rate of inflation and is the reason why RPI was above 5 per cent for so long, not to mention the reduction in consumer demand associated with it. How’s that for stimulating a demand-led economy recovery?) 

Back to matters at hand: my thought was, that if the rate of inflation this year is 2.8 per cent, but the rate of inflation the previous year was 5.6 per cent, the current rate of inflation is likely to have a very different feel than if the previous year’s inflation rate was only 2.4 per cent for instance. The price of goods is going to feel expensive if recent inflation has been high, even if current inflation is low. And this feeling is going to impact on the economic choices that people make. Why is this the case? Very simply, because individuals do not base their behaviour on arbitrary statistics, but rather, on their perception of factors underlying those statistics. For instance, the cost of gas will still seem expensive, if it only increases by 2 per cent this year, if in recent years there have been high price rises. 

This disconnect between the headline rate of inflation and it’s actual impact makes sense – the annual inflation figure was drawn up by economists and statisticians to give a snapshot of what is happening to the cost of goods across the economy at any one particular time. The problem is that this does not reflect how inflation impacts on the real world ie. how it impacts on the economic decisions of individuals and organisations who may also factor in past inflation rates into their behaviour. And this is important – if you want to up-rate state benefits such as the state pension, then the headline annual inflation figure will be appropriate (providing that it is up-rated consistently every year). However, if the aim is to explain and predict behaviour, which is surely one of the major purposes of economics, then it is important to use a measure of inflation which reflects its direct impact on people and organisations’ decision making.   

To draw a more personal example I judge whether or not a packet of crisps is expensive, based on what it cost me to buy a packet with my pocket money as a 12 year old in 1993 – about 18 pence – hardly surprising therefore that I eat less crisps nowadays that the price is about 55 pence, even though my spending power has increased exponentially since then. Stupid examples aside, to properly understand the impact of how inflation impacts behaviour therefore, one has to look at inflation over a longer period than just the previous 12 months. 

How might this be possible? Very simply, by factoring in previous year’s inflation into the calculation of inflation. To illustrate this I’ve put together the table below. This shows RPI going back to June 2010 as well as the compounded inflation since that date. As can be seen, in the background to the current RPI inflation rate of 2.8 per cent, there has been a 13.3 percent increase in the cost of goods since June 2009, which will be influencing the behaviour of consumers across the economy. 

To take this into account I’ve produced a weighted RPI figure that takes into account previous years’ inflation. It is called weighted RPI because I’ve weighted the previous years’ effect on the current year’s RPI, so that the current headline figure is given a 100 per cent weight, the previous year’s figure a 50 per cent weight and two year’s ago 20 per cent in the new inflation figure. This shows that while the headline annual rate is 2.8 per cent, by including previous years’ inflation (because individuals will be including previous years in their behaviour) weighted RPI is 3.71 per cent. As can be seen, weighted RPI drops below the actual RPI for June 2011 and 2010, the reason being that the RPI figure for June 2009 was -1.6 per cent. (The picture would have been different if CPI was used as it only dropped to +1.8 per cent in 2009.)

Now these weights are completely arbitrary. I’m not suggesting that a 50 per cent weighting for the previous year approximates human behaviour in any way. However, it is something that research can quantify, and if it is quantifiable, perhaps an indicator which quantifies it has more explanatory power than the indicators of inflation that we currently use.   

	Annual rate of inflation (RPI)	Compound inflation (RPI)	Weighted RPI
June 2010	5.0	5	2.99
June 2011	5.0	10.25	4.22
June 2012	2.8	13.3	3.71

Finally, quantitative easing explained

Three or so years after I first encountered the concept of quantitative easing, someone has been good enough to explain exactly how it works. I had known that QE involved buying gilts - UK government bonds - but I had no idea why this might be desirable. Until that was I stumbled across this speech by Charlie Bean, Deputy Governor of the Bank of England, in which Mr Bean describes the way the Bank thinks QE benefits the economy:

Quantitative easing essentially involves trading one liability of the state – gilts – for another – monetary claims on the Bank of England. We aim to buy mainly from non-bank private financial institutions, such as pension funds and insurance companies, not from the banks, as is sometimes erroneously claimed. When we buy a gilt, we simply credit the bank account of the seller with an appropriate sum. If the seller were indifferent between holding the gilt and holding the associated bank deposit, that is where things would stop. But because deposits tend to yield less than gilts and assets such as corporate bonds and equities, the seller is likely to want to buy some other asset instead. The consequence is upward pressure on the prices of a whole range of assets, including corporate bonds and equities. That increases the availability, and reduces the cost, of finance to corporates. It also boosts the value of people's wealth, which should encourage more spending.

So, the former holder of the gilts gets credited with cash, and seeing as they can make more money elsewhere rather than hold onto the cash as cash, they invest the money somewhere else. I never would have imagined.......

This still raises the question of course of how well QE filters through to the rest of the economy. One of the explicit assumptions behind quantitative easing is that it will reduce the cost of finance for corporates, however, a characteristic of the current economy is weak business investment, even though corporate profits remain high (because corporates have been very good at cutting costs). The conclusion seems to be that the problem for corporates is not that they do not have access to finance, but that they are unwilling to make investments in the current uncertain conditions, and if this is the case, QE won't make much difference.

Interestingly for anyone who has picked up on the recent arguments that quantitative easing is affecting the value of pension payments in quite a serious way, Mr Bean has this to say:

someone with a £100,000 pension pot, who could have expected that to yield an annual pension of a little under £7,000 three years ago, would now get just under £6,000. That is a rather substantial income loss. But it is only part of the story. Those pension funds will typically have been invested in a mix of bonds and equities, with perhaps a bit of cash too. The rise in asset prices as a result of quantitative easing consequently also raises the value of the pension pot, providing an offset to the fall in annuity rates

Mr Bean even goes onto say that in the long-term, the two effects will cancel each other out. Of course, in the long-term, we will all be dead.