Andrew Sentance's economics blog

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UK housing market needs higher interest rates

posted 8th May 2014

There is growing concern about developments in the UK housing market. These were registered in the latest OECD report on the UK economy which called for “timely measures” to stop the market overheating. Earlier this month, Sir Jon Cunliffe, the Deputy Governor responsible for financial stability at the Bank of England, described the state of the housing market as the “brightest light on the dashboard” warning of dangers ahead for the UK economy.

Doing nothing is not an option. House price inflation is now above 10%, according to the Nationwide. This is no longer just an issue for London and the South-East. Prices are rising throughout the country – albeit at stronger rates in the London area, which has led the recovery from recession.

So what are the options? The two main tools available are: (i) a rise in interest rates; and (ii) targeted measures aimed to restrict lending by banks in the mortgage market. In my view, the evidence suggests interest rates should be used as the main instrument to cool housing demand – though it may be appropriate withdraw some of the other financial support to housebuyers as interest rates are rising.

There are three key arguments which point to the need for interest rate rises to cool the housing market.

First, interest rates are extremely low at present. So there is a need to move them up to strike a more reasonable balance between borrowers and savers over the medium term. The 0.5% Bank Rate, which has prevailed for the past five years, is the lowest we have seen in the UK’s recorded history. Interest rates were reduced to an abnormally low level to restore confidence and growth in the aftermath of the Global Financial Crisis in 2008/9. But over five years on from that crisis, a reassessment of policy is needed to align the level of interest rate with the very different state of the economy we now face.

Second, the UK economy is performing very strongly. The IMF, OECD and PwC all expect the British economy to head the G7 growth league in 2014.  It is not just the housing market which is strong at present. There is a more general upsurge in economic activity. Business surveys are very positive – for example, last month’s CBI Industrial Trends Survey recorded the strongest business optimism readings since 1973 (when the UK economy grew by over 7% - its postwar growth record).  Other business surveys show a similar picture of strong business confidence and healthy growth alongside rising employment and investment.

A wide range of economic evidence points in the same direction. The latest car registration figures show the strongest run of monthly growth since the late 1980s. Unemployment is falling and vacancies are back to the levels we saw before the crisis. GDP growth is the strongest we have seen since the financial crisis. In other words, the buoyant housing market is not just an isolated problem. It is part of a more general picture of strong economic growth, warranting a rise in interest rates.

The third argument in favour of raising interest rates is that it would be much better than the  alternative – restricting access to mortgage finance by various bureaucratic mechanisms. In the 1980s, we moved to a deregulated mortgage market which served the UK economy very well. Access to mortgage finance was freed from the constraints of Dad’s Army’s Mr Mainwairing and his equivalents in the world of Building Societies. The “quid pro quo” of this freer mortgage market was that the demand for housing finance was controlled by the interest rate and the cost of finance, not by bureaucratic financial rules.

Re-regulating and restricting housing finance is a retrograde step and will deny many first-time buyers their first step on the housing ladder. Economists favour the price mechanism as the best approach to regulate demand in markets.  In the case of the housing market, this should mean allowing interest rates to rise in the current circumstances.

Gradually raising the official interest rate from its historical low of 0.5% seems the best place to start to keep the UK housing market in check. If this causes a surprising slowdown in the economy, then the MPC and the FPC should review and other measures might be considered. But the housing market is just one piece of evidence that the UK economy needs higher interest rates. If the MPC can’t deliver this now, they will have to impose a bigger rise later.

Bank of England should reveal its "Secret Agent" reports more quickly

posted 22nd April 2014

Tomorrow, we will be able to read the latest set of minutes of the Bank of England Monetary Policy Committee. The minutes are released within two weeks of the meeting itself and – in my experience – give an accurate reflection of the debate on the Committee. The Committee goes through the minutes on a line-by-line basis. And dissenting views are captured – or at least they were when I was a member of the MPC. Members of the MPC have a right to speak out in public through speeches and media interviews. They are interrogated by the Treasury Select Committee. So there are plenty of opportunities to correct the record of the minutes if they do not faithfully record the views expressed within the Committee. But I can’t recall a time – either when I was a member of the Committee or when I have been a commentator on MPC activities – when this has been a major issue.

But there is an important area where the MPC could greatly improve the transparency of its reporting and add quality to the economic debate. The Bank of England Agents – who monitor economic conditions in 12 regional locations in the UK – present their findings to the MPC each month at the “Pre-MPC” meeting, which is normally held on the Friday before the MPC decision. This information, however, is withheld from more public economic debate for nearly three weeks, and is then released alongside the minutes of the MPC meeting.

There are two downsides to this practice. First, the Bank Regional Agents’ reports do not get the attention they deserve. The main focus of news reporting is around the MPC minutes, and there is little coverage of an important source of information which feeds into economic policy-making. Second, there is an unnecessary delay between the time when the Bank of England’s Agents’ reports are available to the MPC and when they are available to the rest of us. In the current era of increased data transparency, this seems to be unnecessary. For both of these reasons, the Bank’s representatives in the UK regions appear like “Secret Agents” rather than part of an open and honest process of reporting economic data.

In the US, things are handled differently. The Federal Reserve Beige Book – which compiles economic reports from around the country - is published independently of the  FOMC minutes process. And as a result it attracts more attention and is respected as an independent data source.

In general in the UK, we believe that economic data should be published independently of economic policy-making processes. The Office of National Statistics operates independently of the Treasury for this reason. But the Bank of England does not follow this approach in relation to the publication of its Agents’ reports.

Interestingly, recent editions of the Agents’ reports have showed a slightly different picture to that portrayed by the MPC. The MPC view is that there is plenty of spare capacity in the economy to take up slack without a rise in interest rates. Yet the Bank Agents show that in both manufacturing and services, capacity pressures have tightened significantly in the past 12 months (see chart) and have returned to pre-crisis levels.

So when the MPC minutes come out tomorrow, I would encourage all economic commentators to focus on the Agents’ reports and to check how closely these are aligned with the Committee’s view. And it is high time that the Bank of England published their Agents’ reports independently of the minutes – preferably at the same time that the MPC see them, on the Friday before the MPC decision.

Business surveys point to robust recovery

posted 8th April 2014

At times when the economy is changing, business surveys provide a valuable and timely insight into the latest trends and future prospects. They are available in advance of official statistics and can provide information on business plans and expectations as well as out-turns. Business surveys are also a source of information for some key variables which are not measured by official statistics – such as capacity utilisation.

The British Chambers of Commerce (BCC) quarterly economic survey probably has the most comprehensive coverage of the UK business surveys. It covers around 7,500 firms in services and manufacturing. The coverage of the services sector makes this a particularly important survey, as services account for close to 80% of UK GDP and over 80% of total employment in the British economy. The survey has been running for 25 years now, so the recent results can be benchmarked against the experience of the 1990s and 2000s.

The latest BCC survey is released today and it paints a pretty upbeat picture of pace and durability of the UK recovery.

First, the survey shows that demand is strong at home and abroad. The latest results show the strongest growth ever recorded in domestic manufacturing orders and the highest reading for the  growth of domestic orders we have seen in the services sector since the mid-1990s (see Chart, right). Overseas demand also appears to be rebounding from the effects of the euro crisis. Services export orders are at all-time record high according to the BCC survey and export sales by manufacturers are the strongest recorded by 1994.

Second, the recovery in demand and output is now feeding through into business investment and employment plans in both the manufacturing and services sectors. In manufacturing, investment intentions and the expected growth of employment are both at an all-time high. In the services sector, plans to increase investment and employment are back to the levels seen in the years of strong growth before the financial crisis (see Chart, below). On this basis, we should expect to see unemployment continue to fall and investment to grow healthily this year. These are both indicators which the Bank of England’s Monetary Policy Committee (MPC) is looking at to judge the sustainability of the recovery and to inform its policy response.

Third, there appears to be very little margin of spare capacity now in the UK economy – at least according to the business world. Nearly half of firms in both manufacturing and services report they are operating at full capacity – which is at or close to the record levels of capacity utilisation we have seen over the last 25 years (see Chart, above). If growth continues at the current rate, there is little slack to be taken up and it will take time before new investment brings new capacity on stream. There is therefore a heightened risk that continued strong demand growth will push up prices. Indeed, the BCC survey shows that is already happening in the services sector - expectations of price rises are close to the highest level we have seen since the financial crisis.

The strength of the UK economy shown by this latest BCC survey is consistent with other recent business surveys, from the CBI and Markit/PMI.  We may not yet be in “booming Britain”, but growth is robust and is gathering momentum. If monetary policy does not respond soon to this evidence of strengthening demand, investment and employment alongside high capacity utilisation, the MPC is likely to find itself badly behind the curve when it does get round to raising interest rates.

Looking for a Way Out - Time for a change in UK Monetary Policy*

posted 1st March 2014

This month marks the fifth anniversary of the decision of the Bank of England Monetary Policy Committee (MPC) to cut the official Bank Rate to 0.5% and to launch Quantitative Easing (QE). These decisions were taken in the depths of the financial crisis, and they were absolutely the right thing to do at the time. I was a member of the MPC in March 2009, and along with the other eight members of the Committee fully supported the decision to cut interest rates to the lowest level in recorded history and to inject £200bn of money into the economy during 2009 by buying government bonds.

At that time, the expectation of the financial markets – and I’m sure this was the view of most members of the MPC too – was that interest rates would rise once the recovery was underway in 2010 and beyond.

The reality of course has turned out to be very different – as the Chart clearly shows. Instead of raising interest rates during 2010 and 2011, the MPC embarked on two further rounds of QE. It is not clear that this did very much for the recovery, though. UK economic growth in 2011 and 2012 was held back by high inflation and the euro crisis. QE could do little to address these problems – and the negative impact of QE on the value of the pound probably aggravated the squeeze on real incomes from high inflation. But we are coming out of this soft patch of growth in the UK and other Western economies. And so the question is once more on the agenda – when, how far and how fast will interest rates rise.

The answer coming from Mark Carney and the MPC appears to be “not any time soon”. However, the MPC’s policy of trying to hold down borrowing costs in the face of an improving economy carries the risk that the adjustment of rates, when it comes, has to be sharper and more abrupt. That would deliver the shock to the economy which we should all be trying to avoid. We saw the consequences of this in the US in the mid-2000s, when the Fed held interest rates at 1% for too long and then pushed them up quickly to over 5% between late 2004 and early 2006. That policy change was one of the triggers for the global financial crisis, so the risk I am warning about is not trivial.

There are five main arguments being used in speeches and statements to support the current MPC policy. Growth is still fragile, weak or unbalanced; there is plenty of spare capacity; inflation is low; an appreciation of the pound would be damaging; and households cannot sustain an interest rate rise because of high debts. In each case, however, the evidence does not really  support the MPC position – particularly when we take into account the exceptionally low level of interest rates we are starting from – lower even than in the Great Depression of the 1930s. The monetary policy settings required to address the very extreme financial conditions of 2009 are becoming less and less appropriate as the recovery progresses, particularly with economic growth picking up over the past 6-9 months.

Economic growth in the “new normal”

When we consider growth in the UK economy and across the western world after the economic crisis, it is very important to recognise that we are in a “new normal” growth world where we should not expect to return to the heady rates seen before the crisis. In the quarter century before the financial crisis, the UK economy grew on average by 3.3%. The average growth rate over this recovery so far – if we exclude the depressing impact of North Sea oil – has been about half this rate (1.6%). Even compared to a long-term average growth rate for the UK economy (between 2 ¼ and 2 ½ per cent), this is disappointing.

As I argue in my book – Rediscovering growth: After the crisis – the reasons for this sluggish growth are largely structural. Three tailwinds which supported Western growth from the 1980s to the mid-2000s are no longer with us – easy money, cheap imports, and confidence in policy-makers’ ability to stabilise economies. Western economies are going through a slow process of adjustment to find new sources of growth in this post-crisis world. The US, UK and northern and eastern Europe look much better placed to make this adjustment than the struggling economies of southern Europe and France. So in the medium-term it is reasonable to expect growth to gradually pick-up here in the UK. But it may not be until later in the decade that we feel the full benefits.  

Relative to this subdued growth trend of 1.5-2%, the recent pick-up in UK economic growth is quite impressive. GDP is up 2.7% on a year ago, which is strong growth by the standards of the post-crisis “New Normal”. The UK growth picture looks even better in employment terms. Since the end of 2009, the private sector has created 1.7 million extra jobs, including self employment and part-time workers. That is an impressive achievement by any standards, and does provide a counter to the prevailing view that this is the worst recession since the 1930s. The UK’s employment record in the recent recession and current recovery is much better than the experience following the early- 1980s and early-1990s recessions – as the chart shows.

I do not have much sympathy with the notion that that current growth is unsustainable or unbalanced, either because the economy has not rebalanced enough towards manufacturing or because investment growth is weak. We have heard these arguments before at the early stages of previous recoveries. Investment takes time to pick up and the UK is a highly services-oriented economy. Indeed, exports of services from the UK are the highest proportion of GDP of any G7 economy – 12% compared with around 6% in the major continental European economies and 4% in the US. It is not the job of policy-makers to prescribe where growth will come from. It is their job to create the underlying conditions which make it possible – including sustainable fiscal and monetary policies and appropriate supply-side reforms. Also, some of the hand-wringing about the sustainability of the recovery is coming from people who did not recognise the unsustainability of growth before the crisis. We need to accept that it is businesses and the supply-side fundamentals of the economy which will determine the nature of the recovery, not the views of policy-makers.

In assessing the sustainability of growth, I would put much more weight on what businesses themselves have been saying. Business surveys have become increasingly positive over the past year and the most recent surveys from the CBI and other business organisations have generally been encouraging about future growth prospects. That underpins the optimism of forecasters that 2014 will be the strongest year of recovery so far in the UK, with most forecasters expecting GDP to rise on average by 2.5-3% this year.

Spare capacity and inflation

Another area where survey evidence provides a helpful guide is in assessing the margin of spare capacity. The Bank of England’s Agents’ survey  tracks capacity constraints in manufacturing and services and the latest results are shown in the chart. Contrary to the MPC view that there is a sufficient margin of spare capacity, the Agents’ reports show that for the first time since early 2008, capacity constraints are above normal in both manufacturing and services. The MPC points to the amount of spare capacity which is available in the labour market. But this is rapidly being taken up as unemployment falls and skill shortages increase.

According to the MPC analysis, there is around 1-1.5% of GDP in spare capacity available in the economy – which seems to me a pretty slim margin given the difficulties of measuring spare capacity, and the errors in previous estimates. With the economy growing strongly and spare capacity being quickly eroded, the obvious response should be to gradually tighten monetary policy. However, an additional argument is now being advanced against this obvious course of action. Inflation is back on target – so we don’t need to worry. Never mind the fact that inflation has spent most of the last decade above target, and that the Bank’s forecasting record for inflation beyond the next 6 months has been pretty appalling.

I am more optimistic now that inflation can stay around the target, though there are still risks from a renewed surge in energy and commodity prices and/or from wage inflation. However, I do not see a more encouraging inflation outlook as a reason for keeping to emergency interest rate levels set during the financial crisis. If we wait until there is a “clear and present” danger from inflation, we will then need to raise interest rates sharply from current levels – which is exactly what we should be trying to avoid! I also think that deflationary fears are greatly exaggerated;

Worries about the pound

The latest evidence on growth, capacity and inflation do not –in my view – support the current MPC position of keeping interest rates on hold. The fourth issue which seems to concern MPC members in terms of raising interest rates is the potential impact on the value of the pound. Though sterling has recovered a little in recent months, it still looks significantly undervalued. The average level of sterling against our trading partners since 2009 has been about 22% below its average in the 30 years 1977-2006. The UK economy pays its way in the world with exports of high value-added manufactures and services, most of which are not very price sensitive. All we get from a weak pound is an additional squeeze on consumers from high import prices.

As I said three years ago, in my “Selling England by the Pound” speech, embracing a weak pound remains one of the biggest policy mistakes that the MPC has made since the financial crisis. The prospect of a further appreciation in sterling should be welcomed – not resisted - by the MPC, as long as it does not go too far, too fast. Concerns about the strength of the pound are not good reasons for resisting an interest rate rise when the economy is growing well and capacity pressures are increasing. Indeed, the MPC are at risk of repeating the mistake which Nigel Lawson made in the late 1980s, which ultimately led to a very sharp hike in interest rates as the economy overheated.

Household finances and debt

Finally, what about household debt? It is sometimes argued that a rise in mortgage costs will push many households over the edge into arrears, creating many distressed borrowers and a collapse in consumer spending. I don’t buy this argument. Or I only buy it to the extent that there could be a big upward shock to interest rates – which is exactly what I am trying to avoid.  The chart (right) shows two measures of the financial exposure of the UK household sector: financial liabilities (ie borrowing) and the net financial position of UK households. There is a gradual process of deleveraging, partly reflecting restricted availability of mortgage finance, so the liabilities line is gradually falling. That is what we would expect and it may take some time for UK households to fully adjust to the post-crisis world. But if we keep interest rates at 0.5% until this adjustment is complete, there will then need to be a rapid rise in borrowing costs further down the track. Much better to signal and implement a gradual rise so that households can plan and adjust to change over a period of time.

The other line on the chart is the net financial position of the UK household sector, including assets as well as liabilities. The first point to note is that this is strongly positive – about 2.8 times disposable income. If housing wealth were added in it would be about 7 times household disposable income. The UK household sector has very considerable reserves of financial and non-financial wealth, even if it is not distributed as equally as we would like. Second, the net financial position of the UK household sector is as strong as it has been at any time since the late 1980s with the exception of the dotcom bubble in the late 1990s and at the peak of the pre-crisis boom in 2006/7.

By delaying interest rate rises, or giving false comfort that they will remain artificially low, the MPC risks aggravating problems of household indebtedness, not least because house prices are likely to continue to rise. The financial position of the UK household sector is not a valid reasons for delaying interest rate rises.

Forward guidance needs to change

It will be clear from the arguments  I have made that I do not agree with the current policy of the MPC, or its approach to forward guidance. There is a role for forward guidance in setting out a path for gradually raising interest rates. This is the policy that the MPC should have embarked upon lastg summer. They have wasted six months. And the longer they wait and delay, the greater is the risk that when interest rates do rise, it will be a sharp increase that disrupts, rather than supports the recovery which is now becoming well-established.

* This  article is based on the speech given at the Institute of Economic Affairs State of the Economy Conference, on 26th February 2014.

Previous blog postings:

Click on the links below to find recent previous articles: Can we rediscover growth after the crisis? (17/11/13) Growth - not inflation - now the objective under Carney (1/9/13) Don't expect too much from "Forward Guidance" (5/8/13) Carney jumps the gun! (4/7/13) Inflation risks still on the upside (28/5/13) The UK economy - doing better than we think (2/5/13) Monetary activism is likely to end in tears (24/3/13) Central bankers are not Masters of the Universe (27/2/13) Down, down, deeper and down for sterling (2/2/13); Don't abandon the inflation target! (5/1/13) Why has services inflation been so high and persistent? (2/1/13)

Click here for blogs from 2012 and here for blogs from 2011

Can we rediscover growth after the crisis?

posted 17th November 2013

There are encouraging signs that the UK economy is picking up after very sluggish growth in 2011 and 2012. Forecasts for this year and next are being revised upwards. PwC’s latest UK Economic Outlook points to GDP growth of 1.4% this year and 2.4% in 2014. The Bank of England’s latest Inflation Report published last week was even more optimistic.

This improvement is welcome, but the bigger picture shows a disappointing economic recovery for the UK and other western economies. Even with the pick-up that current forecasts now suggest for the British economy, annual  GDP growth is likely to average less than 1.5% in the first five years of recovery – 2010-14. That is less than half the economic growth rate in the recovery from the early 1990s recession, when the UK economy grew by 3.3% on average in the five years 1992-96. And this pattern of disappointing growth is being seen across Europe and in the United States. According to the IMF’s latest economic forecasts, none of the G7 major economies will grow by over 2% this year.  Since 1980, the only previous years that happened was in 2008 and 2009 in the midst of the Global Financial Crisis.

There are many misunderstandings about the reasons for disappointing growth. It is not due to a deflationary global economy, as in the 1930s. Emerging market economies have not had difficulty finding growth opportunities – and their performance has been strong both before and since the crisis. Inflation has been a bigger problem than deflation for many economies around the world since the financial crisis – including the UK. Nor is weak growth the product of restrictive economic policies - fiscal austerity or a lack of monetary stimulus. Across most western economies, government spending restraint and tax increases have not been severe, and monetary policy remains extremely loose.

My analysis of the reasons for this disappointing growth phase and how we might escape it are contained in a new book which will be published at the end of this week: Rediscovering growth: After the crisis*. Its central thesis is that the major western economies - in Europe and North America - have entered a “new normal” of disappointing economic growth and heightened volatility. Three powerful tailwinds which supported growth across the western world from the 1980s until the mid-2000s – easy money, cheap imports and confidence in the policies of governments and central banks - have disappeared. And because these tailwinds are now absent, a quick and easy escape path from this pattern of slow growth across the West is unlikely.

But that does not mean we should be pessimistic about the longer term economic outlook. There is hope of a return to a more stable and sustained world of economic growth if we can learn the right lessons from previous twists and turns in our economic fortunes and adapt them to the circumstances we now face in the early 21st Century.

What are those lessons?  The first is that well-functioning and flexible economies can and do regenerate themselves. The turnaround in the British economy in the 1980s provides a good example of this. The UK economy expanded at an average rate of over 3% per annum from the late 1940s until the early 1970s and then appeared to hit a brick wall after the mid-1970s recession. UK economic growth between 1973 and 1982 averaged less than 1% per annum. Pessimism was rife in the early 1980s, and there was widespread social unrest. 364 economists wrote to The Times newspaper to protest at the failings of government economic policy. And yet the British economy achieved a remarkable turnaround in the 1980s and set off on another quarter century of 3% plus growth in which the size of our economy doubled (see chart). This new “golden age” of economic growth was only brought to an end by the global financial crisis.

