The Bank of England faces a monetary policy dilemma in the "new normal" economy...
The BANK OF ENGLAND's Monetary Policy Committee (MPC) – which voted to set the latest interest rates in the UK this week – faces a dilemma, says former MPC member Andrew Sentance on his blog, The Hawk Talks, posting an article which first appeared in The Times on Thursday.
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 this week would have been 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 have been 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.
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