The Bank of England has not adapted to the "new normal"...
LAST WEEK provided some temporary relief from the doom and gloom with some positive UK economic data, writes former Bank of England Monetary Policy Committee member Andrew Sentance.
We learned that unemployment has fallen again (on the broader Labour Force Survey 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 unanimous 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, totaling over £6000 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 kick start 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 recognize that sterling has a key role to play in stabilizing 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 stabilize 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 stabilize 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.
[NB This article was originally written last week, and is republished here with permission]
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