The second lesson, however, is more challenging. In order to get on a new growth path, painful adjustments in our economies and societies may be necessary. And we cannot guarantee that the necessary changes will take place in countries where there may be strong political resistance to change. Japan provides a very good example of this.  Japan has built its economic success on a very productive, efficient and dynamic manufacturing sector. But from the mid-1990s onwards it has been clear to many observers that Japan needed to reform its labour markets and develop a more productive services sector to complement its very successful manufacturing industry. To date this has not happened, and hence Japanese growth remains in the doldrums. For Japan, its inability to undertake these structural changes is a much more important factor holding back growth than the legacy of its financial crisis in the early 1990s.

There are many other examples of economies which have struggled to recover past glories because they could not make the adjustment required. For example, Spain, Italy and Portugal, which flourished in the 1400s and 1500s, were overtaken by the major northern European powers including Britain, and have struggled ever since to re-establish their economic prowess.

The third lesson is that we should not expect the next growth phase to be like the last one.  In the 1950s and 1960s, growth in the western world was boosted by post-war reconstruction, an emerging middle class in Europe and North America, and the new technologies which had emerged in the 1920s, 1930s and during the Second World War. The development of mass markets for consumer products like motor cars, washing machines and transistor radios were key features of this post-war growth phase.  The next growth phase, which started in the 1980s and developed momentum in the 1990s, was supported by a very different set of forces: financial deregulation and liberalisation; the opening up of the world economy; and the revolution in information and communications technology which brought us the internet and mobile phones.

It is not possible to pinpoint exactly what might drive a new growth phase which could become established later this decade. The experience of previous growth phases can offer only limited insights - we need to look forward rather than back to the past to identify emerging new technologies and business and consumer trends. But there are common conditions which have underpinned the two major growth phases we have seen in the modern postwar era – a supportive financial system and confidence in the stability and sustainability of economic policy. These preconditions do not yet seem to be in place to support a return to stronger growth in the major western economies, though they could be later this decade.

The final lesson I would highlight from past experience is that some countries and some businesses are likely to be much better placed to ride the changing tides of economic growth than others. Northern Europe – including the UK – has been an economic powerhouse for the world economy for at least three centuries now.  North America and other offshoots of European civilisation developed and flourished in the 19th and 20th centuries – led by the United States. And it looks likely that the Asia-Pacific region – led by China and India - will be the economic powerhouse of the 21st century. Looking ahead, we should expect these three regions to continue to provide the main support for economic growth across the world economy. Elsewhere, economic prospects look more uncertain and more variable.

The message of my book is that we can rediscover growth in the UK and other western economies. We are not doomed to continuing stagnation and economic decline. But economies need to change and adapt – in business, finance and government. In a number of western economies, there is work in progress and a transition is underway - and the UK is better placed than most to succeed in our “new normal” world.

Want to know more? You’ll need to buy the book to read the whole story. But it is only £4.50 as an e-book (Kindle, etc) and £7.99 in paperback. Order now to beat the rush!

* Rediscovering growth: After the crisis is published by London Publishing Partnership and will be available from Saturday 23rd November. It can be ordered from LPP, Amazon and other booksellers.

Growth - not inflation - now the objective under Carney

posted 1st September 2013

There were some positive aspects of Mark Carney’s first speech as the new Bank of England Governor in Nottingham last week. It was broadcast over the internet. He took questions from the audience and then gave a press conference afterwards. All this was accessible to the public at large via the Bank’s website. This is a more open and media-friendly style of Governorship – showing the Bank is moving with the times in terms of its communications strategy.

But the content of the speech was more worrying for those who suspect that the Bank is drifting away from its objective of targeting low inflation. Yes, the inflation target was mentioned from time to time. But Carney's speech made clear that monetary policy is now being directed to support economic growth – and this is the primary motivation behind the new policy of “forward guidance”, shorthand for keeping interest rates at current extremely low levels.

Monetary policy can support growth by helping the economy ride out a financial storm, as we saw in late 2008 and 2009. Then, central bankers around the world showed that they had learned the lessons of the 1930s when their predecessors were reluctant to ease monetary policy in the face of a major financial crisis. in 2009, emergency monetary policies – dramatic interest rate cuts and Quantitative Easing - succeeded in stabilising economies and providing a platform for a return to growth.

But this encouraged central bankers to believe that they could do even more to support growth – despite the fact that the monetary accelerator was already pressed hard to the floor with interest rates at near-zero levels. This is unrealistic. There are limits to what monetary policy can achieve in supporting growth and the longer the time frame becomes, the less effective it is likely to be.

Conventional economic theory suggests that the main effect of changing monetary policy is “intertemporal substitution” - economic-speak for shifting spending to/from the future. When interest rates are raised, individuals and businesses postpone spending. And when rates are cut, spending is brought forward. But this trick cannot be repeated indefinitely. Once interest rates have been cut to near-zero, borrowers have brought forward as much spending as they would like. And once the realisation of a near-zero interest rates world is appreciated by savers, they are likely to cut back on spending as their interest income declines, countering the growth benefits of the low interest rate policy.

So even though the objective of the new monetary policy of “forward guidance” is to support growth by promising continued exceptionally low interest rates – it may not be effective and might even be counter-productive. Indeed, the financial market reaction to  recent Bank of England statements has been to push up longer-term interest rates. This is a worrying response as it suggests that the new policy of "forward guidance" lacks credibility - perhaps because stronger growth, higher inflation  or rising interest rates globally will knock the policy off course.

Monetary policy should do what it says on the tin – controlling the value of money, and maintaining price stability. Once it strays into the territory of trying to fine-tune economic growth, there are dangers ahead, as we discovered when inflation ran out of control in the 1970s and when loose monetary policy supported the credit boom which preceded the recent financial crisis. Let us hope we are not going to make the same mistake again under the Bank of England's new policy of "forward guidance".

A version of this article was first published in City AM on 29th August 2013


Don't expect too much from "Forward Guidance"

posted 5th August 2013

Masterly inaction has become the new policy of the MPC. There was no change in policy when the Monetary Policy Committee met last week. The official Bank Rate has now been at 0.5% since March 2009 and there has been no decision to increase the amount of Quantitative Easing since July last year. So far, policy has remained unchanged under the new Bank Governor Mark Carney.

But despite the lack of action, this policy seems to have been good for the economy. Last summer, UK growth appeared to have stalled. But since then we have seen a pick-up in GDP growth, positive evidence from business surveys and the start of a renewed downward trend in unemployment. Car sales, the housing market and retail spending have been picking up. Business and consumer confidence have also been improving.  All this suggests that the more positive recent growth trend should continue, helped by signs that the Eurozone economy is slowly turning around. PwC’s latest forecast is for UK economic growth to pick up to 2% next year – the strongest year of the current recovery so far.

The attention now shifts to the Bank of England’s quarterly Inflation Report next week. The Report will contain the Bank’s normal forecasts for growth and inflation, which are unlikely to be particularly newsworthy. They are likely to suggest a steady recovery in growth and inflation gradually returning to target – a familiar pattern from previous forecasts. The more interesting aspect of the Inflation Report is likely to be the MPC’s statement on “forward guidance” which has been requested by Chancellor George Osborne.

In the world of monetary policy “forward guidance” is an indication from the Central Bank about what it plans to do next. To date, the MPC has been reluctant to give any firm indication of its future intentions. Under the two previous Governors, Eddie George and Mervyn King, the approach was to take each MPC decision one month at a time. The Bank’s Inflation Report provided forecasts of what the Committee expected to happen to growth and inflation – which were two key factors affecting its future decisions. But these forecasts come in the form of fan-charts showing a wide range of uncertainty about future prospects.

The difficulty about highlighting all these uncertainties is that it makes the rest of us feel uncertain. And at a time when the challenge is to build confidence in the recovery, this could be a negative factor. Mark Carney, the new Bank of England Governor, took a different approach in the spring of 2009 when he was in charge of the Bank of Canada. He made a commitment to keep interest rates at the very low level of 0.25% for at least a year.  His idea was to reinforce the view that interest rates would remain low for a while, to help the turnaround in the economy.

This is not the only form that “forward guidance” can take. The US Federal Reserve has taken a different approach. It has committed itself to keep interest rates at their current level until the unemployment rate falls below a certain level – 6.5% of the labour force – and inflation remains well-behaved.  Unless one of these thresholds is breached, interest rates will remain at their current levels until mid-2015.

This is the form of guidance which we are most likely to get from the Bank of England this week – a view that interest rates are likely to remain at current very low levels for a while longer, unless growth or inflation is significantly higher than the MPC currently expects. It is possible that the MPC will set an unemployment threshold like the US Federal Reserve. But guidance based on GDP growth and inflation would be more consistent with the Bank’s existing forecasting framework.

Such guidance from the MPC, however, may not be as helpful as it looks at first sight. First of all, it will not significantly change the view of the financial markets, business and the public about the short-term outlook for interest rates. All the signals the MPC has given since the financial crisis is that the Committee is reluctant to raise interest rates until the economy appears much stronger than it is now. Interest rates have been kept at record low levels despite persistent above-target inflation. So a formal announcement that the MPC is not prepared to raise interest rates unless growth is stronger or unemployment is lower only confirms what we know already.

Second, the recent forecasting record of the MPC underlines the difficulty of offering guidance about the future.  Generally, the Bank has been too optimistic in its forecasts for growth and inflation since the financial crisis. The UK economy, like other western economies, is affected by a “new normal” of weaker growth, more volatility and persistent inflation shocks from rising energy and commodity prices.  In this environment, monetary policy may also need to respond differently from past norms and the “forward guidance” offered by a well-meaning Central Bank could be overtaken by events.

Third, the “forward guidance” offered by the Bank of England next week is unlikely to answer the most important question facing the Bank of England over the next few years: how it will manage the exit from the very low interest rates put in place during the financial crisis and return to the market the £375bn of government bonds it accumulated through Quantitative Easing? My view is that these policies can only be unwound without damaging confidence by proceeding slowly and gradually. But the more commitments that the Bank of England and other central banks make to hold interest rates low, the greater becomes the risk that the correction – when it comes – is more abrupt and is a big shock to us all.

For all these reasons, any “forward guidance” offered by the Bank of England this week is unlikely to change the outlook for the UK economy significantly. The economy is already on a recovery track, but growth is still likely to be slow by historical comparisons. The 2% GDP growth that PwC is forecasting for next year would be strong by the standards of the current recovery. But it is still less than any year of growth we saw from 1993 until 2007.

That is telling us something about the current growth environment and it is not unique to the UK. All the major western economies are facing a more difficult climate than before 2007. The tailwinds which supported economic growth before the financial crisis have been replaced by a set of headwinds which are contributing to a “new normal” of low growth for western economies. Access to finance is more restricted. High and volatile energy, food and commodity prices are squeezing living standards. And central banks and governments no longer have the room for manoeuvre to support growth – with interest rates already on the floor and large deficits and rising debts in most western economies.

This is a very difficult environment for central banks wishing to design “forward guidance” and we should not build up our hopes about its accuracy or effectiveness. After Mark Carney promised to keep Canadian interest rates at 0.25% for a year in 2009, he raised them very quickly to 1% in 2010. So when the world changes, monetary policy must also adjust. We may also find that in the UK, whatever the Bank says next week.

A version of this article was first published in the Sunday Times, 4th August 2013


Carney jumps the gun!

posted 4th July 2013

The Bank of England Monetary Policy Committee (MPC) was due to produce a view about the role of “forward guidance” on UK monetary policy alongside the August 2013 Inflation Report. This statement has been upstaged by its MPC statement today, aimed at slapping down expectations of interest rate rises next year – which had come to be priced into the market curve before the MPC meeting. MPC statements when there is no explicit change in policy are rare events – I can only recall one when I was a member of the Committee. So this is an important statement.

What did the MPC say? The key paragraph reads as follows:

“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report.  The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”

There are a number of puzzling aspects to this statement.

First of all, it represents a form of forward guidance – the MPC is saying they want to keep interest rates lower for longer than the market was currently expecting. This pre-empts the fuller statement on forward guidance which is due to be released alongside the August Inflation Report – but without the opportunity to explain in detail the MPC’s thinking.

Second, the MPC is using its interpretation of very recent data to make judgements about policy over the next 1-2 years. How has the MPC become so confident that it can predict policy 1-2 years ahead on the basis of current economic indicators? Experience teaches us that the economy is frequently subject to unexpected shocks, to which policy-makers need to react. A better way of providing  “forward guidance” is to link policy moves to the future path of the economy – but this was a step too far for the MPC in today’s statement.

Third, we could be more confident about this type of forward guidance if the MPC’s forecasting record had been more accurate in recent years. Unfortunately, the opposite has been the case. In particular, the MPC has consistently under-predicted inflation – its key target variable. And the negative reaction of the pound to the latest MPC announcement suggests that there may be more imported inflation in the pipeline over the next few months.

Mark Carney has jumped the gun. The media hype around his appointment was likely to make a “no change” decision disappointing. But this statement – a few days into his term as Governor – could be more problematic. In the western world, Central Banks face a strategic problem – of exiting from emergency monetary policies – put in place to deal with an extreme financial crisis from which we are now recovering. The challenge for Carney, Bernanke and his counterparts is to recognise and address this challenge. The longer they delay, by promising continued very low interest rates, the bigger the problem becomes for the future.


Inflation risks still on the upside

posted 16th May 2013

There is one thing which can be guaranteed when the Bank of England releases its quarterly Inflation Report – in two years’ time the central projection for CPI inflation is at or very close to the 2% target. Yesterday’s report was consistent with this tradition. Inflation is expected to rise to 3% or so in the short-term. But by 2015, it is forecast to be back around 2 percent.

Recent experience, however, does not inspire much confidence that this will be the case. Since the onset of the financial crisis, the only time when UK inflation was close to the 2% target was when it was artificially suppressed by a cut in the VAT rate to 15% in 2009. The rest of the time it has been persistently above the target, rising to over 5% in 2008 and 2011 and averaging over 3%.

There have been three main reasons for this persistent above-target inflation. First, surges in energy and commodity prices – including the price of oil – have pushed up the cost of imports. Second, the decline in the value of the pound has added to these imported inflationary pressures. And third, services inflation has remained stubbornly high – averaging close to 4% in the past five years.

The MPC’s latest forecast of inflation coming back to the 2% target requires all these sources of above-target inflation to subside. This seems quite unlikely.

First, the Bank of England forecast assumes that the world economy picks up over the next two years. When the world economy picked up in 2003/4, 2006/7 and in 2010, stronger growth was followed by a surge in energy and commodity prices. With strong growth expected to continue in resource-hungry emerging and developing economies, it is quite likely that a pick-up in global growth will be accompanied by a similar price surge in 2014/15.

Second, we cannot be sure that we have yet seen the full effects of the 20-25% devaluation of sterling since 2007. As the UK economy recovers, importers and domestic producers may seek to pass through import costs to consumers which they have been absorbing until now. And we cannot rule out the possibility of a further decline in the value of the pound if investor confidence shifts against the UK economy and sterling.

Third, it will be very difficult for CPI inflation to fall to 2% if the prices of services – which make up around half of the consumer basket – continue to rise at close to 4%. The MPC has been waiting for some time for low wage growth and spare capacity to feed through into lower services inflation. But this has not happened. One explanation is that inflation expectations in the services sector are running significantly above the target – which would point to services sector inflation remaining stubbornly high.

For all these reasons, it looks as if the inflation risks are still to the upside of the latest Bank forecast. The MPC will struggle to get inflation back to 2% over the medium term without some change in monetary policy.

This article was first published in City AM


The UK economy - doing better than we think

posted 2nd May 2013

Do last week’s GDP figures create a case for optimism about the UK economy? At face value - “No”. The first quarter rise in GDP was just 0.3% - an annual rate of growth of 1.2%. Looking back over the past year, the UK has grown by just 0.6%. These rates of growth are far from satisfactory at first sight – and well short of the 3% or so growth we enjoyed before the financial crisis.

But that is the wrong benchmark against which to assess recent economic performance.  Even though it wasn’t clear at the time, we now know our pre-2007 economic growth had insecure foundations. It was sustained by a world of easy money, cheap imports and excessive confidence in economic policy-makers. These growth tailwinds have now disappeared. And this has not just affected the UK. Growth across the whole Western world has been sluggish in the aftermath of the financial crisis – reflecting a “New Normal” of disappointing economic performance that is likely to continue through the mid-2010s.

The IMF estimate that this year GDP in the “advanced economies” – which includes the US, Japan and the leading European economies – will be just 3.7% above the peak of the cycle in 2007/8. At the same stage of the early 1980s and early 1990s recoveries, output had recovered to a level 15-16% above the peak (see Chart).

Though UK GDP has yet to recover its early 2008 peak, there has been a very big drag from three sectors of the economy which make up less than 20% of output and about 10% of jobs – financial services, North Sea oil/gas and construction. With the exception of the financial sector, the services activities which make up the bulk of our economy are doing well, which is why employment has increased so strongly. The private sector has created over a million UK jobs in the past two years.

And taking into account growth before the financial crisis as well as the last few years of disappointing economic performance, the UK scores surprisingly well in relation to its peer group of economies. As the chart below shows, the UK comes second behind Germany among the G7 in terms of the rise in living standards (GDP per head of population) achieved in the 21st century.  France and Italy are the real laggards on this measure. In the case of Italy, GDP per head has fallen by over 6% since the start of the new century.

The UK economy has some weaknesses, but it also has hidden strengths. While we no longer have the large manufacturing base which sustained our economy in the 19th and early 20th centuries,  we still have some world-leading manufacturers – in sectors like aerospace, high-technology engineering and pharmaceuticals. Our car industry achieved an all-time record level of exports last year.

The common characteristics of the sectors where the UK remains competitive in manufacturing are the deployment of knowledge, technology and skills. There is no future for us trying to compete in low wage, labour-intensive manufacturing industries which have migrated to emerging economies like China, India and Indonesia.

We also have some highly successful and competitive services sector businesses which compete very effectively on world markets.  The output of UK business and professional services has been growing at about 5% a year during this recovery. These are services which we sell to the rest of the world on the basis of our experience, reputation, knowledge and skills.

Education is another successful UK exporter – attracting overseas students who pay fees and spend money in the UK economy. The creative industries – music, fashion, art and design – are another area where the British economy has a strong competitive edge, helped by the global reach of the English language. Tourism, culture and heritage is yet another UK success story – hopefully boost ed by the Olympics last year.

We should recognise these pillars of success for the British economy and build on them. The UK’s future is as a high-skill, high-tech economy – selling products and services to the rest of the world which depend on our knowledge, reputation and experience.  We have a flexible labour market and the potential to create many new dynamic and innovative businesses, as long as regulatory burdens and excessive taxation do not get in the way.

In the “New Normal” economy affecting the whole Western world, our GDP figures will continue to look poor by comparison with the 1990s and 2000s. But if we continue to reinforce success in areas where the UK economy has a competitive edge – particularly in the services industries – the UK should still be able to perform well compared to our peer group of economies in northern Europe and North America.

A version of this article was published in City AM on 2nd May 2013.


"Monetary activism" is likely to end in tears

posted 24th March 2013

David Cameron and George Osborne (in his Budget speech last week) have committed the UK government to a policy of “monetary activism”. The intention is obvious. They want to use monetary policy to support growth in an environment in which other factors – fiscal tightening and the euro crisis – are holding back the UK economy.

This sounds good in theory. But in practice it won’t work. There are three good reasons why we should not try to apply a programme of further monetary stimulus to the UK economy in the present circumstances.

First, the UK economy is not as badly placed as the current media debate would suggest. Among the G7 economies, we have the second-highest rise in living standards (behind Germany) in the 21st Century (see chart, right). Employment growth has been especially strong, with over a million private sector jobs created since the trough of the recession. And our unemployment rate remains below 8%, compared with the situation in the early 80s and early 90s recessions when unemployment rose above 10% for a sustained period. These positive economic trends undermine the argument for further stimulus.

Second, we already have very extreme monetary policy settings designed to stimulate economic growth. The official UK Bank Rate has been sustained at a historic low of 0.5% for four years already. And the Bank of England has already accumulated a third of the national debt through its Quantitative Easing programme of purchasing UK government bonds. Despite these aggressive stimulatory policies, we have not seen a return to strong UK economic growth. And it is therefore doubtful that further stimulatory policies would have a beneficial effect.

Third, UK inflation is high. At 2.8%, CPI Inflation is above the 2% target and current forecasts from the Bank and independent forecasters suggest it is set to rise further. Inflation has averaged around 3.5% in the past three years – and the stimulatory policies pursued by the Bank of England Monetary Policy Committee (MPC) have added to recent inflationary pressures. In particular, money creation has depressed sterling and aggravated imported inflation even though wage growth has been subdued.

So the danger is that further “monetary activism” by the Bank of England is not needed, will not work, or will just add to inflation.

What should the Bank do instead? Despite various tweaks to the monetary policy framework announced in the Budget, the target for the MPC remains 2% inflation – which is a working definition of price stability. That remains a sound objective. But we have not seen a sustained period of inflation around this level since the mid-2000s. So the first thing that the MPC should do is ensure that they steer inflation back to the 2% target.

This may require higher interest rates, but that might not be a bad thing. Low interest rates are a short-term palliative for the economy and if we become too dependent on low borrowing costs, this can be a drag on growth, as Japan found out in the 1990s and early 2000s. Also, savers are suffering heavily in the current climate of extremely low interest rates. That is not a good signal in terms of the incentive to save and invest – which is a vital ingredient for longer term economic growth.

