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Time to Change UK Monetary Policy

Economic growth might be the "new normal". Zero interest rates aren't...
 
THIS WEEK 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) writes former Bank of England policy-maker Andrew Sentance, in this article based on a speech to the Institute of Economic Affairs State of the Economy Conference late last month.
 
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.
 
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 2.25% and 2.50%), 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.
 
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;
 
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.
 
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.
 
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.

Now senior economic advisor to PricewaterhouseCoopers and part-time professor of sustainable economics at the University of Warwick in England, Andrew Sentance is a British business economist who from 2006 to 2011 served on the Bank of England's Monetary Policy Committee. Consistently calling for higher interest rates to combat rising inflation during his last 12 months in the role – and overwhelmingly outvoted each time – Dr. Sentance today shares his views on macroeconomic and monetary developments in his weekly blog, The Hawk Talks. His previous roles include senior economist at the Confederation of British Industry (CBI), chief economic advisor to the British Retail Consortium, and chief economist at British Airways.

See full archive of Andrew Sentance articles

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