We should replace the emphasis on “monetary activism” with “monetary realism”. While monetary policy can help stabilise the economy in the short-term, as it did in 2009, it cannot drive growth in the long  run. Indeed, our experience in the past has been that very expansionary monetary policies just  end up supporting higher inflation –and we have already seen signs of this in the UK in the past few years.

In addition, if the UK government appears to be changing the Bank of England’s monetary remit to suit its own political agenda, that is a serious threat to the Bank’s independence and credibility. So Cameron and Osborne should be careful. We need monetary realism, not an activist monetary programme. Attempts to force growth higher with monetary policies have generally ended with higher inflation or financial instability. “Monetary activism” is likely to end in tears..


Central bankers are not Masters of the Universe

posted 27th February 2013

In 2009, when we were rocking and reeling in the wake of the financial crisis, the actions of Central Banks played a key role in stabilising economies and laying the foundations for economic recovery. But in many economies, including the UK, the recovery has been disappointing. This has contributed to the view that Central Banks need to “do more” to stimulate economic growth.

Central bankers themselves have encouraged this view. In the US, the Federal Reserve has embarked on successive rounds of Quantitative Easing (QE) and has recently committed itself to keeping interest rates at their current extremely low levels until unemployment falls below a key benchmark level. Mark Carney, the Governor of the Bank of Canada who takes over at the Bank of England this Summer, told us at Davos that he did not think Central Banks were “maxed out” in terms of the stimulus they could provide to support economic growth.

And, this week, we found out from the MPC minutes that the current Governor of the Bank of England and two of his MPC colleagues were keen to go down the same track. They voted for further QE purchases of government bonds in the hope that this would lead to higher output growth. This is despite the fact that previous asset purchases have already led to an accumulation of a third of the UK national debt in the vaults of Threadneedle Street.

There is a danger we are falling into a similar trap which ensnared the major western economies in the decade before the financial crisis. Private sector bankers, who believed themselves to be “Masters of the Universe” fuelled a global credit boom which went spectacularly bust in 2007/8. Now, there is a danger that we are putting excessive faith in new “masters of the universe” – the ability of Central Bankers to sustain economic growth through the magic of money creation.

These policies are not working because they do not address the main reasons why the major western economies – including the UK – are currently locked into a low growth cycle. The key forces underpinning slow growth lie predominantly on the supply-side of the economy. Western economies enjoyed a long growth boom from the 1980s until the mid-2000s underpinned by three main forces – easy money, cheap imports and confidence in the ability of Central Banks and governments to keep economic growth and inflation on a steady course. All three of these conditions have been undermined by recent global economic developments.

First, we are no longer in a world of easy money. The banking system has been traumatised by the experience of the financial crisis, and regulators are now encouraging banks to be much more cautious in their approach to lending. Second, the world of cheap imports – driven by low energy prices and the entry of low-cost producers like China into the world economic system – has also come to an end. It has been replaced by repeated upward shocks to energy, food and commodity prices as the growth in Asia and other emerging market economies becomes more self-sustaining.

A third factor underpinning growth in major western economies before the financial crisis was confidence in the private sector that governments and central banks could maintain stable economic conditions. That private sector confidence has been replaced by a prevailing mood of uncertainty and lack of confidence in which companies and consumers feel reluctant to commit themselves to major new projects and expenditure.

Monetary policy cannot recreate these pre-2007 conditions. Extremely low interest rates may support growth by providing respite to borrowers for a while. But when savers start to adapt to low interest rates, they too cut back on expenditure. Over a long enough period of time, the short-term boost to economic activity fades away.

The same is true of Central Bank purchases of government bonds. They push down longer-term interest rates and boost confidence – which can support economic activity for a while. But once the medium-term consequences of these policies become clearer they are likely to be a drag on economic growth. Pension funds suffering low returns turn to their sponsoring firms for a top-up – reducing the funds available for business investment. Savers recognising that their longer-term income has been hit start to cut back expenditure.

This is not a new insight. Economists have long recognised that monetary policy can help smooth out short-term fluctuations in our economy. But a deliberate policy of excess monetary expansion will ultimately lead to inflation or other financial imbalances, which then needs to be corrected.

So how does this apply to the current situation facing the UK economy? The perception in the UK is that the performance of our economy has been disappointing. That is true in relation to past growth trends – GDP growth in the quarter century before the financial crisis averaged over 3% per annum and we have struggled to achieve growth of around 1% since then.

But other aspects of our economic performance have been more positive. The UK labour market has been very flexible, helping to support employment – and this week we saw another set of positive jobs numbers. Total employment in the UK is around 600,000 up on a year ago and over half of this growth is in terms of regular full-time employment.

UK economic growth also looks much better in relation to our peer group when we take into account the period before the economic crisis. As the chart above shows, going back to 2000, the UK is second among the G7 economies in terms of the growth of GDP per head of population – which is a widely used measure of broader living standards. We are just behind Germany, which appears to be the superstar western economy in the aftermath of the financial crisis. But on this key measure we are ahead of the US, Japan, Canada (Mark Carney, take note) and other European economies.

Where the UK looks less good is in terms of very recent growth performance and inflation. But in my view these failings are connected. We have acquiesced to a relatively high rate of inflation driven by a weak pound, which in turn squeezes consumer spending. The much hoped-for benefit of sterling devaluation for the UK economy has not materialised. But that should not be a great surprise. The last time the UK experienced a large devaluation in its currency, from the mid-60s to the mid-70s, it ushered in a period of dismal economic performance. We seem to be repeating the mistakes of the past in hoping for the quick fix of a weak pound to help our underlying growth performance.

The fact that UK inflation looks set to continue above target for at least the next couple of years will add to the concerns of holders of sterling. As the chart shows, the Bank’s forecasts have persistently underpredicted inflation since the financial crisis. So it is not surprising that the markets greeted the votes of Mervyn King and his two other MPC colleagues for more QE by dumping sterling once again last week.

So what is the way forward for the UK and other western economies? We need to recognise that growth will be disappointing in relation to past trends and that major structural adjustments are needed in our economies. But expecting Central Banks to sort out these problems is looking in the wrong direction. Monetary policy is a short-term palliative. But the longer we cling on to the hope it will boost longer term economic performance, the more likely it is that we will delay the necessary changes to our tax system, business regulation, infrastructure plans and education and skills policies which will ultimately be needed to deliver a return to healthy growth in the UK economy.  

A version of this article was published in the Sunday Times on 24th February 2013

Down down, deeper and down for sterling

posted 2nd February 2013

Before the Second World War, the UK pound held its head high in the world of international finance. The UK was the dominant economic power in the 19th century  and sterling’s link with gold helped to establish the gold exchange standard which prevailed across the global economy until 1914. The UK remained committed to gold after the First Wold War, and briefly returned to its pre-WW1 parity from 1926-1931. And even though the UK departed from the gold standard in 1931, it was soon followed by the US (in 1933) and other European nations.  As a result, the external value of sterling against other currencies was sustained in the 1930s.

It was after the Second World War, when sterling began its long decline. Immediately after WW2,  the pound returned to a parity of £1= $4, which was not far out of line with the value it had sustained against the US dollar before the Second World War and in the 19th Century. But this proved unsustainable and sterling was devalued in 1949 to $2.80, alongside a number of other realignments of European currencies.

This parity was sustained under the Bretton Woods system of fixed exchange rates until 1967 when sterling was devalued again from $2.80 to $2.40. That was the beginning of a slippery slope for the external value of the UK currency. After the Bretton Woods system broke down in the early 1970s, sterling fell rapidly to around half of its late 1960s value (see chart) in 1976 - when the UK was obliged to request IMF assistance, a humiliating experience for a major industrialised nation.

Contrary to expectations in the late 1970s, sterling stabilised and maintained a fairly consistent value against its major trading partners for the next 30 years. In the late 1970s and early 1980s, sterling was supported by a petro-currency effect as North Sea oil came on stream – with the pound rising above $2 again in the early 1980s. The UK’s improved inflation and growth performance in the 1980s also provided a support to sterling.

Sterling suffered again in the Lawson boom of the 1980s, but the high interest rates introduced to rein in the boom supported the UK currency. And though the attempt to peg sterling against the Deutschmark and other European currencies failed in the early 1990s, the depreciation which followed the pound’s departure from the ERM was short-lived. The pound appreciated strongly in 1996/97 and maintained a relatively stable value from then until 2007.

The financial crisis of 2007/8 precipitated another fall in sterling. Between mid-2007 and early 2009, the UK currency fell by around 25% against the euro, dollar and other currencies. At that time, sterling’s decline appeared to be justified by the perception that that the financial crisis would have a disproportionate impact on the UK economy. As it turned out, that was not the case.  But the dovish stance of the MPC – resisting interest rate rises in 2010/11 and pursuing second and third rounds of QE – worked to prevent any substantial rebound in sterling.

Sterling did strengthen somewhat in 2012, as financial flows sought a safe haven outside the euro area. But these flows are now reversing.  And currently there is little official support for sterling – with the Governor of the Bank of England and government ministers arguing publicly that a weak pound is necessary for the “rebalancing” of the UK economy – despite relatively little evidence so far for that proposition. (See my recent PwC blog – “Still selling England by the pound”.)

With this lack of official support, recent poor growth figures, relatively high inflation and stubbornly high public borrowing, it is not surprising that sterling is under pressure. And it is not clear that the recent pattern of sterling decline can be easily reversed. In the words of Status Quo, it appears to be "Down, down, deeper and down" for sterling!

Don't abandon the inflation target!

posted 5th January 2013

Last October, the UK passed the 20th anniversary of inflation targeting. Since 1992, a target of low inflation has been the key anchor for our monetary policy framework. Though there have been a couple of slight adjustments to the target – in 1997 and 2004 - for more than 20 years the UK has benefited from a remarkable degree of consistency in our monetary policy framework.

We have to go back to before the First World War – under the Gold Standard - to find such a long period of stability in UK monetary policy. Since then, the only other period which comes close was 1949-1967, when the value of the pound was pegged at $2.80 against the dollar.

Mervyn King marked the 20th anniversary of inflation targets last October with a speech broadly supportive of this approach. But not long after that, his successor - Mark Carney – suggested that a nominal GDP target might have some advantages.  And the Chancellor of the Exchequer appeared to encourage this debate on the objectives of monetary policy – suggesting some change might be on the cards.

There are three main strands to the argument for change. The first is that by focussing on inflation, Central Banks stifle growth and contribute to high unemployment. However, this view is not borne out, either in theory or practice.

In theory, the argument for focussing on an inflation target is that it builds confidence - in business, in financial markets and with the public more generally - that price stability will be maintained. This creates a much better climate for wealth creation and economic growth over the medium-term, removing a key source of uncertainty and volatility.

In practice, the British economy has performed relatively well under an inflation target regime. UK economic growth in the two decades to 2012 averaged 2.3%, despite the impact of the financial crisis - a respectable rate of progress for a mature western economy. Unemployment has averaged 6.8% of the labour force in the inflation target era, compared with 8% in the two decades before. And in the aftermath of the financial crisis, unemployment has not risen as high as it did in the 1980s and early 1990s, and job creation in the private sector over the recovery has been impressive.

It would also be hard to argue that the inflation target has held back the Bank of England from injecting economic stimulus. In response to the financial crisis, the Bank has cut UK Bank rate to its lowest level in recorded history and kept it at this exceptionally low level for nearly four years. It has also undertaken a substantial programme of Quantitative Easing – accumulating £375bn of bonds on its balance sheet.

A second argument levelled against inflation targets is that this was the dominant paradigm for monetary policy in the run-up to the global financial crisis. So why was monetary policy not more effective in preventing such extreme and damaging economic events?

The short answer is that while an inflation target approach should help to stabilise economies, it does not remove all sources of economic and financial instability. In the highly globalised economy we now live in, there are many other sources of volatilty, notably in the financial sector. But the solution lies in addressing these problems at source – with better financial regulation and international co-ordination. To expect monetary policy to address all these sources of instability single-handed is totally unrealistic.

A third problem frequently cited with inflation targets is that they do not distinguish between domestic and global sources of inflation. If inflation arises from global energy and commodity price rises – as it has recently – it may require a different response from inflation driven by a domestic wage-price spiral, as long as the resulting inflation does not become self-sustaining.

This argument makes sense for genuine one-off shocks. But what if these shocks to energy and commodity prices are repeated, as they have been over the past decade? One approach is to look to an appreciating exchange rate to offset these global inflationary forces.  However, that has not been the policy of the Bank of England. Instead, Mervyn King and other key MPC members have generally emphasised the benefits of a weaker, rather than a stronger pound.

Any monetary policy framework needs some degree of flexibility to deal with unexpected shocks. But in the UK, the Bank of England has persistently accommodated inflationary shocks from a wide range of different sources, with inflation averaging close to 3.5% over the past five years. And the public now appears to be expecting future inflation to continue at around 3.5% as a result.

Rather than shifting away from an inflation target, we need to make our current monetary framework more transparent and more credible.  That should include setting out more clearly the Bank’s strategy for containing the inflationary impact of global energy/commodity prices and a weak pound and making clear the circumstances in which interest rates would start to rise.

There will be an opportunity to do just that in the next few months when –as seems very likely – inflation exceeds 3% and the ”Open Letters” between the Governor and the Chancellor resume.  In the past, these letters have offered little indication that the MPC was prepared to take action to bring inflation back to target and the Chancellor has not raised any issues with this “hope for the best” approach. In future, both parties should aim to make this correspondence much more substantive and informative about future policy and the commitment to price stability.  

A version of this article was published in the Financial Times on 3rd January 2013

Why has services inflation been so high and so persistent?

posted 2nd January 2013

In October 1992, the UK government introduced a framework based on an inflation target to guide monetary policy decisions. For the first 15 years of this period, things seemed to go pretty well. Inflation averaged very close to the target – initially 2.5% for RPIX and then 2% for CPI (from 2004). But this “good” average performance concealed very different trends in the main components of the inflation index.

This is illustrated clearly in the chart below. Services inflation has averaged consistently close to 4%, double the current inflation target, since the early 1990s The only reason why overall inflation performance was satisfactory until the mid-2000s was that the UK experienced static or falling goods prices. This was the product of two main factors – the appreciation of sterling in 1996/97 and the impact of China and other low-cost producers on global prices from the 1990s onwards.

However, both of these disinflationary forces have now disappeared. Since the mid-2000s, the global economy has provided an inflationary impetus as a result of upward pressure on global energy and commodity prices. At the same time, strong growth in China and other emerging market economies has resulted in high domestic cost inflation in these economies, which has also added to the cost of imports to western economies like the UK.

For the UK, rising import costs are being reinforced by a falling currency. Sterling depreciated sharply against other currencies in the global financial crisis. Over a 2-year period, this marked the biggest fall in the value of sterling against our major trading partners since 1931, when the UK departed from the Gold Standard.

No longer is the UK benefiting from a favourable tailwind of flat or falling goods prices. This puts the spotlight on the persistence of services inflation.

If UK services inflation –accounting for about half of the consumer basket – continues at around 4%, it is unlikely that the UK will achieve and sustain inflation at 2% or below. So why has UK services inflation been so persistently high?

Three main influences have been at work. First, services sector prices are much less exposed to international competition – which has been the main disinflationary influence on the UK in the past two decades. The prices charged by car park operators, piano tuners, restaurants and other suppliers of consumer services are not subject to the rigours of international competition in the same way as retailers of goods who can take advantage of purchasing at the most competitive prices on global markets.

Second, until 2007, consumer spending growth in the UK was very buoyant and this created an environment in  which firms found it very easy to increase prices. That should have changed with the onset of the financial crisis, but it didn’t. Big cuts in interest rates and the additional stimulus from Quantitative Easing encouraged companies to raise prices in the same way as they had before the recession. In “economic-speak” we did not see the sharp jolt to inflation expectations in response to the recession, because policy-makers have been so clearly focussed on maintaining demand.

Third, the signals sent by government and the Bank of England have been very tolerant of high inflation. Very significant deviations from the 2% inflation target have been tolerated without any policy response from the Bank of England in the form of higher interest rates. Aand the letter exchanges between the Governor and the Chancellor have shown implicit government support for this strategy. At the same time, there has also been little government resistance to very substantial increases in regulated prices. Last year, UK postal prices rose 30—40%. Rail fares rose this January by over 4%. And car park charges at London Underground stations are set to rise by nearly 20% this year.

These three factors have helped to sustain a view that prices in the UK services sector can rise at around 4% or more, despite the impact of the recession. Without a change in this inflationary psychology, it will be almost impossible for the MPC to hit its 2% target. The amazing thing  is that the MPC seems so unconcerned about this situation, and is happy to trust in hope that inflation will eventually come back to target or fall below – when our experience over the past five years has been totally contrary to this view.

Articles from 2012

The future of UK monetary policy (13/12/12) Time to start preparing the monetary exit plan (8/11/12) Stockton lets the MPC off the hook (4/11/12) Tough times to continue for UK consumers and retailers (22/10/12) The financial crisis - five years on (10/8/12) UK monetary policy needs a fundamental rethink (19/7/12) Time to call time on more QE (9/7/12) Disappointing but predictable response from the MPC (5/7/12) Good news from the labour market (23/6/12) The Queen of prosperity, growth and inflation (4/6/12) Monetary policy dilemmas in the "New Normal" economy (10/5/12) Inflation and rising interest rates back on the agenda (22/4/13) Defining recessions - 2 out of 3 is bad! (30/3/12) The next energy and commodity price surge is underway (19/3/12) Wanted! A focus on tax reform in the Budget (18/3/12) Time to start the shift away from emergency policies (4/3/12) Economic policy-making is "All Shook Up!" (23/2/12) Learning to live with the "New Normal" (11/2/12)


The future of UK monetary policy

posted 13th December 2012

Two recent developments have sparked a debate on the future of monetary policy in the UK.

In a speech on Tuesday 11th December, the Bank of England Governor designate, Mark Carney, floated a suggestion that a nominal GDP target might be more appropriate to an economy where interest rates were close to zero and monetary policy was in danger of becoming ineffective. The next day, the US Federal Reserve issued a statement which set a firm target for the unemployment rate as part of its monetary policy framework:

“The Committee … anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

This has sparked a debate in the media and among economic commentators on whether the current UK inflation target framework should be replaced by an approach which gives more weight to the real economy. George Osborne, in his evidence to the Treasury Select Committee on Thursday 13th December, has appeared to encourage this discussion, welcoming the contribution by Mark Carney to the debate on monetary policy and noting that “there was a lot of innovative stuff happening around the world” – though he also commented that the current inflation target framework had “served us well”.

So is there a case for a change in the UK’s monetary policy framework – in particular shifting away from the current inflation target approach?

The first question to ask is whether the UK inflation target framework has held back the growth of the UK economy? In my view the answer is “No”. Before the financial crisis, the UK economy grew extremely strongly. GDP growth from 1997 to 2007 averaged 3.2% a year and consumer spending averaged 3.7%. These figures compare with a long-term trend growth rate for the UK of 2-2.5%. In other words, for the first ten years in which the MPC was in control of UK monetary policy under the current  inflation target framework, UK GDP rose by about 10% more than longer term trends might have suggested, and consumption rose by about 15% more. A rational observer might have concluded a day of reckoning was coming, and it indeed arrived with the onset of the financial crisis.

Not surprisingly, more recent growth performance has been disappointing – but that reflects the big adjustments that the UK economy has been making as the imbalances that grew up in the 1990s and early 2000s are corrected. GDP fell by around 5% in the recession and has recovered only around half of that shortfall so far. But from 1997 to 2012, GDP growth in the UK has averaged around 2% - broadly in line with longer run trends. It is hard to make the argument that over the period when the MPC has been operating UK monetary policy under an inflation target regime, growth has been stifled below long-run trends.

Second, over the period since the financial crisis, the MPC has acted in a very judgemental fashion and has effectively ignored inflation as an input into its longer term decisions. The Committee cut interest rates aggressively in 2008 when inflation had just spiked at over 5%. It also reintroduced QE in 2011 when inflation had just hit another 5% spike. On both occasions the justification was that inflation was set to fall back to target and was in danger of remaining below it for a sustained period. These forecasts have proved remarkably inaccurate. Instead of inflation falling below target it remains stubbornly above it. The credibility of MPC forecasts of inflation has been seriously eroded. Indeed, a  recent review of Bank of England forecasting performance conducted by Dave Stockton from the US Federal Reserve concluded that the Bank’s forecast errors had been bigger than other central banks and also larger than other private sector forecasts for the UK economy. (See my review of the Stockton Report below.)

Third, the UK’s unemployment performance through the recent recession has been much better than in previous downturns – in the early 1980s and early 1990s. The unemployment rate has risen to around 8% instead of the 10-`12% seen in the aftermath of the previous two recessions. And job creation has been strong – with over a million new private sector jobs added over the recovery since mid-2009. This partly reflects the increased flexibility of the UK labour market and other structural factors which have changed in our economy over the last 2/3 decades. But it also reflects the very accommodative stance of UK monetary policy through the recession, which has eased some of the pressures on businesses to shed workers.

So what is the case for changing the Bank of England’s monetary policy remit? Growth has been in line with past trends, taking good times with bad. And the period of weakest growth performance has coincided with a period when the Bank has largely set asides its inflation target remit. Employment has held up better than we might have expected. To me, this looks like a case for reinforcing the Bank of England’s inflation target remit, not changing it.

As for the Fed’s idea of setting targets for the unemployment rate. Milton Friedman effectively demolished this idea in his 1967/8 AEA Presidential address.  I cannot do justice to his arguments in this blog – but he devoted a long section to rebutting the idea that monetary policy can affect the rate of unemployment on a sustainable basis. I am not aware that Friedman’s analysis has been significantly undermined by later research.

In the longer term, most economic research suggests that the level of unemployment and the rate of economic growth are driven by supply side factors, not monetary policy. That might explain why the MPC has been so unsuccessful in promoting growth with their very stimulatory monetary policies. A rethink is needed – not on the inflation target – but on the conduct of monetary policy within the current framework by the MPC and on the government’s supply-side agenda for boosting growth.

Time to start preparing the monetary exit plan

posted 8th November 2012

The MPC has brought its programme of asset purchases to a halt again. This partly reflects better news on the UK economy over the last few months. But it may also indicate that the MPC is beginning to doubt the effectiveness of continuing to provide further monetary stimulus through Quantitative Easing (QE).

In 2009, cuts in interest rates and the first round of QE helped stabilise the UK economy in the immediate aftermath of the financial crisis, and provided the basis for a slow recovery. Growth has been disappointing – but this may not be something that can be addressed by monetary policy.

In my view, relatively slow growth is part of the “new normal” for the UK and other western economies and reflects the departure from the world of easy money, cheap imports and strong confidence which prevailed before the financial crisis. That world cannot be recreated imply by providing more and more demand stimulus. The major western economies including the UK face a prolonged process of economic adjustment, and this is not an environment in which we should expect growth to return to the rates we were accustomed to before 2007.

So monetary policy is on hold for now . But at some point the MPC needs to plan for an exit from the very stimulatory monetary policies that have been pursued in recent years. The current official Bank Rate of 0.5% is not only low by recent standards. It is the lowest in the history of the Bank of England and much lower than the 2 percent rate which prevailed in the Great Depression of the 1930s.

The MPC strategy so far has been to wait until the “time is ripe” for interest rates to rise – a combination of strong growth and an inflationary threat which justifies rising interest rates. But in the current “new normal” world it will be very difficult to judge the right economic conditions to start raising interest rates. The recent growth and inflation performance of the UK economy has been very different to the experience before the financial crisis. There is a risk that the time never appears to be right to raise interest rates and unwind the bond purchases made under Quantitative Easing.

This scenario raises a number of concerns. First, a rate of interest which compensates savers for inflation and provides a reasonable return in real terms is one of the mechanisms which ensures that investment funds are deployed efficiently to support the long-term growth of the economy. There is therefore a serious risk that the growth potential of the UK economy will be harmed by a very prolonged period of exceptionally low interest rates. Second, the longer we persist in a world of very low interest rates, the greater will be the shock to the private sector when interest rates do start to rise. Businesses and households are likely to be able to plan for and adjust to a gradual approach to raising interest rates over a number of years.

A third concern is the impact on the credibility of the Bank of England and perceptions of its independence. The Bank has so far been reluctant to raise interest rates, even though inflation has been almost continually above the 2 percent target since 2007/8. If this situation persists – as it could well do – the credibility of the Bank’s commitment to stable prices will increasingly be questioned. Similarly, if the £375bn of bond purchases made by the Bank through QE are not eventually unwound, it may appear that the Bank has printed money simply to finance the government’s deficit – a policy which has created inflation and threatened the financial stability of economies in the past.

A better strategy would be for the MPC to plan for a gradual rise in interest rates, accompanied by a gradual unwinding of its QE asset purchases over the next few years. It would be unrealistic and undesirable for interest rates to go back quickly to the rates seen before the financial crisis. But a gradual rise to around 2-3% over the next 2-3 years would help the economy to acclimatise to a more normal level of interest rates – allowing firms and households to plan accordingly. This would help avoid the twin risks of a very prolonged period of exceptionally low interest rates - which could be damaging for longer term growth - and a sharp lurch in monetary policy which derails the recovery.

Interest rate rises may not be on the agenda yet. But if the economy continues to grow next year and the recovery becomes more strongly established – as economic forecasts generally suggest - it will make sense for the MPC to start planning for an exit from the emergency monetary policies which have been in place since early 2009.

This blog summarises a longer article in the November 2012 Economic Outlook which is available on the PwC website and also contains updated forecasts for the UK economy.

Stockton lets the MPC off the hook

posted 4th November 2012

I was very pleased earlier this year when the Court of the Bank of England commissioned a review of the MPC forecasts published in the Bank’s Inflation Report. In my last year as an external member of the MPC, I had publicly outlined my own critique of the Bank of England’s approach to forecasting inflation.

My argument was that the Bank of England staff and the majority of MPC members were putting far too much weight on the view that there was a large "output gap" which would drive down inflation. And they gave far too little recognition to the role of the global economy, the growth of nominal spending and movements in the sterling exchange rate in pushing up inflation.

I set out my arguments in a number of speeches and articles in the first half of last year – notably my “Selling England by the Pound” speech in February 2011 and my penultimate MPC speech in Manchester in April. And my prognosis turned out to be broadly correct. I argued that the Bank forecasts driven by the consensus view on the MPC were far too optimistic about a fall-back in inflation. Inflation peaked at over 5% last autumn and has yet to fall back below 2%.  Rising energy and food prices this winter probably mean inflation is set to rise again – towards the 3-4% level which has been the average inflation rate since the onset of the financial crisis. By contrast, MPC forecasts have tended to project medium-term inflation at around 1-2% and continue to do so.

The Bank of England forecast review – which was conducted by Dave Stockton, an experienced economic forecaster from the US Federal Reserve – has now been published. It contains some useful recommendations – particularly in terms of the process of carrying out the forecast. However, Stockton ducked the key issue of whether the MPC’s approach to analysing the economy was a key factor contributing to its forecasting errors.

Here are two key paragraphs from his report:

69. On the whole, I find the Bank narrative for its forecast errors of recent years reasonably persuasive, assuming that I have stitched it together correctly. But that narrative leaves open the question of whether the serial persistence of the MPC’s recent errors represents only a string of bad luck, points to some slowness in responding to these errors as they became apparent, or reflects a deeper flaw in the analytical framework of the MPC. And, the lack of more detailed quantitative support for the narrative makes it quite difficult to assess its balance and completeness.

97. Some former MPC members that I interviewed reported that they encountered difficulties getting divergent points of view to be seriously considered in the forecasting process. As expressed to me, the problem was one of breaking strongly held "house views" on key issues relevant to the forecast. Some examples provided were the magnitude and duration of the effects of financial shocks on aggregate demand, the effects of house prices on consumer spending, and the effects on aggregate prices of relative price shocks, such as changes in oil prices. As noted above, for a brief period in the early 2000s, some MPC members requested an additional table be included in the Inflation Report to illustrate the consequences of their alternative judgments about key aspects of the forecast. More recently, the public surfacing of such differences has relied on the initiative of the individual MPC members that have held divergent views.

These key paragraphs let the MPC off the hook in terms of its significant forecast errors. But they are not consistent. Para 69 says that the MPC was probably just unlucky and just made some bad judgement calls. Para 97 says that there were voices on the MPC alerting the Committee to these bad judgements. The fact that these voices (including my own) were downplayed or ignored could well mean that the way in which the MPC was looking at the UK economy and the outlook for inflation was wrong and is still wrong. But Stockton did not pursue this line of analysis in his report.

A comparison of UK inflation performance with the US and the euro area highlights the weaknesses in the Bank of England forecast narrative. Oil and commodity price inflation - which is cited as a major factor causing UK forecast inaccuracies - should have affected the UK, the US and the euro area inflation to broadly the same extent. And yet the US and euro area kept their inflation rates in line with a 2% target level (see chart). UK inflation was much higher, even though the MPC were projecting below-target inflation for most of this period.

It is domestic factors, rather than the global economy, which account for the UK’s high inflation and the forecasting failures of the MPC. These include the big decline in the sterling exchange rate. But the resilience of domestic demand and high and persistent service sector inflation have also played a part. These were all factors I highlighted in my late 2010 and early 2011 speeches as a member of the MPC.

I stand by the critique which I advanced in early 2011. The Bank of England continues to put too much faith in the power of the “output gap” to hold down inflation, and it continues to underplay the impact of the global economy and the exchange rate. This is not just a forecasting error – it feeds through into policy misjudgements. When the global economy was powering ahead in 2010 and early 2011, there was an opportunity to start to raise UK interest rates from the emergency levels in 2009. That opportunity was missed.

The exchange rate has been a powerful influence on UK inflation since 2007, and yet the MPC is reluctant to acknowledge that it can influence the value of sterling by changing UK monetary policy. This flies in the face of conventional open economy macroeconomics. In a relatively open economy like the UK, the impact of monetary policy on the exchange rate is a key channel through which changes in interest rates might affect inflation, and this was a key part of my argument for a modest tightening in UK monetary policy in 2010/11.

So 5/10 for the Stockton Report. It contains some valid criticisms of MPC processes and practices. But it ducked the key issues in terms of the way the MPC analyses the UK economy and produces its forecasts. In its approach to forecasting inflation, the Bank of England and the MPC still puts too much emphasis on the “output gap” and not enough on the global economy and the exchange rate. Until this is rectified, the MPC forecasting record will not improve.

Tough times to continue for UK consumers and retailers

posted 22nd October 2012

The UK and other western economies face a major adjustment to a dramatic change in the economic climate which has occurred since the financial crisis. The long period of economic growth from the 1980s through to 2007 (briefly interrupted by the early 1990s recession) was supported by easy money, cheap imports and strong confidence in the ability of governments and Central Banks to sustain steady growth and stable economic conditions.

These conditions have been undermined by the financial crisis and successive bursts of global inflation, driven by strong growth in Asia and other emerging market economies. Confidence in the ability of governments and Central Banks to sustain growth has been severely eroded.

In this “new normal” world, consumer-facing businesses, like retailing, face particular challenges. Not only has the macroeconomic environment become less favourable. Consumers are also shifting their patterns of spending, taking advantage of the new opportunities created by the internet.

Though the euro crisis is widely blamed for recent disappointing UK economic growth, the weakness of consumer spending has been a much more significant drag on the British economy in recent years. UK consumer spending accounts for 70% of UK GDP while our trade with the euro area accounts for just 15%.

Consumer spending fell sharply in the 2008/9 recession in both nominal and real terms. But the main factor squeezing consumer spending over the recovery has been inflation. Over the past three years, UK consumer spending in cash terms has risen by a respectable 4.4% per annum. If inflation had been around 2%, this would have translated into real growth of around 2½% - in line with the historical average over the postwar period . The problem has been that inflation has been around 4% rather than 2% and the resulting squeeze has reduced the growth of real consumer spending to just 0.4% per annum since the middle of 2009.

Food and energy have played a major part in generating this inflation squeeze. Food price inflation has averaged 5.3% per annum since 2007 and energy price inflation has averaged 7.6%. With continued strong growth from Asia and other emerging market economies putting upward pressure on the demand for energy and commodities, we are likely to see further bouts of food and energy price inflation in the future – squeezing consumer spending in the UK and other western economies.

This inflation-induced squeeze is easing in the short-term, with UK CPI inflation dropping to 2.2% in September 2012. But a new round of food and energy price rises is coming through the pipeline. So September’s figure is likely to be the trough of the recent inflation cycle. And when the global economy starts to pick up again in 2013 and 2014 – as most economic forecasters expect – these imported price pressures are likely to intensify.

In addition to these general factors squeezing consumer spending, traditional retailers face another structural challenge – a massive disparity between the growth in online sales and retail spending through traditional retail stores. Since 2007, the share of internet sales in retail sales (excluding motor fuel) has risen from less than 4% to over 10% - with internet spending growing at around 25% per annum in value terms. As a result, retail spending through stores has grown at 1.3% per annum in value terms since 2007, around 2% per annum below the pre-2007 growth rate.

The combined impact of the shift to internet sales and macroeconomic factors means that the volume of retail sales through traditional outlets is now around 20% below the level implied by a continuation of pre-2007 trends (see chart). This is creating pressure for a major structural adjustment in the retail sector. There are already high vacancy rates for retail properties, particularly outside the south of England. And recent research by PwC has revealed that multiple store chains made a net reduction of nearly 1,000 outlets in the first half of 2012 – a reduction of 1.4% in the total number of shops.

The outlook for UK consumer spending is for a gradual recovery in 2013 and growth of 1.5-2% per annum in the mid-2010s. However, this is around half the rate of consumer spending growth seen in the decade prior to the financial crisis. The challenges facing the retail sector which are now apparent are likely to persist for some time.

In this environment, it seems reasonable to expect further structural change in the retail sector. Along with other consumer-facing sectors, retailing faces a big adjustment to the “new normal” world of constrained finance, higher inflation and weak confidence. The growth of online retailing will contribute to this process of structural change. Retailers which can realise the cost and convenience advantages of multi-channel retailing will be much better positioned to achieve sales growth and protect profit margins than those locked into large legacy property portfolios.

For a more detailed paper on the implications of the “new normal” world for UK consumers and retailers, click here.

The financial crisis – five years on

posted 10th August 2012

This week marks the fifth anniversary of the first tremors of the financial crisis. In fact, the warning signs had been emerging before that. The MPC minutes for the meeting of 1st/2nd August 2007 read as follows:

“The main news this month in financial markets had been the sharp deterioration in credit markets and the associated falls in equity prices and changes in market interest rates. A trigger for this turbulence appeared to be renewed concerns about the US sub-prime mortgage market, the losses of some prominent hedge funds, and the revisions to the ratings of some mortgage-backed securities; this had led to a reduction in demand for products such as sub-prime mortgage-backed securities and collateralised debt obligations…. It was not clear how far the downturn in financial markets would go, nor how long it would persist.”

More than just a financial crisis

We now know that the downturn in financial markets was very serious indeed and its consequences are still with us today. But it is not just the scale of the financial shocks which hit major economies from 2007 until early 2009 which is making economic life so challenging at present. There are three other factors which are contributing to the current environment of disappointing growth and volatility which has become the “new normal” for the major western economies.

First, we are in the middle of a big geopolitical transition, as the Asia-Pacific region becomes the dominant force in the world economy – led by the emerging economic superpowers of China and India. The Asia-Pacific region – including Japan, Australia and New Zealand – now accounts for over 30% of global GDP, compared with 22% for the US and 24% for the European Union. No longer are the mature western economies the dominant force in the world economy.

This creates a disconnect between growth in the West and across the global economy more broadly. The world economy is still growing reasonably strongly – powered by Asia and other emerging economies - even though growth in the US and Europe is disappointing. The IMF’s forecasts still show global growth in the years 2011 to 2013 in the 3.5-4% range, above the 3.3% long-term average. One consequence has been a climate of much higher and more volatile energy and commodity prices – as successive price surges since the mid-2000s have eroded the low import costs which supported western consumer growth in the 1990s and first half of the 2000s. This erosion of cheap imports is being compounded by the impact of domestic inflation in emerging market and developing economies – expected to average 6% from 2011 to 2013.

The second factor aggravating the impact of the financial crisis is the need for many western economies to make structural adjustments to find new sources of growth after a long period of economic expansion. The UK and many other western economies enjoyed a long expansion which started in the early 1980s and was only briefly interrupted by the early 1990s recession. UK economic growth averaged 3% in the twenty-five years 1982 to 2007, very similar to the growth rate of the previous long expansion which included the 1950s and 1960s.

A key driver of this period of growth from the early 1980s through to 2007, was a process of supply side reform, liberalisation and regulatory change which allowed resources to shift from the manufacturing industries which had powered the 50s and 60s long expansion into the services sector. A key component of this liberalisation agenda was the deregulation of financial services, which broadened the access of consumers and businesses to sources of finance.

The financial crisis has undermined confidence in the ability of banks and financial institutions to operate safely and responsibly in such a deregulated climate. A process of financial re-regulation and reassertion of state control is underway. And in other areas of economic life – employment law, environmental protection, infrastructure development and planning – there has been a tide of re-regulation and increasing government intervention for some time. This creates potential barriers to the adjustment of the economy to the changed economic circumstances since the financial crisis.

The third ingredient contributing to a “new normal” world of disappointing growth and volatility in the major western economies is the difficulties which policy-makers are experiencing in adjusting to new realities. Prior to the financial crisis, an economic policy consensus had developed in the major western economies. As long as economies grew at a reasonable rate, public sector finances could be kept on an even keel and central banks appeared able to steer economies on a steady growth, low inflation course. In 2008/9, governments and central banks adopted extreme and emergency measures to stabilise their economies – very low interest rates, direct injections of liquidity and monetary stimulus, and various forms of fiscal stimulus. Five years on from the onset of the crisis, we are struggling to move away from these emergency policy settings. And there is a danger that persisting with these emergency stimulus policies over the medium term will add to distortions in the economy rather than facilitating the process of structural adjustment.

In the private sector, the fact that policy-makers are struggling to set a clear and credible medium-term direction for policy adds to the general feeling of nervousness and lack of confidence. It makes financial markets jittery and volatile. Businesses are reluctant to invest and hire new workers. And so we are stuck in a negative feedback loop of uncertain policy responses, financial market nervousness and weak private sector confidence. Breaking out of this loop is a key pre-condition of establishing a new and sustained growth momentum.

We need the right diagnosis

So what is the way ahead? The first step towards identifying the right policy approach is recognising the nature of the problem. And too much of the policy discussion so far has focussed on one dimension – the aftermath of the financial crisis and the problems in the banking sector. Yes, this is very important. But the reason why major western economies like the UK are struggling to recover their pre-crisis growth rates is that other factors are at play, which are having much broader and complex economic effects: the geo-political shift to the Asia-Pacific region, and the impact that this is having on energy and commodity prices; structural readjustment in western economies; and the need for policy-makers to rebuild confidence and credibility in the aftermath of the crisis.

The second key point to recognise is that we are not dealing with a simple problem of demand deficiency in western economies, even though that is the way the current situation is conventionally analysed by many commentators. There is plenty of demand in the world economy. World GDP in 2012 is expected to be 17.5% up in dollar terms on its 2008 peak, and nearly 25% up on the 2009 trough. And if demand is so weak, why has global growth been consistently above its historic average since 2010? Why has inflation been relatively high in so many countries, including the UK? And why are energy and commodity prices so high?

So those who argue that the solution is to inject bigger and bigger amounts of stimulus are basing their analysis on a mis-diagnosis. They are also advocating a return to the conditions which created the financial crisis in the first place. Advocating more borrowing and money creation as a way out of our current problems is actually an argument for returning to the conditions of the mid-2000s which precipitated the financial problems we are struggling to recover from.

The third key conclusion is that disappointing growth for western economies, accompanied by financial volatility and bursts of energy and commodity price inflation, is likely to be the environment we face for the next 3-5 years. So economic forecasts, public spending plans and private sector expectations need to adjust to this “new normal”. But that does not mean we all need to hunker down and endure a prolonged era of austerity. There will be growth opportunities in the economy – driven by technology, social trends, growth in Asia and emerging markets, and the restructuring of the economy. Don’t give up on growth – just recognise that it will not come in the same areas which benefited from the past debt-fuelled expansion, including property and housing construction.

What should policy-makers do?

Finally, what should policy-makers in the UK and other western economies be doing to encourage a return to stronger and more sustained growth?  I am sure the answer does not lie in more stimulus. Some of the most successful western economies in recent years – Canada, Germany, Sweden – are those which turned their back on stimulatory policies most quickly. There is no quick fix. The policies which will deliver economic success over the medium term are those that will help economies adjust to the realities of the “new normal” world.

So, here is my policy agenda for the UK for the next 3-5 years. First, stick with the government deficit reduction programme in terms of its general shape and direction. But ensure that the detailed composition of government spending and tax policy is much more supportive of wealth creation. Infrastructure spending has borne a disproportionate share of public spending cuts. Also, benefit recipients have seen their payments indexed for inflation while the wages of public sector workers have been frozen. Though the focus on deficit reduction is correct, the detailed implementation does not seem to be supportive of economic growth over the longer term.

Second, the MPC should change the focus of monetary policy – away from perpetuating the emergency policy stance which we established in 2008/9, towards a medium-term exit policy – of gradual and well-anticipated interest rate rises. Needless to say, continued injections of QE act in the opposite direction – perpetuating the view that lazx monetary policies can continue indefinitely. Another shift needed in monetary policy is a stronger emphasis on a stronger exchange rate to shield the UK from successive bursts of energy and commodity price inflation. We’ve seen little benefit from the current policy of exchange rate depreciation, as the UK’s manufacturing base is too narrow and specialised to benefit from a short-term cost advantage. Meanwhile, a weak exchange rate has menat that rising import prices have squeezed consumer spending – over and above the impact of rising oil and commodity prices.

Third, we need a stronger emphasis on supply side policies to help the UK economy to adjust to the realities of the “new normal” world. These policies should include: (1) Reducing the burden of regulation on normal business activity, including reforms to the planning system and employment law (including freezing the minimum wage); (2) Reforming the tax system by spreading the base of taxation, reducing rates, and shifting the burden of tax to spending rather than earning wealth; (3) Helping the labour market adjust by providing unemployed workers with the skills and opportunities they need to enter the world of work; (4) A much greater recognition within government of how well-meaning policy initiatives can make life more difficult for business. An independent competitiveness watchdog or regulator should be appointed to enforce this approach.

Learning to live in the “New Normal”

The world which has emerged since the financial crisis contains many challenges for the UK and other western economies. The key to managing these challenges, however, is not to look back to the policies which worked in the past. These policies were based on over-optimistic views of growth potential, an unrealistic approach to public finances and an excessive belief in the ability of central bankers to stabilise our economic affairs.

We need to shed these views which are rooted in a pre-2008 world, and focus on the future challenges. In the western world, the future belongs to highly competitive and flexible economies, which do not look to devaluation to address underlying competitiveness problems. Sound public finances and low inflation are still important pre-conditions for economic success in this new environment. But they are not enough. The key ingredient is the effectiveness, productivity and efficiency of the supply-side of the economy. That is where UK policy-makers now need to focus.

UK monetary policy needs a fundamental rethink

posted 19th July 2012

This week has provided some welcome relief from the doom and gloom with more reassuring UK economic data. Unemployment has fallen again (on the broader LFS measure). And inflation also came down more than expected – easing  the squeeze on consumers, which was particularly acute last year.

These figures were not available to the Bank of England Monetary Policy Committee when it took its decision to restart Quantitative Easing (QE) last month. But I was pleased to see from yesterday’s MPC minutes that this was not a unanimlous decision. Both my MPC successor Ben Broadbent and Bank Chief Economist Spencer Dale opposed the decision to restart QE. If I had still been on the Committee, I would have been on their side of the argument – as my vote on the Times Shadow MPC showed earlier this month.

But if I were still on the Committee, I would have gone further than this. I would have been arguing for a more fundamental rethink of UK monetary policy. We have had over three years of exceptionally loose monetary policy – with Bank Rate at 0.5% and three rounds of Quantitative Easing, totalling over £6,000 for every man, woman and child in the UK by the autumn. We have not seen such low interest rates in recorded history. Prior to the 2008/9 financial crisis, interest rates had not been below 2% in the preceding 315 years, including the Great Depression of the 1930s.

The idea behind these policies was to kickstart economic growth and to prevent deflation. Yet after an initial spurt in 2010, growth has been disappointing. And instead of deflation we have had persistently high inflation. Even though inflation fell to 2.4% in June, we should remember that it is still above the 2% target, and has only been below the target for just 12 months in the past 7 years.

The counter-argument is that things could have been much worse if different policies had been pursued. I dispute that. As a member of the MPC, I argued for gradual interest rate rises in late 2010 and early 2011. This policy could have had the impact of strengthening the pound and shielding us from very high imported inflation last year. And it would have been a strong signal to the private sector that the Bank was not prepared to allow them to pass through price increases to consumers. Both of these effects could have cushioned the squeeze on consumer spending which we saw last year – protecting, rather than damaging growth.

The majority of MPC members still seem to believe they are setting interest rates in a world governed by the rules which prevailed pre-2008, which was a regime of predictable steady growth and low inflation. In my view, we have entered a “new normal” world in which growth in western economies will be much lower for a prolonged period and the UK economy is subject to much more volatility – particularly from the global economy, energy and commodity prices and financial markets. There are many parallels here with the late 1970s and early 1980s.

UK monetary policy needs to adapt to this changed situation in four main ways. First, because inflation is subject to more volatility, we should not be overly worried about a period of below target inflation.  Indeed, we should welcome the current fall in inflation and the possibility that it could drop below target. Consumers would benefit from a period of sub-target inflation which compensated them for the big inflation overshoots in recent years.

Second, we should look to sterling to provide a better buffer against fluctuations in the global economy. In 2008/9, the MPC rightly welcomed the fall in the pound to help manufacturers in difficult global market conditions. But when the world economy picked up, we would have been better protected against rising oil and commodity prices if some of this exchange rate decline had been reversed. The MPC needs to recognise that sterling has a key role to play in stabilising the economy and controlling inflation, rather than simply asserting that a weak exchange rate is needed to “rebalance the economy”.

Third, the policy of responding to periods of disappointing growth with further injections of QE should end. QE may have been effective in 2009 in helping to stabilise the economy after a big shock from the financial crisis. But the financial and economic circumstances are now much less conducive to it having an impact. With bond yields now at very low levels, the policy has much less traction than in 2009 – and may create other financial distortions. And the “shock and awe” effect that injections of QE can have on confidence get weaker the more often they are deployed.

Finally, the MPC needs to develop a better medium-term plan for moving away from the extremely low interest rates which were put in place in 2009 and have been maintained since. Low interest rates help stabilise the economy in the short-term, but they risk becoming damaging in the longer-term – by squeezing savers, undermining the financial strength of pension funds and by creating unrealistic expectations in financial markets. Jaime Caruana, the head of the Bank of International Settlements (BIS), has warned recently of the damage created by long periods of low interest rates. He argues that this might hinder, rather than help, the adjustment of the economy following the global financial crisis. We should heed his warnings, not least because the BIS was the most vocal institution warning of the dangers of the global credit boom which led to the financial crisis in the first place!

We are now five years on from the first tremors of the financial crisis in July 2007. We are also five years on from the last rise in UK interest rates which also took place in July 2007. This is the longest period without a rise in interest rates in over 60 years. Now is the time for the MPC to reappraise its monetary strategy and adjust it to meet the challenges of the “new normal” world we now inhabit.

This is a longer version of an article published in The Times on Thursday 19th July 2012

Time to call time on more QE

posted 9th July 2012

It is hard not to feel some sympathy for my former colleagues on the Bank of England Monetary Policy Committee. The UK economy is being buffeted by a wide range of global economic forces over which they have little control – including the euro crisis and volatile oil and commodity prices. Growth has been disappointing and inflation too high.

This is in large part a reflection of the “New Normal” facing western economies as we grapple with the legacy of the financial crisis and the stresses and strains arising from the shift in the balance of economic power to the Asia-Pacific region and emerging markets.

In a different world – which existed before 2007 – it might have been right to respond to these threats to economic growth by providing extra monetary stimulus. But now that is not the right policy, and in my view it was a mistake for the MPC to return to its policy of Quantitative Easing (QE) last week.

First of all, the MPC has already injected a large amount of monetary stimulus into the UK economy since the financial crisis. The official Bank Rate has already been at a rock bottom level of 0.5% for over three years. This is not only the lowest rate of interest we have seen in modern times. It is much lower than the 2% rate set in the Great Depression of the 1930s and is the lowest official rate set by the Bank of England in its 300-plus year history.

In addition to these exceptionally low interest rates, the MPC has already sanctioned the injection of £325bn of new money into the economy through earlier rounds of QE – over £12,000 for each UK household. If these highly stimulatory monetary policies were going to be effective in lifting the economy back into sustained growth, we might have seen more benefits by now.

Second, the financial and economic circumstances are much less conducive to QE having an impact than was the case when the policy was first launched in 2009. QE involves the Bank buying bonds from the financial sector and hence one of its key influences on the economy is through the price of bonds and the yield they return. With bond yields now at very low levels, the policy is likely to have much less traction than when it started in 2009 – and may create other financial distortions.

Another way in which QE boosted the economy in 2009 was the “shock and awe” effect on confidence in financial markets and more generally as the Bank of England pulled out all the stops to turn the economy round. QE no longer has this impact and the muted response of financial markets last week shows that.

Third, even if the latest round of QE was effective, it would push up inflation in the UK. This is openly acknowledged by the MPC which still sees the main threat in terms of inflation being below the official 2% target. In my view, their preoccupation with below-target inflation is totally misplaced. Instead, we should welcome the prospect of inflation falling below the official target which would help ease the squeeze on consumer spending in a low wage growth environment.  With the exception of a few brief episodes, UK inflation has been above target now since mid-2005. This inflation over-run has been equivalent to a cumulative squeeze on real living standards and consumer spending of 8% - close to £3,000 per annum for each UK household.

Finally, there is an increasing risk that continued injections of QE are creating an unsustainable position for the UK economy which will damage our growth prospects in the future. The larger the pile of government bonds that the Bank of England accumulates, the greater the difficulties which could arise in selling them back to the market. Other potentially negative impacts are the effect on the returns available to long-term savers and pension funds. Larger pension fund deficits will create a bigger drain on corporate finances and a prolonged period of very low interest rates cuts the income and consumption of pensioners and other long-term savers.

QE was probably effective in helping to turn the UK economy around in 2009 and halting a spiral of declining confidence and business activity.  But to move the economy forward over the longer-term, we need a different set of policies. And we need monetary policy to build confidence that inflation will be low and stable. By taking risks with inflation, further QE undermines rather than builds this confidence .

There may be scope for the Bank of England to support the economy in the short-term in other ways – for example through the initiatives to ease constraints on bank lending announced last month at the Mansion House. And there are other ways in which the government can support growth – by easing the burden of business regulation, reforming the tax system, and by taking other steps to improve the employment and business climate here in the UK. It is these policies which should be the main focus now – and we should call time on further injections of QE.

Disappointing but predictable response from the MPC

posted 5th July 2012

Today, the MPC decided to inject another £50bn of new money into the UK economy through its Quantitative Easing (QE) programme.

The decision to restart QE is not unexpected. But it is unlikely to be effective in supporting economic growth and may hold back a much-needed fall in inflation. The MPC should be focusing more strongly on ensuring inflation comes back down to target, which would ease the squeeze on consumers. With interest rates already extremely low, there are limits to the ability of monetary policy to counter the headwinds we are currently seeing from a weakening global economy and the euro crisis.

To support economic growth, we need to look at other levers of policy. The ‘funding for lending’ scheme and other measures announced in the Governor's Mansion House speech may help ease the blockages in the financial system. More emphasis is also needed from the government on supply-side measures which can support the longer-term competitiveness of the UK economy - such as reductions in business regulation, medium-term tax reform and a stronger programme of employment and training opportunities for young people.

Good news from the labour market

posted 23rd June 2012

The latest figures on UK unemployment showed a welcome fall in the jobless total, after increases last year. But unemployment in the UK remains high. It is currently around 2.6 million – 8.2% of the workforce, an increase of about a million since before the global financial crisis and the 2008/9 recession.

Though higher unemployment is unwelcome, the fact that the UK labour market has performed better than many feared in the immediate aftermath of the financial crisis. The drop in GDP in the recent recession appears larger than we saw in the early 1980s and early 1990s recessions. And in 2009 there were forecasts that unemployment could rise to over 3 million or even 4 million. The fact that growth over the recovery so far has been disappointing might have compounded these concerns. Yet unemployment has still not risen as high as it did in the 1980s and 1990s. In both of these previous recessions, unemployment rose above 10% of the labour force and in the 1980s remained at a double digit rate for over five years.

The contrast between recent employment performance and these two earlier recessions is stark (see Chart). In the early 80s and early 90s, employment dropped by about 6% and only started to level out and recover after 3-4 years. In the 2008/9 recession, the decline in employment was initially much less – about 2.5% - and the decline levelled out after about a year. Since the end of 2009, we have recovered about half of the jobs lost in the recession. The private sector has created nearly 850,000 new jobs in the past two years, though recently this has been offset by job cuts in the public sector. And the difference between the employment track we are now on, compared to the previous recessions is around 5% of the labour force – about 1.5 million jobs.

How do we square the circle between figures which show a very deep recession, but relatively good employment performance? One possibility is that the GDP figures will eventually be revised to show a milder recession and a stronger recovery. The Office of National Statistics (ONS) has made significant revisions to the course of previous recessions and recoveries – notably the early 1990s recession. However, we would have to see quite dramatic changes to the GDP picture to explain such a significant difference in the profile of employment between the latest recession and earlier economic cycles. Rather, I believe the explanation lies in changes in the structure of the economy and the way in which the labour market,  businesses and policy-makers have responded to the shocks created by the financial crisis.

Four factors have played a part in delivering a more positive outcome for UK employment than we have seen in previous recessions. The first is a change in the structure of employment, with the services sector now playing a larger role in the economy. In the 80s, 90s and 2008/9 recessions, around 90% or more of the job reductions occurred in two highly cyclical sectors of the economy – manufacturing and construction. Between 1979 and 1981, these sectors shed over 2 million jobs in the space of two years, and between 1990 and 1992, they cut employment by nearly 2.5 million. Employment in the services sector has tended to be much more stable during UK recessions.

In the 2008/9 recession, job losses in manufacturing and construction were much lower – at just over one million. A large part of the explanation for this difference lies in the long-term decline in the manufacturing share of employment in the UK. In the late 1970s, manufacturing industry accounted for over a quarter of total employment, whereas by 2007 its share of jobs had dropped below 10%. This meant that the same proportionate drop in manufacturing employment had a much less significant impact in terms of the number of lost jobs, even though UK manufacturing employment fell by over 15% in the 2008/9 recession.

A second factor contributing to better employment performance through the latest recession was the underlying health of the UK business sector. In both the early 80s and early 90s recessions, the shake-out of employment was intensified by the need to address underlying structural problems. In the 1980s, businesses faced the challenge of restoring competitiveness after the turmoil of the 1970s – when British industry struggled with turbulent industrial relations, poor productivity and low profitability. In the early 1990s recession, there was a big job shake-out in consumer and property-related businesses which had grown rapidly in the preceding “Lawson Boom”.

In the run-up to the recent recession, the non-financial business sector of the economy was in much better shape. Profit margins were healthy pre-crisis. And the UK had developed a diverse and flexible business sector mainly based on services activities, which had enjoyed consistent growth from the mid-90s until the advent of the financial crisis. Though there was then a big shock to the financial sector and to banking in particular – this did not have large direct employment consequences, as UK financial services only accounts for around 1 million jobs – around 3% of the total.

The other two factors which helped to support employment through the recent recession and into the recovery are wage flexibility and policy measures. Though inflation has been high, wage increases have remained subdued, and the resulting flexibility in real wages has allowed employers to maintain a higher level of employment without incurring excessive costs. There have also been other aspects of labour market flexibility which have supported job growth – with part-time jobs and self-employment growing strongly. The UK also benefits from now having a well-developed suite of “active labour market policies” – programmes which support the transition of the unemployed back into work, either directly or through training opportunities. Macroeconomic policy has also operated more flexibly through the most recent recession than in the early 80s and early 90s – when policy-makers were battling to bring down inflation. The Bank of England has been remarkably t0lerant of above-target inflation in recent years. There may be a price to pay for this in the future.

What lessons can we draw from the performance of the UK labour market through the recent recession and the rather faltering recovery? The first lesson is that the change in the structure of the UK economy over the past 20/30 years has not necessarily been bad for job prospects. Yes, we do not have the substantial manufacturing base we had back in the 1960s and 1970s. But the manufacturing we do have is much stronger and more competitive. The current structure of the UK economy – with a diverse range of services activities and a leaner and fitter industrial base – has enabled the labour market to cope better with recessionary conditions than we did in earlier downturns.

A second lesson is that the UK non-financial business sector is remarkably resilient. Despite big shocks to demand and financial markets, we have not seen the shake-out of employment experienced in previous recessions. The third lesson is that labour market flexibility – in terms of wages, employment conditions and the deployment of active labour market policies – has been a great asset for an economy exposed to big international shocks like the UK.

We should therefore take encouragement from recent UK labour market and employment performance. The euro crisis may make it difficult for unemployment to continue to fall in the short-term. But the business resilience and labour market flexibility of the British economy should be positive for medium-term economic prospects.

The Queen of prosperity, growth and inflation

posted 4th June 2012

How has the economy fared over the Queen's 60-year reign? The last few years have been dominated by the global financial crisis, coupled with worries about slow recovery and the impact of more austere spending and tax policies.

Despite all this doom and gloom, however, the nation has enjoyed unprecedented prosperity during the reign of Queen Elizabeth II. Living standards have increased - reaching an all-time high before the recession. And in her 60 years on the throne, the Queen has presided over a much stronger growing economy than any of her predecessors. GDP growth in her reign (1952-2012) has averaged 2.4% per annum. This is the strongest economic growth rate seen in the reign of any monarch since the start of the Industrial Revolution in the mid-18th Century (see Chart, below).

William IV's short reign from 1830 to 1837 is the second best for growth, at 2.2%. And Queen Victoria only managed 2% per annum in her long reign. From the start of the Industrial Revolution, the UK economy grew on average by around 1.6% per annum prior to Queen Elizabeth's accession to the throne in 1952. Before that, it is most unlikely that any monarch presided over such a strongly expanding economy - economic historians estimate that the rate of growth in the pre-industrial UK economy averaged around 0.5%*, about a fifth of the growth rate we have experienced since 1952.

But while the growth record has been good for the Queen, the record on inflation is less encouraging. The average inflation rate since 1952 (using the Retail Prices Index) has been 5.5% per annum. Even if we take out the period 1972-82, when UK inflation averaged nearly 15%, inflation still averaged nearly 4% for the rest of the Queen's reign.

Such a long and prolonged period of inflation has a major impact on  our perception of money values. Back in 1952, you could send a letter for 2.5 old pence (just over 1p) - whereas this now costs 50-60p. A loaf of bread or a pint of milk cost 6d (2.5p). Now they cost 20-40 times as much. A gallon of petrol in 1952 cost 4 shillings and 3 pence - just over 20p in decimal coinage. Now a gallon of petrol costs £6 or more - around 30 times as much. The TV (and radio) licence in 1952 cost £2. Now a colour TV licence costs £145.50 - a 70-fold increase. Taking all the goods and services in our consumer basket together. they cost in money terms nearly 25 times as much as when the Queen came to the throne in 1952.

This drift into a world of higher inflation did not start with Queen Elizabeth II in the early 1950s. Inflation averaged 5.8% in the reign of her father, King George VI, from 1936 to 1952. The war was a major factor pushing up prices in his reign, and prices had also risen sharply in the Napoleonic wars and the First World War. But there was a downwards correction in prices after 1815 and 1914 which restored the perception of price stability. That did not happen after 1945, and inflation burst out again in the late 1960s and 1970s and continued into the 1980s. It was not until the 1990s - after three major recessions, that a version of price stability was re-established.

Once again, we seem to be living in a world where inflation is tolerated as the price for economic growth. That underpins the economic policy consensus of today - and hence the willingness of the Bank of England to continue to inject stimulus into the UK economy when inflation is significantly above their official target.

But classical economics teaches that economic growth cannot be supported in this way indefinitely. Longer term economic progress depends on supply-side fundamentals, which western policy-makers are currently neglecting. Over the longer term, inflation - particularly unanticipated inflation such as we have seen recently - is bad for economic growth. 

I suspect that the disappointing growth we are now experiencing in the UK and other western economies is an indication we have reached the end of the road for these inflationary policies - just as we did in the 1970s. The "New Normal" is likely to see the UK economy growing on average by around 1.5% per annum, or maybe even lower. Unfortunately, it seems most unlikely we will quickly return to the trend rate of nearly 2.5% GDP growth we have enjoyed during the 60 years of the Queen's reign so far.

* See Stephen Broadberry's paper on economic growth since 1000:

Monetary policy dilemmas in the "new normal" economy

posted 10th May 2012

The Monetary Policy Committee (MPC) of the Bank of England - which announces its latest interest rate decision today - faces a dilemma. GDP figures have disappointed but inflation remains high, at 3.5%. Indeed, inflation has averaged around 3.5% since the beginning of 2008 - this is no short-term "blip".

Looking at the growth picture might suggest more QE, while the persistence of high inflation would point much more strongly to higher interest rates. When Sir Mervyn King took to the airwaves last week and delivered the Today Programme lecture, he acknowledged that inflation was too high and that growth had been disappointing. But he gave no new insights into how the MPC which he chairs should respond to this situation.

The Committee’s decision will be informed by new economic forecasts – published next week. But past MPC forecasts have been too optimistic on economic growth and have persistently underestimated the upward pressures on inflation. Unless there has been a radical rethink of economic forecasting at the Bank, we are likely to see the same pattern repeated again.

The underlying problem is a fundamental shift in the performance of the UK economy and most other western economies which has become very apparent since the onset of the financial crisis. The crisis marked the end of a long economic expansion, which goes back to the early 1980s, and was only briefly interrupted by the early 1990s recession.

In the twenty-five years ending in 2007, there was only one calendar year in which GDP fell (1991). UK economic growth over this period averaged nearly 3% per annum and consumer spending rose by nearly 3.5% a year. The economic growth rate for the quarter century 1982-2007 was virtually identical to the long postwar expansion from 1948 to 1973, which included the “golden age” of the 1950s and the 1960s.

When the long expansion of the 50s and 60s came to an end in the early 1970s, it ushered in a decade of disappointing growth, relatively high inflation and economic and financial volatility. We appear to be seeing something similar in the aftermath of the financial crisis, albeit without the rip-roaring inflation we saw in the 1970s and early 1980s. The financial system has been severely disrupted  - as it was when the Breton Woods exchange rate system came to an end  in the early 1970s. And now, as then, we appear to be living in a period of high and volatile energy and commodity prices.

This “new normal” of disappointing growth and volatility for western economies is not just the legacy of the financial crisis. It also reflects the pressures within the global economy as the balance of economic power shifts from West to East. Strong growth in China, India and other large emerging market economies is putting significant upward pressure on the demand for energy and other commodities. And labour costs are also rising in these emerging economies.

The “China effect” through which low cost producers held down manufactured goods prices has given way to a more inflationary trend in global markets. And the era of low and stable energy and commodity prices which prevailed from the mid-1980s until the early 2000s has come to an end. For about a decade now, we have not been able to combine strong growth in the emerging world and reasonably healthy growth in the west without a burst of energy and commodity price inflation. And this has been a material contributor to the inflationary pressures which the UK and other economies have experienced in recent years.

The most recent burst of energy and commodity price inflation accompanied the initial resumption in global growth from the recession in late 2009 and continued until early 2011. Though it subsided somewhat later in 2011 as the world economy slowed, global energy and commodity price pressures could recur if the world economy picks up again later this year and in 2013 as most forecasts currently suggest. These pressures could be aggravated if there was disruption to the supply of energy, for example due to instability in the Middle East.

This all creates a very difficult climate for the operation of monetary policy and I have some sympathy for the dilemmas faced by my former colleagues on the MPC.  However, the persistent forecasting errors made by the MPC since the financial crisis suggests that the Committee is being slow to adapt to the realities of this “new normal” economy.

The MPC can no longer set monetary policy based on the performance of the economy before the financial crisis. The underlying growth trend appears to be weaker now, and the simple ”output gap”  relationship between growth and inflation - which informed policy before 2007/8 - does not seem to be operating as expected. The Committee has continued to emphasise the influence of spare capacity created in the recession holding down price increases, despite inflation remaining stubbornly above target.

Global forces have a significant impact on UK inflation, and these cannot be ignored or treated as “one-off” shocks. The MPC can influence on the way these shocks feed through into UK inflation, notably through the impact of monetary policy on the sterling exchange rate.

There may be some members of the MPC who feel that the latest negative GDP figures justify a further injection of QE. But these arguments should not prevail at this week’s meeting. The latest GDP figures are provisional and subject to revision, while business surveys and the data from the labour market point to a more positive growth picture. At the same time, inflation remains stuck considerably above its target level, and the Committee risks a steady erosion of its credibility if it continues to blame a sustained over-run in the inflation target lasting many years on factors outside its control.

For me, the right decision at the May meeting would be to bring the QE programme to an end but to keep interest rates on hold – recognising the current uncertainties in the global economic climate.  But the situation may change later this year if relatively high UK inflation persists, as I suspect it may, and if global economic conditions improve, as most forecasts suggest. That could put the case for higher interest rates back on the agenda in the UK.

This is an edited version of an article which appeared in The Times on 9th May 2012

Inflation and rising interest rates back on the agenda

posted 22nd April 2012

Is the Monetary Policy Committee about to do a U-turn in its approach to inflation? So far, the Committee has been relaxed about above-target inflation . Even though inflation hit over 5% late last year and has averaged around 3.5% over the past four years, the MPC has kept interest rates at a record low of 0.5% and has recently been injecting money into the economy through a renewed programme of Quantitative Easing (QE).

This is the opposite direction of the policies normally used to counter high inflation. But the Committee has been concerned about the weakness of the real economy and has consistently argued that, over the medium-term, inflation would fall back to its 2% target level once various shocks had worked their way through the system.

However, the message appeared to change last week when the decline in inflation stalled. In January, when the VAT rise dropped out of the calculation, CPI inflation dropped to 3.6%. But there was only a small drop in February – to 3.4%. And the March figure released last Tuesday showed a rise to 3.5%.

This was not a great surprise to me. Over a year ago, I warned that the underlying inflation picture was not as good as the majority of my MPC colleagues thought at that time. And when the MPC relaunched its QE programme last autumn, I warned that inflation could get stuck at around 3-4% this year, instead of falling below target as the Bank’s forecast suggested.

Thinking on the MPC now seems to be moving in this direction. The minutes of the April meeting showed that “arch-dove” Adam Posen had dropped his call for more QE. And in a subsequent newspaper interview to explain his decision, Posen was quoted as saying that the Committee was “taking seriously” the persistence of measures of “core” inflation at around 3%.

On the day the minutes were released, Deputy Governor Paul Tucker said in a speech that inflation was likely to remain above 3% in the short-term and could well stay around the same level for the remainder of the year. Paul Tucker is widely tipped to succeed Mervyn King as Governor next year , which gives added weight to his views.

In my final speeches as a member of the MPC last year, I gave four reasons why relatively high inflation was likely to persist. First, strong growth in China, India and other rapidly growing parts of the world economy would continue to put upward pressure on energy and food prices. Second, the big fall in the pound during the recession would push up prices further. During the recession, businesses struggled to recover the full amount of rising import costs and would continue to try and restore margins during the recovery. Third, the level of spare capacity in the economy was not exerting downward pressure on inflation in the way the MPC thought. And finally, rising prices were starting to encourage businesses and the public to expect higher inflation in the future. In these circumstances, what starts as a temporary rise in inflation can become self-sustaining.

These concerns still remain very valid. At the same time, the latest evidence suggests that the weakening global economy and the euro crisis have not created a double-dip recession in the UK. Business surveys point to a resumption of economic growth in the first few months of this year and the March retail sales figures suggest that consumer spending is proving surprisingly resilient. Unemployment is now falling again.

The first official estimate of economic growth for January to March will be published next week. Because GDP figures are frequently revised, and have recently been affected by erratic factors, a big health warning should be attached to this first release. But whatever GDP shows, the weight of evidence in the first quarter is that the economy is growing – albeit slowly. And there is a good prospect that growth will strengthen through the year.

As we move into the second half of the year, therefore, we may well see a shift in the debate taking place on the MPC. Instead of discussing the merits of more QE, the Committee may find itself considering whether interest rates should start to rise in response to stubbornly high inflation and an improving real economy.

Financial markets currently see rising interest rates as a distant prospect. But the latest economic data, and the smoke signals from the MPC, suggest it could be back on the agenda much sooner than they think.

An edited version of this article appeared in the Sunday Telegraph on 22nd April 2012.

Defining recessions - two out of three is bad!

posted 30th March 2012

The OECD made the headlines yesterday by suggesting that the UK economy was heading back into recession. The definition of recession which underpinned their view is widely used in the economics  profession – 2 consecutive quarters of falling GDP. So the fact that the OECD expect a fall in GDP in the first quarter of this year (erroneously in my view) to follow on the fall in the final quarter of last year means that we might “technically” be back in recession. (See my latest PwC Economics in Business blog entry for more discussion on this issue.)

I have never liked this technical definition of recession. It seemed to become more widely used in the UK in the 1980s and 1990s, and its origins can be traced back to the United States in the 1970s.

There are four problems with it. First, the time period is relatively short. Two quarters is a period of six months, but data on GDP in one quarter can be heavily influenced by what happens in a single month. In December 2010, a bad bout of snow brought the UK economy grinding to a halt and knocked 0.5% off UK GDP according to the Office for National Statistics. And there is now an active discussion about whether the burst of panic buying of fuel, jerry cans and other items could materially influence the Q1 GDP figure for this year. (See, for example, Andrew Lilico’s Telegraph blog today.)

Second, GDP figures are frequently revised. So the snap assessment  which is made on the basis of one set of figures can be reversed by later revisions. This is particularly so for the UK. In the early 1990s, the recession appeared to continue through 1992 and into early 1993. At the time, it was believed to be the longest recession that the UK had experienced since the Second World War. The most recent data show the decline in GDP coming to an end in late 1991, exactly when Norman Lamont declared he could see the “green shoots of recovery”. He was right, though ridiculed at the time. At the IEA State of the Economy conference in February, Norman Lamont himself noted that the GDP figures covering his time as Chancellor were now unrecognisable from the data available at the time.

Third, I believe it is wrong to base your judgement of the state of the economy on a single economic indicator. GDP probably contains some useful information about the current state of the economy. But so do the employment numbers, business surveys, retail sales and a raft of other data. In the autumn of 2009, this broader picture of the economy suggested to me that the UK economy was recovering (see the speech I gave at Royal Holloway in November 2009), even though the ONS estimates of GDP at that time showed little sign of sustained recovery. According to the initial estimates, GDP fell in the third quarter of 2009 and rose by just 0.1% in Q4. The revised figures are now much more consistent with the view I formed looking at a wider range of data, with growth resuming in Q3 and strengthening in Q4.

The final problem is that a slow-growing economy runs a greater risk of falling into recession than a fast-growing one, just because its underlying growth rate is closer to zero and risks falling below it. That does not necessarily make sense because economies vary greatly in terms of their underlying growth rates. China – which grows at 6-10% per annum – would have to suffer a cataclysmic economic accident to experience a recession on the technical definition. Yet economies with declining populations and low productivity growth – like Japan – will appear excessively recession-prone.

So what can we do to come up with a better approach to defining recessions? One suggestion is to form a committee to do the job. In the United States, the National Bureau of Economic Research (NBER) has the technical role of defining turning points in the economic cycle. However, they come out with their judgments after quite a delay. Not particularly helpful for business and general public awareness of the state of the economy. And the notion of setting up another Committee to judge on economic progress (we already have the MPC, OBR and the Treasury Select Committee) does not appeal.

A combination of simple indicators seem to be the answer. The three indicators I would choose are: (1) an underlying measure of GDP, such as non-oil GDP or a weighted average of manufacturing and services output; (2) the unemployment rate; (3) a weighted average of reliable business surveys of business activity. However, in terms of GDP, the “two quarters of decline” rule does not make sense. There should be some reference to the underlying trend rate of growth and how far GDP has dropped below it.

If you have three indicators, it may not be necessary that all three are signalling recession – particularly recognising the unreliability of early GDP data. Perhaps we need to take some advice from Meat Loaf, who proclaimed in 1977 that “Two out of three ain’t bad”. Or in this case two out of three is bad – recognising that a recession might be a “Bat out of Hell”! If two out of the three indicators are signaling recession – then we are likely to be in one. But that is a long way from the so-called “technical definition” based on dodgy initial GDP estimates which so many people now casually and unthinkingly use

The next energy and commodity price surge is underway

posted 19th March 2012*

In 2008/9, chaos on global financial markets created a large recession across the world economy. But the recovery from the recession has been hampered by a different global market problem – rising and volatile energy and commodity prices.

In 2010, the world economy bounced back more strongly from recession than most forecasters were expecting. With stronger growth came higher energy and commodity prices. After dropping to about $40-45 in early 2009, the oil price rose to $75-80 in early 2010 on the way back to over $100.

Last year saw a broader-based surge in commodity and energy prices, pushing up inflation rates around the world. The squeeze on consumers reinforced the slowdown in global growth last year. And though Inflation rates peaked in most countries last autumn , the oil price is picking up again as signs of life return to the global economy – with Brent Crude up to around $125/barrel.

Looking back over the past decade, an ominous pattern is emerging. The era of relatively stable energy and commodity prices which prevailed from the mid-1980s until the early 2000s has given way to periodic bursts of energy and commodity price inflation. The first occurred in 2003-5, the second in 2006-8, and the third in 2009-11. If – as many forecasts suggest – the world economy starts to gather momentum again as we move through this year, we are set for another phase - carrying through into 2013 and possibly 2014.

This reflects the fundamental balance of supply and demand. New sources of energy supply and natural resources are costly and slow to come on stream. Meanwhile, demand is being pushed up by the activities of the 6.8 billion people now living on the planet, with the vast majority of them participating in the global economic system and aspiring to a higher standard of living. We have never been in this situation before.

We cannot guarantee, either, that the next surge in energy and commodity prices will be the last. The world economy experienced a prolonged period of rising and volatile energy and commodity prices from the late 1960s until the early 1980s. And that was in a world with a much smaller population and many fewer nations participating in the global economic system.

How should policy-makers react? Central Banks in the UK and other western economies have generally turned a blind eye to the surges in inflation created by successive waves of energy and commodity price inflation. They have done so because of other concerns (such as the financial crisis) and because they believe that inflation expectations are well anchored and underlying confidence in their ability to sustain stable prices remains intact. But continuing to tolerate phases of relatively high inflation will raise questions about this commitment to price stability.

In the 1970s, the western Central Bank which took the inflationary threat from energy and commodity prices most seriously – the Bundesbank – emerged from that period of volatility with its reputation greatly enhanced. Others, including the UK, faced a long battle against high inflation and fared less well. Currently, the focus of the western Central Banks is on combatting the aftermath of the financial crisis rather than the threat of high and rising energy and commodity prices. That judgement may have been right in 2008/9. But a renewed burst of commodity and energy price inflation - which may just be getting underway – could require a different policy approach.

* This is an edited version of an article published in the Financial Times on Tuesday 20th March

Wanted! A focus on tax reform in the Budget

posted 18th March 2012

The content of the forthcoming Budget has been the subject of intense speculation. Most of the focus has been on short-term measures, with much less discussion of the medium-term tax agenda. Yet setting out a clearer direction for medium-term tax reform is one of the most useful things that the Chancellor could do in his Budget next week.

Why is this so important? There are three reasons. First of all, the Chancellor has limited room for manoeuvre in the short-term – so there is limited to scope for immediate tax giveaways. Second, a major overhaul of the tax system is long overdue. The last Chancellor who had a clear and comprehensive tax reform agenda was Nigel Lawson, who left office over two decades ago. In the meantime, successive Chancellors have made many piecemeal changes to the tax system – adding to complexity and spawning a wide array of tax reliefs and exemptions.

Third, tax reform is one of the levers which a government can use to support longer term growth and improving the climate for business, enterprise and employment. It is part of a broader “supply side” agenda - including lightening business regulation and measures to ensure that the labour market is working effectively – which was effective in supporting growth in the 1980s and 1990s.

So what should the Chancellor do next week? Three broad principles should underpin his tax reform agenda. First, keep tax rates low and limit the extent of tax reliefs – creating a broader tax base. Second, tax income and wealth when people spend it rather than when they earn or invest it. Third, tax and hence discourage activities which create problems for society – such as pollution, smoking and traffic congestion.

The government has already laid out a clear reform agenda for corporate taxation, which aims to cut the corporate tax rate to 23%. But three other areas of taxation also require attention. First, within the personal tax system, there are genuine concerns about the impact of high marginal rates and disincentives both at the top and the bottom of the income spectrum. Taking lower earners out of tax is a government priority. But so also should be ensuring that the UK does not appear to have a penal tax regime for successful entrepreneurs and business managers.

Second, at the heart of the taxation of spending is a VAT system in which a wide range of items is zero-rated. Can it make sense for caviar to be zero-rated for VAT (as a food) while toothpaste and soap carry the full 20% rate? Narrowing zero-rating to more basic items of expenditure could create greater scope for reductions in personal or corporate tax rates, benefiting the economy as a whole.

Third, the application of taxes to address environmental problems is very ad hoc and uneven, with individual sectors bearing a disproportionate burden – notably motorists and air travelers. A more even-handed approach could help both the economy and the environment.

The Chancellor should not rush to set out detailed measures in this Budget – he needs to prepare the ground first. But he can set out the direction of travel by publishing Green Papers (ie consultation papers) on tax reform in the three areas I have highlighted – personal taxation, expenditure taxes and the environment. He could also set out the principles which will underpin reform – lower tax rates on the creation of wealth, a broader revenue base and clearer economic principles to drive the tax agenda. This would be a strong signal that the government supports enterprise and wealth creation, which is much needed.

This is a shortened version of an article published in City AM on Friday 16th March. Click here for the full version

Time to start the shift away from emergency policies

posted 4th March 2012

This month marks the third anniversary of the MPC meeting at which I and my fellow MPC members unanimously agreed to cut interest rates to 0.5% and started the programme of injecting money directly into the UK economy, known as Quantitative Easing (QE).

Three years on, Bank Rate remains at 0.5%. And the Bank’s money creation programme was restarted last autumn after a pause of around eighteen months. By the beginning of May, the Bank’s QE injections will have totalled £325bn - over 20% of GDP and equivalent to over £5,000 for every man, woman and child in the country.

In 2009, I was a supporter of QE and the need for exceptionally low interest rates.  The minutes of the MPC meeting three years ago record how difficult the economic situation was at that time. The economy was rocking and reeling from the shockwaves of the financial crisis. Economic activity was falling sharply and unemployment was rising alarmingly.  It was essential that the MPC took all necessary measures to stabilise the economy at that time.

The world is calmer now, and recovery is underway – even if it is uneven. The world economy started to pick up in the second half of 2009, when recovery also started here in the UK. Though growth has been disappointing recently, it has been sufficient to create around 600,000 extra jobs in the private sector since the trough of the recession in mid-2009.

But in 2009, I did not envisage that we would have persisted with such exceptionally low interest rates for so long. Nor did I expect that the MPC would embark on a second round of QE in late 2011. And I was not alone in these views. The expectation of financial markets in mid-2009, when the first round of QE was in full swing, was that official interest rates would be back up to 3-4% by now, not stuck at 0.5%. QE has reinforced the effect of these low interest rates - by depressing government bond yields and hence the whole structure of long-term interest rates in the economy.

In another important respect, the MPC’s expectations in 2009 were also awry. The Bank of England’s official remit is to set UK monetary policy to keep inflation on target at 2%. Three years ago, the forecasts suggested that the main problem we were likely to face was a prolonged period of very low inflation with a significant risk of deflation. As it has turned out, inflation has run persistently above the 2% target for over two years, peaking at over 5% late last year.  Even in January, with the VAT rise dropping out of the annual rate, CPI inflation was 3.6%. With oil prices now picking up again, the current phase of above target inflation could persist through this year and into 2013.

This combination of low interest rates and high inflation has been particularly painful for savers. But all members of society have felt the squeeze from the prolonged period of above target inflation we have experienced since the financial crisis.

It is far from clear that an economy which has been suffering from persistent high inflation needs a policy which is designed to push up inflation further. Yet that is precisely what the MPC expects QE to achieve. The Committee believes it is forestalling a sharp fall in inflation and hence helping to keep inflation on target. But it has consistently underestimated inflationary pressures in previous forecasts, and is at serious risk of making the same mistake again.

At this month’s meeting it would be most surprising if the Committee did anything other than continue with this policy. But I hope that when the May meeting comes round, the Committee will decide to bring its current QE programme to an end.

The Bank of England – along with other Central Banks – faces the challenge of moving away from emergency policy settings which have been maintained since the depths of the financial crisis (see my "All Shook Up!" posting, below). There may well be no easy time to embark on this process, given the world of disappointing growth and economic volatility which now appears to be the “new normal” for the UK and other western economies. But if we don’t start the gradual shift away from emergency monetary policy settings soon, the MPC risks having to play catch-up in the future: pushing up interest rates sharply and triggering a large negative shock to business and consumer confidence.

A longer version of this article was published in the Sunday Telegraph on 4th March 2012

Economic policy-making is "All Shook Up!"

posted 23rd February 2012

Before the financial crisis, economic policy for the major western economies seemed relatively straightforward. Economic growth tended to fluctuate around a reasonably steady rate accompanied by low inflation. Central Banks adjusted interest rates to keep economies on track and their interventions appeared to be effective.

Healthy economic growth also helped the planning of public finances. It provided a steady source of additional tax revenue – supporting increases in public spending in key services like education and health while keeping deficits under control.

However, this regime has been disrupted by two key developments since the mid-2000s. First, strong growth in Asia and other emerging markets has started to exert significant upward pressure on energy and commodity prices. That has added to inflation and squeezed spending power in western economies and made the challenge of steering economies along a steady growth, low inflation course much more difficult.

Second, the financial crisis created a major recession from which most western economies are struggling to recover. There has been a double whammy – the impact of the recession itself and the withdrawal of a key engine of growth from the financial sector. For over two decades from the 1980s, growth in the western economies was sustained by dynamic and deregulated financial markets which opened up new opportunities for consumers and businesses. The financial system is now much less supportive of growth as banks seek to repair their balance sheets. And the natural caution of lenders and investors in the wake of the crisis is being reinforced by a re-regulation of the financial system.

These developments are combining to create a difficult recovery accompanied by volatile economic and financial conditions – which is the "new normal" for the UK and other major western economies for the time being. And these characteristics of the economic climate are not short-term. They are likely to persist into the mid-2010s.

The initial reaction of economic policy-makers as the financial crisis hit in 2008/9 – quite rightly – was to fight it with all means available.  Interest rates were cut to historically low levels and unconventional monetary policies – such as Quantitative Easing in the UK – were implemented. Budget deficits were allowed to expand. And governments injected capital into troubled banks to  stabilise the banking system.

But though these policy interventions were justified in the short-term, they cannot be used to sustain growth in the longer term. Government deficits need to be reduced to ensure sustainable debt levels. And the continuation of highly stimulatory monetary policies risks creating some combination of high inflation or permanently distorted financial markets.

Policy-makers face the challenge of making a difficult transition from the emergency policy settings which were adopted in the depths of the financial crisis, and returning to more sustainable economic policies. This involves recognising the limitations of demand stimulus as a means of securing sustainable growth and putting more weight on supply-side policies which seek to improve the business climate through tax reform, lighter and more efficient regulation and strategic government support for infrastructure, education and research.

For the time being, economic policy-making is “All Shook Up”. The stable policy framework which existed before the financial crisis has disappeared, but a new framework for managing economies in the “new normal” has yet to emerge.  Businesses and financial markets are going to have to live with this uncertainty for a while as economic policy-makers adjust to the new realities of the global economy in the aftermath of the financial crisis. But policy-makers can help address this lack of confidence by recognising the need for a return to more sustainable policies and making the transition clearly, confidently and effectively.

Learning to live with the "new normal"

posted 11th February 2012

Since the depths of the financial crisis in late 2008 and early 2009, economies around the world have started to recover. In Asia and other emerging markets, growth has been strong. But in the UK and other western economies, recovery has been relatively slow and uneven. Business and consumer confidence in most western economies remains fragile and financial markets are volatile. The current financial market preoccupation with the euro crisis is just the latest of a long “worry list” of issues affecting financial sentiment.

Another feature of the economic climate in recent years is volatility and upward pressure on energy and commodity prices. Since the mid-2000s, healthy growth in both western economies and in the emerging markets has not been achieved without strong upward pressure on global energy and commodity prices. These bursts of energy and commodity  price inflation have made cost control difficult for business and pushed up consumer prices, choking off spending growth. This has added to the volatility of the current economic climate,

A key question for business is how long this pattern of disappointing growth and volatility will last? Is this the “new normal” or are we about to break out of this pattern and emerge into the “sunlit uplands”?

One thing is pretty clear. We are not going to return to the “old normal” we saw prior to 2007, when growth was underpinned by high leverage in deregulated financial markets,  providing relatively easy access to finance for consumers and businesses. We face a prolonged balance sheet adjustment in the financial sector, reinforced by tighter regulation – and the era of easy credit which preceded the financial crisis is unlikely to return.  If a new wave of sustained growth does emerge in the future, it will need to be underpinned by a different set of forces.

And it also seems likely that a new wave of sustained growth will not emerge quickly. The major western economies are in the middle of a prolonged period of adjustment. The imbalances in the economic and financial system have built up over a long expansion which started in the early 1980s and continued for quarter of a century until 2007, with a brief interruption to growth in the early 1990s. Not only do we face the legacy of the financial crisis, but western economies face an adjustment to co-existing with the rising powers of Asia. Confidence in policy-makers has been eroded by the experience of the financial crisis and will need to rebuilt. All this will take time.

The long expansion of the 1950s and 1960s was followed by around a decade of volatility and disappointing growth starting in the 1970s and continuing until the early 1980s. We may not be facing the rampant inflation of that period. But just as economies took a long time to adjust after the era of “full employment”, we probably face a similar prolonged period of adjustment after the long financially-driven expansion which ended in 2007.

It seems likely that the “new normal” of disappointing western growth, coupled with volatility in financial and energy/commodity markets will continue for a few years yet – into the mid-2010s. Businesses need strategies which will help them survive this period – while looking to make the most of growth opportunities opening up in emerging markets, and which are occurring in more traditional markets in response to changes in society, technology and regulatory frameworks.

Andrew Sentance


Articles from 2011

Time to reform the MPC (6/11/11) How to support economic growth (1/11/11) Ten questions for the Governor (22/10/11) Shocking inflation numbers (18/10/11) Central bankers need more humility (16/10/11) Is this the worst financial crisis ever? (9/10/11) The MPC's latest decision - hitting the wrong target (7/10/11) More monetary stimulus would be a big mistake (4/10/11) Time to start adjusting to new economic realities (27/9/11) The 50p tax debate (11/9/11) Ignore inflation at your peril (11/9/11) More demand stimulus is not the answer (1/9/11)


Time to reform the MPC

posted 6th November 2011

Later this week, the Monetary Policy Committee (MPC) will meet again to decide UK interest rate policy and to reassess its recent decision to inject more stimulus into the UK economy through Quantitative Easing. There is little doubt about the outcome of the meeting. Interest rates will be held at 0.5%, and the Committee will confirm its October decision to inject £75bn of new money into the economy over the next few months.

But while the outcome of the meeting is predictable, MPC members should feel uncomfortable about their current policy stance. They have injected more stimulus into the UK economy when inflation has been running persistently above target. Since January 2008, CPI inflation has averaged 3.4% and our consumer prices have risen at double the rate seen in the US and the euro area. The primary remit of the MPC is price stability and the Bank of England website proudly boasts that “The Bank sets interest rates to keep inflation low to preserve the value of your money”. Yet UK monetary policy no longer “does what it says on the tin”.  Price stability no longer underpins the decisions of the MPC.

This is fairly clear from the behaviour of the Committee since the summer of 2007. While UK inflation has been persistently running above target, all the policy moves have been to provide more stimulus to head off deflation – cutting the Bank rate from 5.75% to 0.5% and injecting £275bn of new money into the economy. No acknowledgement is given to the possibility that the policy response of the MPC might have aggravated the over-run in UK inflation. The arguments that I made from the middle of 2010 onwards that policy stimulus should be reduced were rejected by the majority of the Committee, which prefers to believe its own model of how the economy should work rather than observing how it is actually behaving.

Over the past few weeks, I have given a number of public talks highlighting the current problems with UK monetary policy which have contributed to this situation. The MPC, led by the Governor of the Bank of England, has effectively redefined its target – and the Government appears to have acquiesced to this approach. No longer does the Committee feel bound by its mandate which states clearly that: “The inflation target is 2 percent at all times: that is the rate which the MPC is required to achieve and for which it is accountable.” Instead, the Committee is targeting its own forecast of inflation, and is disregarding actual inflation performance. 

There are two problems with this approach, which I have discussed in earlier blogs. First, the Committee’s recent forecasts of inflation have been badly awry. A couple of years ago, the MPC forecast that inflation around now would be 1-1.5%, not the 5% plus we have experienced. Even in the second half of last year the MPC forecasts were for inflation of 2.5-3% by the end of this year. These forecast failures are not just the result of a chapter of unhappy accidents. They reflect the fact that the Committee puts far too much weight on the impact of spare capacity in pushing down inflation, and not enough on the factors which have been driving UK inflation recently - global inflationary pressures, the decline in the value of the pound and persistently high services sector inflation. I highlighted these problems in a series of speeches early this year when I was a member of the Committee, but these criticisms have been effectively ignored. And the bodies which scrutinise the MPC – notably the Treasury Select Committee – did not take up the challenge.

The other problem is more deep-seated and structural. The MPC is being allowed to make its own forecast, which then drives its decisions. It is a bit like students taking a degree course who are allowed to forecast their own results, instead of being assessed by the objective measure of their performance in their final exams. It is very easy to predict which way the bias will operate in these circumstances. Very few students will forecast a fail and most will over-estimate their success. That is exactly what is happening with the MPC. It is being allowed to forecast its own success in bringing down inflation when the reality, reported by the Office of National Statistics, tells us otherwise.

Inflation is 5.2%. It will probably rise higher before falling back. And the fact that it has averaged 3-4% over the past four years suggests it will fall back to that level, not to below the 2% target as the MPC is currently forecasting. An independent Central Bank is meant to safeguard price stability, not pursue policies which drive high inflation.

What should be done to address these problems? In my recent talks, I have advanced a number of proposals for reforming the MPC and the UK monetary framework. The framework which was put in place in 1997 is not perfect, and we should learn from the problems we have encountered in recent years. Here is my agenda for reform.

First, we need to strengthen and diversify the external membership of the Committee so it is no longer dominated by an internal bloc of Bank insiders – as is currently the case. Paul Tucker and Charlie Bean, the two Deputy Governors, have recently revealed they were very close to voting for interest rate rises earlier this year. Can we really believe that their decisions were not influenced by their working relationship with the Governor who made very clear in a speech at the end of January that he was strongly opposed to higher interest rates? With the Bank taking on new responsibilities and strengthening its financial stability role, a 9 member MPC which had a majority of external members (eg 6 external and 3 (internal) could be much more effective and independent of a prevailing “Bank view”. This would also free up time for some internal members to focus on their core financial stability and regulatory responsibilities. And such a structure would allow a greater range of experience to be included on the MPC. For example, there is currently no-one on the MPC with the business background that Kate Barker, DeAnne Julius and I were able to bring to the committee.

Second, the MPC mandate should be tightened to counter the reinterpretation and redefinition of inflation target which has occurred over the past couple of years. In particular, the paragraph in the mandate which allows the MPC to accommodate deviations in inflation due to “shocks and disturbances” should be more tightly worded. Such shocks and disturbances should not be allowed to justify inflation deviations lasting many years, as has been the case throughout the financial crisis.

Third, the MPC should be held more firmly to account for inflation performance by the Government and the Treasury Select Committee (TSC). There are a number of ways in which this could be achieved. The exchange of letters between the Governor and the Chancellor which occurs when there is a significant deviation of inflation from target should be a more substantial event. At present, it is something of a farce, with the Governor repeating a familiar list of excuses for high inflation and the Chancellor writing back saying “that’s OK”. There is little in the letter exchange which reflects the notion of accountability for inflation performance. The Chancellor is far too happy to accept the Bank’s forecasts, despite the appalling recent forecasting record. There should be a parliamentary debate and a series of TSC hearings every time these letter exchanges occur. The TSC could also hold an inquiry into the conduct of monetary policy and Bank forecasting record since the financial crisis. This would put the spotlight on some of the weaknesses of the “output gap” model of inflation being used by the Bank, which I have highlighted above.

Fourth, serious consideration should be given to separating forecasting from decision-taking in the UK monetary policy framework, as we have done in the fiscal framework. The Treasury (the decision-making body) no longer forecasts public finances – that is carried out by a specialist body, the Office for Budget Responsibility (OBR).  The forecasting failures of the Bank of England and the MPC have been so significant that we should consider a similar approach in the monetary sphere – establishing an OMR (Office for Monetary Responsibility) to match the OBR. Or there may be merit in a combined OBR/OMR to achieve efficiencies of scale.

At the tenth anniversary of the MPC, the Treasury Select Committee held a major inquiry – “The MPC, ten years on” – and by and large gave the UK monetary framework a clean bill of health. Nearly fifteen years on, after facing the stern test of a financial crisis, things don’t look so good. There is a strong case for reforming the MPC framework to counter the inflationary drift we have seen in recent years.

How to support economic growth

posted 1st November 2011

Today's GDP release showing 0.5% economic growth in the third quarter of 2011 is welcome. It was better than expectations. The UK economy is still growing - albeit less slowly than we would like.

The weakness of the recent GDP figures has put the spotlight on what the government or other official bodies (such as the Bank of England) can do to support growth. As I have made clear in earlier blogs, I don't support further demand stimulus through additional rounds of Quantitative Easing. Nor do I think that it is right for the government to back away from its deficit reduction plan.

Reverting to more monetary and fiscal stimulus involves pumping more demand into the economy. It was right to do this in 2008/9 when there were very negative demand trends. But we now face a problem of persistent inflation, alongside slow growth. Stimulatory demand policies in this environment risk making inflation worse without helping much on the growth front. Tempting though it is to go down this route, it is not the right approach in the current situation.

So what is the way forward if we want to support growth in the UK economy? Stimulating demand is a temporary fix. The way in which government can help support economic growth and employment on a longer-term basis is through supply-side policies, which aim to improve the environment in which business operates and help the functioning of market mechanisms which support economic growth - especially the operation of the labour market.

There are a wide array of policies which can be deployed to help supply-side performance of the economy. They tend to be more slow-burning than demand-side policies - with an impact over 5-10 years rather than 1-2 years. But effective supply-side policies can also help to boost business confidence, which is a major issue at the moment.

In his Autumn Statement, at the end of November, George Osborne has an opportunity to set out a much clearer and coherent supply-side agenda to support the growth of the UK economy. Here are three areas for him to focus his efforts.

1) Youth unemployment: We need a much stronger programme of measures to help younger unemployed workers get into work. Many companies have held onto their skilled and experienced workers through the recession - which is a good thing. But in the current uncertain economic environment, it also means they are reluctant to take on new recruits, particularly where they are lacking in skills and experience. While there are already a number of initiatives in this area, we need a bolder approach. Young people who have been unemployed for over 6 months should be able to take their benefit payments to an employer as a job subsidy. As long as the employer pays national insurance payments, they should not have to worry about wage costs. Over a period of time (12-24 months), the job subsidy would be phased out and an employer would be expected to pay the regular minimum wage or higher. But by using the benefit system to give young workers help in getting back into employment, we can reduce the risk that they become part of a persistent long-term unemployment problem in the future.

2) Tax reform: We have not had a serious tax-reforming Chancellor in the UK since Nigel Lawson, who left office over twenty years ago. The Institute of Fiscal Studies has recently published a radical tax-reforming agenda, based on a Review chaired by Nobel prize-winning economist Sir James Mirlees. Not all the recommendations of the Mirlees Review are politically feasible. But it should be a launch-pad for a new wave of UK tax reform, aimed at reducing tax rates and phasing out exemptions to spread the burden of tax more fairly. The aim should be to create a tax structure which is much more favourable to wealth creation because it spreads the burden of tax more widely and fairly across society - avoiding the need for high tax rates which discourage economic activity.

3) A bonfire of business regulation: Over the long period of growth from the mid-1990s until the onset of the financial crisis, it was very easy for government to add to the burden of regulation of business. The economy was buoyant, at home and abroad, so businesses tended to absorb the costs. These same regulations are now operating as an impediment to growth. The red tape surrounding taking on new workers and expanding business needs to be cut back urgently. The UK planning system is particularly cumbersome and there should be a fast-track planning procedure (maximum 6 weeks) for any business development proposal which will create more than 20 new jobs. The Business Secretary, Vince Cable, should be leading the charge in this area and challenging his Cabinet colleagues to cut back in the burden of regulation across government.

In the depths of the financial crisis, the main challenge for economic policy-making was to stabilise demand in the short-term. The challenge is now different - it is to provide confidence for medium-term growth prospects. Supply-side policies aimed at improving the business climate and supporting the flexibility of the economy are what is now needed. That should be the main focus for the Chancellor's Autumn Statement later this month.

Ten questions for the Governor

posted 22nd October 2011

The Treasury Select Committee (TSC) has requested a hearing with the Governor, Sir Mervyn King, and Charlie Bean on the MPC decision to increase its QE programme. This is a positive development. Given the MPC's very poor performance in controlling inflation, better scrutiny of its decisions is long overdue (see my Policy Exchange presentation from earlier this week for more thoughts on this issue). Here are ten questions I would pose to the Governor and Charlie if I was a member of the TSC at that hearing:

    1)      The MPC resisted arguments for a rise in interest rates in the second half of 2010 and earlier this year. And yet it has moved very quickly to mobilise more QE based on short-term worries about economic growth, despite the fact that inflation is now over 5%. Is this not evidence that the MPC is targeting growth not inflation?

    2)      The Bank’s analysis of the original round of QE showed that it raised inflation. How can a new round of QE be justified when inflation is at 5.2%, the highest rate we have seen since the early 1990s?

    3)      MPC forecasts have seriously under-estimated inflation since the onset of the financial crisis. How can the Committee be so confident that inflation is set to fall below target when its previous forecasts have been so inaccurate?

    4)      The MPC has taken a decision to re-activate QE without the support of a quarterly forecast. How can the Committee then assert so confidently that inflation will fall below the 2% target without a further injection of QE, when it has not carried out a forecast exercise to support this judgement?

    5)      Some economists have argued that QE will depress sterling and add to inflation directly through that route. Given that the weakness of sterling and rising import prices have added to UK inflation in the past 2/3 years, is this not a very legitimate concern?

    6)      The MPC minutes suggest that the Committee believes that QE will be as effective in the current environment as in 2009. Yet a key channel of influence for QE is the downward impact on long-term interest rates, which are now much lower than in 2009. Does this not suggest MPC will now be less effective?

    7)      The first round of QE in 2009 probably boosted business and consumer confidence because the Bank of England appeared to be “pulling out all the stops” to stabilise the economy. Is there any evidence that the confidence effect of this current round of QE will be so positive, particularly when there are major worries about high inflation at present?

    8)      If QE is effective, it brings forward future growth into the present.  But that means growth may be weaker in the future – and the Governor acknowledged this problem in his Liverpool speech. Why does the Bank/MPC think that we will be better placed to cope with weaker growth in the future than now?

    9)      A big concern for the public and business is pensions. By depressing long-term investment returns, QE makes the pension funding problem more difficult. Has the MPC taken this into account in its decision on QE and how does it respond to these criticisms?

    10)   The broader public will find it hard to understand why the MPC has not taken any steps to counter high inflation and yet seems very ready  to inject more stimulus which might add to inflation over the longer term. Surely the actions of the MPC are undermining confidence in price stability and the inflation target?

Shocking inflation numbers

posted 18th October 2011

The September 2011 inflation numbers, released today, show that CPI inflation is 5.2% and RPI inflation is 5.6% - its highest level for twenty years. Energy prices have pushed up the inflation rate, but this is one of a wide range of factors which are contributing to higher inflation. Of the 12 sub-categories of the CPI, only one - recreation and culture - is showing inflation below 2%. In other words the current surge in inflation is broad-based.

This surge in inflation will not be short-lived. Though some of the factors will become more favourable next year - the rise in VAT drops out of the annual rate and energy price increases will start to drop out of the calculation - two factors are likely to sustain this period of above-target inflation much longer than the MPC is currently forecasting.

Services inflation remains stubbornly high - at 4.6% on the latest figures. Services inflation in the range 3-5% has been a feature of the UK economy since the late 1990s. It will take a period of flat or falling goods prices to offset this and bring the overall inflation rate back to target.

And such a period of flat or falling goods prices seems most unlikely in the foreseeable future. Sterling remains weak -particularly against the euro - and the MPC continues to pursue its policy of benign neglect of the pound. And import costs continue to rise sharply. The prices of UK manufactured imports are increasing at 8-9% according to the latest figures. And UK factory gate prices are up by 6.3% on a year ago according to the latest figures.

Wage growth has already crept up to 3% in the private sector over the past couple of years and will be given added momentum by these high RPI and CPI figures.

UK inflation looks set to remain persistently above target, contrary to the MPC remit. It is increasingly clear that the MPC missed an opportunity to head off some of these current inflationary pressures by raising rates in the second half of last year and earlier this year. And the decision to inject more stimulus by restarting QE is going to make the task of getting inflation back to target even more difficult.

Central bankers need more humility

posted 16th October 2011 (a version of this article will shortly be published in The Banker)

The financial crisis and its aftermath has been a humbling experience for the banking industry. But there is a need for humility among central bankers too.

The global credit boom which preceded the financial crisis was supported by a view that central banks could guarantee a world of continuing steady growth and price stability in most western economies.  This belief - encouraged by the statements of Alan Greenspan and other central bank governors – contributed to the increase in the risk appetite of the financial markets which in turn fuelled irresponsible lending.

At the same time, loose global monetary policy helped to sustain the excesses which led to the financial crisis – particularly the large and sustained relaxation in US monetary policy in the early 2000s. And while low inflation could be readily achieved in a world where Asia and the emerging market economies were driving down the prices of traded goods, it has proved much harder to achieve when the same economies have been exerting upward pressure on global energy and commodity prices. Yet the central banks which were all too ready to claim the credit for low inflation in a global disinflationary environment are now blaming current inflation on “one-off” price shocks.

The financial crisis exposed the limitations of the view that monetary policy could keep economies on a steady growth, low inflation track indefinitely. It should have resulted in a more cautious assessment of the role of monetary policy. But the opposite has happened.

While commercial bankers are now pilloried as society’s villains, central bankers are riding high. They are the “go to” players on the economic pitch, to help provide support to the economy when it is needed. And once the power of interest rate cuts is exhausted, they have now started to come to the rescue with “unconventional” monetary policies, expanding their balance sheets and pumping money out into the wider economy.

These policies were probably necessary and justified in the depths of the financial crisis in 2008/9, when demand was collapsing across the world economy. As a member of the MPC, I supported all the Bank Rate cuts and QE injections made in the UK from the autumn of 2008 until the end of 2009.

But it is far from clear that they are justified now, three years on from those traumatic events. Monetary policy should be able to affect economic growth in the short-term, over a period of one to two years. But in the longer term, its impact on growth will fade. As the time horizon expands - to three, five years and beyond - it is supply-side and structural features of economies which determine growth. And yet we seem to be clinging to a view that all that the economy needs is another injection of stimulus to keep it going, just as the impact of the last injection appears to be fading.

What is needed in the current climate – particularly in the UK and the US – is a bit more humility from central bankers and a recognition of the limits of monetary policy. The warning signs are already apparent. Across the world economy, 2010 and 2011 have seen much more inflation than conventional monetary policy would regard as acceptable, despite the impact of a massive global recession. In the Asia-Pacific region, policies have been tightened to rein in inflationary pressures. And a number of western central banks also tightened policy since the depths of the crisis – including Canada, Sweden and the ECB.

But in the UK and the US, there still seems a strong belief that more monetary injections will do the trick, even though both economies are experiencing inflation around double the normal level. This reflects a refusal to acknowledge a key lesson from the financial crisis – that there are limits to the effectiveness of monetary policy to support economic growth over the longer term.

Unconventional monetary policy measures – such as Quantitative Easing in the UK – can be effective in unusual and exceptionally difficult circumstances. But we are in danger of pulling the monetary trigger repeatedly when it is not clear it will be effective or is warranted. The latest MPC decision is an example of this. And while the MPC argues that this decision is justified in terms of its inflation target framework, that claim lacks credibility when its forecasts have persistently underpredicted inflation for a number of years.

Independent central banks were established for a reason – to take tough decisions when needed, in order to maintain price stability and monetary discipline. They are not the “saviours of the universe” just as the commercial bankers were not the “masters of the universe”. It is time to recognise the limits of repeated bouts of stimulus and return monetary policy to a more conventional focus on price stability.

Is this the worst financial crisis ever?

posted 9th October 2011

In his media interviews to justify the MPC's decision to expand its Quantitative Easing programme (see blog below), Mervyn King said "This is the most serious financial crisis we have seen at least since the 1930s, if not ever." This is a very sweeping statement, and one that the Governor has made before - for example in his speech to the TUC last autumn.

The problem with the Governor's statement is that the phrase "financial crisis" - which has a specific technical meaning for him - does not have the same meaning in the wider world. In the media and in popular discussion, the distinction between a "financial crisis" and a broader economic crisis is blurred. Many people see them as the same thing. Because of that, the Governor's statement is potentially very misleading to the public and risks creating a much more apocalyptic and negative view of the economy than is justified by the economic data. 

This can be seen clearly in the way that the Governor's remarks were picked up in the media. For example, on the BBC website, the word "financial" dropped out of their headline and the story became: "Bank of England governor fears crisis is worst ever". The Daily Mirror ran the headline: "Mervyn King warns financial crisis is worst slump ever" and its interpretation of the Governor's comments was in line with the headline.

Sir Mervyn and the media professionals who advise him must be aware of this, and yet he continues to make the same claim. In an environment in which consumer and business confidence is very fragile, this is potentially very dangerous - fuelling and reinforcing some of the negative influences on the economy which the Bank claims to be taking steps to counter through its QE programme. In terms of justifying the policy stance of enhanced QE, this might fit in with the Bank's narrative - but I can't believe it is good for the economy.

One measure of how serious the current financial crisis is for the UK is the unemployment rate. As the chart to the right shows, unemployment performance since the onset of the financial crisis has been better than previous recessions. Whereas unemployment rose to over 10% in the aftermath of the early 1980s and early 1990s recession, the unemployment rate is currently just below 8%. It may rise a bit further as the slowing of the global economy and the UK economy show up in the employment numbers. But so far we have not seen anything like the unemployment experience of the 1980s - when the unemployment rate was over 10% from late 1981 until early 1987. In the 1990s recovery, it was only after four years of recovery - in late 1996 - that unemployment came down to its current rate of just under 8%. In the 1920s and 1930s, the measured unemployment rate was over 10% for two decades and peaked at around 22% in the early 1930s. (Click here for a House of Commons Library research paper discussing unemployment and other economic trends in the 20th Century.

When assessing the severity of a financial crisis, the benchmark must surely be the impact on the wider economy. One of the more positive features of the response of the UK economy to the current crisis is the resilience of the non-financial sector business community. Business failures and redundancies have been much lower than many expected, which has helped sustain employment - as the chart shows. 

Maintaining the confidence of the business community through these difficult times is a key issue for economic policy-makers. In terms of this challenge, the Governor's apocalyptic and gloomy statements are surely counterproductive.

Postcript: In my view, the worst financial and economic crisis to affect the UK since the 1920s and 1930s is still the mid-1970s crisis, which saw inflation rising to average nearly 25% in 1975, and peaking at 26.9% in August 1975. The UK stock market fell by 73% in 1973-4, a much bigger decline than anything we have seen in the current crisis. This period also included a secondary banking crisis in the UK, the first major recession since the Second World War, and a request for IMF assistance for the UK economy in 1976. The unemployment rate rose from 3-4% on our current LFS measure to 5-6% initially and then to over 10% as the inflation consequences of the crisis were dealt with in the early 1980s. Unemployment only fell below 6% on a sustained basis in 1999, around 25 years later. In 25 years time, perhaps we can evaluate whether the recent financial crisis has been worse than this. But it is about 20 years too early to rush to judgement!

The MPC’s latest decision – hitting the wrong target

posted 7th October 2011

It goes without saying that I think the MPC was wrong to launch another round of Quantitative Easing at its October meeting. I have made that clear in my contribution to the public debate over the past year, and particularly over the past week. I don't think that this new round of QE will help growth and it risks sustaining the surge in inflation we are now experiencing.

But what worries me more is that the MPC is going down the wrong track for reasons which are deeply embedded in their processes and procedures.

UK inflation is currently 4.5% and could soon hit 5%. It has been above target for the past five years, bar nine months, and is likely to remains so for at least another year – and possibly much longer. You might think that the obvious response of an independent central bank with a 2% inflation target would be to worry about the persistence of this high inflation and seek to tighten policy – particularly when interest rates are at record low levels.

Instead, the most recent policy move that has been taken by the MPC has been to try and stimulate the economy with a new programme of Quantitative Easing, which risks pushing inflation up further. That is because in the world of the MPC, it is not actual inflation which matters but the forecast for the future. While there is a justification for this approach – economic policy cannot influence the past, only the future- there are other more important pitfalls.

The first and most obvious is that forecasts can be wrong. That has been a big problem for the MPC since the financial crisis. About 2 years ago, the MPC was forecasting 1% inflation in mid-2011; not the 4.5% we have experienced. Forecasts are useful, but they do not describe reality. It is the actual rate of inflation which matters for the public , the business community, and stability of the economy – not the MPC’s forecast. And persistently wrong forecasts can undermine credibility.

The second problem with forecasts is that they reflect the model which you are using. So what is the model that the MPC is using to justify its recent decisions?

The justification for the new round of QE is that: “the weaker outlook for, and the increased downside risks to, output growth mean that the margin of slack in the economy is likely to be greater and more persistent than previously expected” and that “the deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term.”

From this statement, it is clear that the MPC is sticking rigidly to its “output gap” model of inflation,. According to this model, the large fall in GDP in the financial crisis should have reduced inflation much more than it did. The “output gap” model of inflation has failed woefully. UK inflation has been much more heavily influenced by the value of the pound and global inflationary forces. So this would suggest that the value of sterling should be a key issue being monitored by the MPC at present. Instead, the Governor and other key members have welcomed the decline in sterling, and the resulting inflation, as a “necessary requirement for the rebalancing of the Uk economy”.

The third source of problems in a forecast-based approach to policy-making is that forecasts are never purely model-based; they require judgements. It is the judgements of the MPC members, led by the Governor Mervyn King, which shape the MPC’s forecast. For a combination of reasons, which are probably linked to the experience of the financial crisis, key members of the MPC appear to put more weight on downside risks to the economy and are unwilling to acknowledge that persistent above-target inflation is a potentially serious problem. That has introduced an inflationary bias to UK monetary policy.

One of the signs of this is the great rapidity with which the majority of MPC members have been prepared to respond to weakness in growth in its latest decision, despite their great resistance to my earlier arguments for raising interest rates in response to persistent inflation over-runs. In 2010, strong global growth pushed up UK inflation via energy and commodity prices, but this was not grounds for MPC action. And yet a weakening in global growth prospects over the summer is sufficient to generate a massive new programme of money creation – purely on the basis of the MPC’s forecasts.

While the inflation target continues to be interpreted in terms of the MPC’s forecast, there is far too much scope for the Committee to reinterpret its mandate in its own terms and “get off the hook” when inflation performance has been poor. In terms of recent MPC decisions, the inflation target has effectively become a growth target – because of the excessive weight on the “output gap” model. The recent MPC decision confirms this view.

So who is going to hold the MPC to account? Unfortunately, the government appears complicit in the Bank's approach. Sir Mervyn’s regular letters to the Chancellor are always welcomed with a positive response, rather than a severe rebuke. In this environment, it is not surprising that many are questioning the Bank’s independence and commitment to price stability and the inflation target.

The virtue of having an independent central bank is that it is prepared to take tough decisions  in defence of price stability when politicians are unwilling to do so. The MPC is  ducking this challenge, which brings into question its independence and commitment to its price stability goal. Unless this behaviour changes, those who worry about relatively high and persistent inflation in the UK are right to do so.

More monetary stimulus would be a big mistake

article to be published in City AM, 4th October 2011

The most recent MPC minutes suggested that the Committee may be moving towards injecting more stimulus into the UK economy by restarting its policy of Quantitative Easing (QE). This would be a big mistake. It would confirm what many are beginning to suspect – that price stability and the 2% inflation target are no longer the key objectives of UK monetary policy. And it would do little to support growth when the squeeze on consumers from high inflation is itself one of the biggest impediments to the progress of the UK economy in the short-term.

The case for injecting more stimulus into the UK economy rests on relatively disappointing GDP figures over the past year, which has reignited worries about future growth.  This partly reflects a softening in the global growth trend – though the latest IMF forecast still suggests that the world economy will grow by 4% this year and next, after expanding by over 5% in 2010.

At home, the main factor holding back economic growth is the squeeze on consumer spending from rising prices – with consumer price inflation now at 4.5% and set to rise further in the months ahead. The latest retail spending figures show this very clearly. In money terms, retail spending is up a respectable 4.5% over the past year, and with inflation around 2% this would have been associated with healthy increases in sales volumes. But all of this increase in money spending is now being swallowed up by price rises. This leaves consumers no scope to increase their spending in real terms and support the growth of the economy. In other words, high inflation and slow growth are inextricably linked.

The MPC believes that this rise in inflation is temporary. But if that is the case, there is no need to provide extra stimulus to the economy, as a fall-back in inflation next year will allow the growth of consumer spending to resume.

Worryingly, there are signs that relatively high inflation may persist into next year and beyond. Services sector inflation – which accounts for about half of the consumer basket - has been stubbornly high in the UK since the late 1990s, and continues to run above 4%. In addition, the weakness of the pound against the dollar and the euro is pushing up the cost of goods imported into the UK - much more so than in other countries. Unless the pound begins to recover, particularly against the euro, we are likely to continue to experience high imported inflation.

The injection of more stimulus through QE is likely to make this problem worse by further weakening the pound. It would reinforce the expectation that the MPC has a very dovish stance and will be reluctant to raise interest rates for some time. And the direct effect of more money creation in the UK is likely to depress sterling by boosting the demand for foreign assets as investors rebalance their portfolios.

In the short-term, the impact of QE on the value of the currency would therefore simply prolong  the pattern we are now seeing – of high imported inflation squeezing consumer spending growth. There is likely to be little offsetting benefit to the manufacturing sector, which is already highly competitive at the present value of sterling and where capacity pressures are already beginning to emerge.

In addition, there are two longer term dangers of a policy of injecting more stimulus in the current environment . The first is that the experience of high inflation continues to push up wage increases – which are now running at over 3% in the private sector. Against the current background of weak productivity growth, a further drift upwards in pay growth to 4-5% would not be consistent with 2% inflation in the medium term.

The second risk is to the credibility of the MPC itself. The purpose of having an independent central bank is that it is prepared to take tough decisions in defence of its core mandate – price stability. There has been little evidence recently that the MPC is prepared to do that. In the second half of last year and early this year, the Governor and other senior Bank officials resisted a rise in interest rates which could have helped to head off the current surge in inflation.

A further round of QE in the current circumstances would provide fairly clear confirmation that the MPC has an inflationary bias, and is much more prepared to tolerate inflation above the target than below it. This would be a bitter blow for all those on fixed money incomes – especially pensioners living off their savings - who had put their trust in the price stability mandate of the Bank of England.

This autumn, there is an opportunity for the MPC to give a clear signal that they are not sliding down the slippery slope to a high-inflation future.  The Committee should turn its back on the siren calls for more stimulus and focus on its core remit of price stability.

Time to start adjusting to new economic realities

article published in the Financial Times, 27th September 2011

It is sometimes said that bad news comes in threes. That certainly applies to global financial markets over the summer.

In late July, the US budget deficit crisis erupted, followed by the downgrade of US sovereign debt by S&P in early August. That helped to reignite the most recent phase of financial market anxiety about high deficits and debts in the euro area. Most recently we have had gloomy statements about world growth by global financial leaders.

There is a common theme behind this trio of harbingers of bad economic news. It is a failure of leadership. In the US, policymakers showed themselves incapable of devising a credible deficit reduction plan. A similar impasse seems to exist in the euro area.

Yet global economic forecasts are not excessively downbeat. The latest International Monetary Fund forecasts point to 4 per cent global growth in 2011 and 2012 – in line with the healthy economic growth rate we saw before the financial crisis. However, the gloomy prognostications of world leaders have fuelled suspicions in markets that something dark and nasty is lurking in the woodshed.

So what is the way out of this impasse? The first step to get out of a hole is to stop digging. If world leaders and policymakers have nothing positive to say about the current economic environment, then they should say nothing.

The second step is to build a positive agenda for action at the G20 summit in early November. However, the policy action we now need is not a repeat of 2008/9, when the main focus was on stimulatory policies to halt a downward spiral in world demand and output. Instead, we need a focus on the policies which will help build recovery.

That requires a recognition that in the world economy of the 21st century, it is the Asia-Pacific region – supported by other emerging market economies – which will be the strongest engine of world growth. Europe and the US need to adjust to economic growth of around 2 per cent over the medium term (if they can achieve it), and focus on maintaining relatively high levels of employment.

The policy agenda for the western economies now should not be about demand expansion, but structural adjustment: ensuring labour markets are flexible; the business climate is not encumbered by excessive regulation; tax rates are as low as they can be; and tax structures are efficient and reward enterprise and innovation.

The third ingredient needed is for central banks to stop pretending they can remedy all the deficiencies of the economic system by providing unending amounts of stimulus whenever growth appears weak in the short-term. Historical experience suggests that continual injection of demand stimulus to counter weak growth leads to persistent inflation and financial instability.

Central banks acted boldly – and rightly – in 2008/9 to stabilise economic conditions in the face of sharply falling demand and output. But they should now be focussing on a more conventional interpretation of their mandates. That means responding to upside risks to inflation by tightening policy when appropriate, as well as being prepared to relax policy in response to downside risks.

In the UK, we missed the opportunity in the second half of last year to start to rein in monetary stimulus. And the US embarked on its QE2 programme. These policies have not boosted growth. Rather, they have led to relatively high inflation. More stimulus is likely to result in more of the same, while doing little if anything to support growth.

What western economies now need is not further stimulus, but an opportunity to adjust to the new post-financial crisis reality. And they need stronger and more confident signals from policymakers that they are committed to pursuing sound economic policies in the medium-term.

We are in a tough period of economic policymaking, both for governments and central banks. But if policymakers duck difficult decisions in the current climate, they will find life even more challenging in the future. The experience of recent months has highlighted that very clearly.

The 50p tax debate

posted 11th September 2011

I disagree with the 20 economists who wrote to the FT last week protesting about the rise in the top tax rate in the UK to 50%. They may have a point that the impact of this measure may have less benefit for public finances than the government hoped. However, no evidence is yet available about the scale of the loss of tax revenue through tax avoidance and movement of high revenue-earning individuals away from the UK. Until it is, we should beware of basing tax policy on ideological arguments, however compelling they may appear to the well-off members of society who are affected by a rise in the top tax rate.

Some "revenue dilution" is clearly a risk from a rise in the top tax rate. But a more important issue is to demonstrate that all sections of society - particularly the well-off - are sharing in the pain of deficit reduction. I am very uncomfortable with the notion that the well-off should be exempt from tax increases because they are internationally mobile - unlike the poorer members of society. The campaigners against the 50p tax rate would have a stronger argument if they could demonstrate how the money that the government expected to generate from this measure could be raised more easily by other tax or spending changes.

What is missing in the current debate about taxation is a view on how the tax system can be restructured and made more efficient through a process of tax reform. We have not had a serious tax-reforming Chancellor since Nigel Lawson left office over 20 years ago. The current deficit-reduction programme is a missed opportunity to raise extra revenue through tax reform. All the emphasis is on higher tax rates: for top earners and for consumers generally through a higher VAT rate. But the onus is on those who oppose the current thrust of policy to propose a genuine alternative

Those opposing the rise in the top tax rate to 50p would have more credibility if they were advancing serious proposals to restructure the tax system to raise extra revenue while avoiding disincentives. They have not done so, and this greatly weakens their case.

Ignore inflation at your peril!

posted 11th September 2011

This week we will see the August 2011 inflation numbers published. CPI inflation is expected to be around 4.5% and RPI inflation will be around 5%. This is not the world of price stability, promised when the Bank of England was given independent responsibility for monetary policy and the Monetary Policy Committee (MPC) was established in 1997. Yet the MPC shows little concern - indeed the current perceived wisdom is that the Committee may soon start to try and inject more economic stimulus.

So how has the MPC sought to defend its position? Broadly, three main arguments have been deployed. First, the Committee has argued that this is a "blip", outside its control. Second, there has been a suggestion that a rise in inflation is acceptable because the alternative - raising interest rates - would be worse, risking pushing the economy back into recession. Third, the Committee has sought to argue that other underlying measures of inflation are more reassuring. The favoured indicator to support this argument is the rate of growth of wage increases, which is currently running at around 3% in the private sector.

These are, however, powerful counter-arguments on all three points.

First, we do not appear to be experiencing an inflation "blip". Rather, high UK inflation appears rather persistent. Despite the impact of the global financial crisis, UK inflation has continued to run ahead of our peer group of economies, such as the US and euro area. UK inflation of around 4.5% compares with 3.6% in  the US and 2.5% in the euro area. UK inflation has been persistently above the inflation target, averaging 3% over the past five years compared to the 2% CPI target. Recent global inflationary pressures appear to have had a bigger impact in the UK than elsewhere, partly because they have been aggravated by a relatively weak pound.

Second, it is far from clear that a gradual rise in interest rates - which is the policy I have argued for since the middle of last year - would have destabilised the recovery. The main threat to growth at present comes from high inflation itself - rising consumer prices are squeezing disposable incomes and hence consumer spending. A greater willingness to raise interest rates would have probably resulted in a stronger pound and hence helped to curb some of the imported inflation we have experienced. Monetary policy affects inflation in a 1-2 year time window, so we could have done something to curb the inflationary pressures we are now experiencing if we had acted last year.

Third, there is no reassurance that current indicators of wage growth will prevent high inflation in the future. We have experienced high inflation over the past 2/3 years, even though wage growth has been weak. And wage growth is creeping up in the private sector. The annual increase in private sector average earnings has already risen from about 1% a year ago to around 3%. And it could easily rise further, as pay settlements respond to the current spike in headline inflation. Also, the relationship between wage growth and inflation is dependent on productivity growth. Recent figures show a weak productivity trend as the UK economy emerges from recession. If this persists, and wage growth returns to its past historical average of over 4%, unit labour costs will be rising at a rate inconsistent with the 2% inflation target.

A much less reassuring picture of the underlying inflation trend emerges if we look at services sector inflation - which is currently 4.4% and has been consistently in the 3-5% range for over a decade now. This is significant, as services account for about half the consumer basket. It is much harder for the MPC to blame persistently high services inflation on "temporary" factors, such as energy and commodity prices and the value of the pound, as these factors tend to have their main impact through the prices of goods. If the margin of spare capacity was exerting downward pressure on UK inflation, as the MPC has consistently argued, we should have seen its influence by now on price-setting in the services sector. While services inflation remains stubbornly high, to achieve the inflation target we will need to see flat or falling goods prices, which seems most unlikely with the pound so weak against the euro and with global inflationary pressures likely to persist.

In my view, high UK inflation is no longer a temporary inconvenience but it is a problem which requires an adjustment of monetary policy. Timely action last year would have mitigated the squeeze on disposable incomes and consumer spending we are now experiencing, which is one of the more significant factors currently impeding UK economic growth. In the 1970s and the 1980s, economists argued against tolerating inflation because it was bad for growth. We should heed these arguments in the current climate, however tempting it is to pursue more stimulus and to accommodate high inflation in the short-term.

More demand stimulus is not the answer

originally published in the Wall Street Journal on 1st September 2011

In late 2008 and early 2009, it was quite right for economic policy to seek to head off a self-sustaining downward spiral in the major economies around the world. Dramatic interest-rate cuts, unconventional monetary policies and expansionary fiscal policies combined to support demand, helping to stabilize economic conditions and restore confidence.

The situation now is different. It is not "debt deflation" but relatively high inflation that has been squeezing out growth. The global economic recovery has been under way for about two years and we need to allow for some fluctuation in growth rates, particularly following the recent disruption to the Japanese economy.

In 2008-9, the requirement was to head off an abrupt short-term drop in demand. Now the challenge is to provide conditions that build confidence in the health of the economy over the medium term. That should provide the private sector, which is ultimately the engine of economic growth, with the confidence to invest, generate new jobs and create wealth.

First of all, government finances must be put on a more sound footing. This will take a number of years to achieve, so it requires governments to set out clear and credible long-term plans and to stick to them. Prevarication and confusion about deficit reduction is not good for private-sector confidence, as we saw in the U.S. this summer. The private sector needs to have confidence that persistent government deficits are not a long-term threat to financial stability. And a long-term plan implemented over a number of years should help businesses by giving them time to adjust to the required spending and tax changes.

Second, monetary policy needs to shift away from the emergency settings that were put in place to halt sharp falls in demand in late 2008 and 2009. The deflationary risks that were then a worry have now receded. Indeed, in some countries—such as the U.K.—persistent inflation is now the bigger worry. Again, this withdrawal of monetary stimulus is best achieved gradually. As a member of the Bank of England Monetary Policy Committee (MPC), I argued that U.K. interest rates should have started to rise in the second half of last year. Postponing this process of monetary adjustment has not helped the British economy. It has aggravated the rise in inflation, done little to support growth and called into question the MPC's commitment to price stability as the central objective for U.K. monetary policy.

A third key ingredient in the policy mix for managing the recovery is a renewed focus on measures to improve the supply-side performance of Western economies. A solid and sustained recovery relies on the dynamism and efficiency of the supply side of the economy. Government policy initiatives can support growth by encouraging new start-ups, promoting the innovative capacity and flexibility of existing businesses, boosting the skills of the work force and removing regulatory and administrative impediments to business growth and efficiency.

Though elements of these policies are being put in place, in general, policy making across the Western economies has moved too slowly to embrace this agenda for managing the recovery. As a result, it is not surprising that private-sector confidence remains fragile and financial markets are jittery.

Concerns about the pace of global economic recovery and renewed calls for action to stimulate demand need to be viewed in this context. A slowdown in growth this year should not be a great surprise. World economic growth in 2010 was 5.1% according to the International Monetary Fund—only the third year in the past three decades when it has exceeded 5%. (The other two were 2006 and 2007, at the peak of the global credit boom.) Even so, the drop in the global growth rate now seems likely to be more pronounced than earlier forecasts suggested, for three main reasons.

The first is a deceleration in growth in the Asia-Pacific region, which played a key role in lifting the world economy out of recession in the second half of 2009 and 2010. The expansionary policies that supported strong Asian growth are now being reined in, partly because of concerns about high inflation. Asia is likely to remain a major engine of world growth in the medium term, reflecting its strong economic fundamentals. But recent short-term economic indicators have been mixed—indicating that the pace of growth in the region is slowing from "super-strong" to just "strong."

The second factor is the temporary impact of the Japanese earthquake and tsunami. Not only did this dislocate the growth of the world's third largest economy, but it also disrupted global supply chains, depressing output in key manufacturing sectors such as IT and motor vehicle production around the world. However, this effect should prove temporary. The latest positive CBI survey suggests that the rebound may already be under way in U.K. manufacturing.

The third negative influence on global growth has been inflation. Rising energy and commodity prices, and a recovery in profit margins, have pushed up inflation in the U.S. and Europe. In the U.S., headline inflation on a year-over-year basis has risen to 3.6% from 1.2% over the past year, and in the EU it has risen to 2.9% from 2.1%. The U.K. has been particularly hard-hit, with inflation running at around 4.5% and set to rise further in the autumn. These relatively high rates of inflation are suppressing economic growth as price increases squeeze disposable income and consumer spending.

Against this background of rising inflation, further stimulus of the demand side would be a move in the wrong direction. It may appear to offer the prospect of short-term respite from economic difficulties. But it will not help us secure the conditions for sustainable growth and lasting economic recovery.