The role of a central banker is to take away the punchbowl just as the party gets going. Bank of England governor Mervyn King took things a stage further last week, coming close to cancelling the festivities even before the invitations have been sent.
This was a week when the National Institute of Economic and Social Research said the economy may have stopped sliding in April for the first time in a year. One City forecaster — JP Morgan — revised up its UK growth forecasts and another, HSBC, said the storm had passed for sterling. Yet the Bank of England decided to be downbeat.
There is always the possibility that the Bank knows something we do not, explaining its gloomy tone. Its intimate knowledge of the banking system — over the past 18 months at least — may have persuaded it that what it describes as “the dislocation in the financial sector” will be more of a drag on recovery than others assume.
My sense, however, is that the Bank, given a “glass half-full or glass half-empty” choice, had no incentive to be upbeat. It has taken as much of a beating as the Treasury for failing to forecast the scale of the recession (in common with everybody else) and did not want to risk its reputation further on what are still fragile green shoots. It is in the middle of an unprecedented monetary relaxation programme, including a 0.5% Bank rate and £125 billion of quantitative easing.
Too optimistic a message, despite the “promising signs” it has detected that the pace of decline is moderating at home and abroad, would have sat uneasily alongside that and perhaps conveyed the message that a tightening of policy is on the horizon, which was not the intention.
The Bank’s forecast produced the knee-jerk “another blow for Alistair Darling” response, led by opposition politicians. However, the new forecast — for the economy to decline by some 3.75% this year before rising by a shade over 1% next — was close to the Treasury’s numbers.
The doubts come further out, 2011 and beyond, when the governor’s “slow and protracted recovery” contrasts with the chancellor’s strong rebound, which after the past few weeks he no doubt expects to be viewing from the opposition benches.
However, this is a public service column, so let me perform one by repeating to you what was the main message from the Bank last week. It was that, if you did not know it, the outlook is extremely uncertain. The Bank cannot predict the future. The governor wants every household and every business to be aware of that. If things go wrong over the next two to three years, nobody will be able to say they were not warned. If they go right, the Bank has a convincing story to tell on that too.
The uncertainties include the possibility of a short-term return to growth, resulting from the stimulus of very low interest rates and sterling’s depreciation. But then it runs out of steam as the realities of postrecession adjustment kick in, the “double dipper” referred to here last week.
They include the danger of permanent rationing of credit and of the dramatic downturn in world trade — the biggest in the post-war era — failing to reverse itself. The “period of healing” from last autumn’s dramatic near-collapse of the global banking system will take time.
These are big issues but there is also a significant uncertainty closer to home. What will consumers do? Will they save, rebuilding their finances but depriving the economy of spending when it needs every penny. Or will they spend, leaving their balance-sheet adjustment until later?
On the face of it, people have no choice but to cut spending. Unemployment is rising — by 244,000 in January to March, according to the Labour Force Survey — and average earnings, broadly measured, are down on a year ago. Credit availability remains tight.
We should probably treat the earnings numbers with a pinch of salt. Though the figures including bonuses are indeed down on a year ago, that merely reflects the collapse in City bonuses. Excluding bonuses, earnings were up 3%. Most people in work will see their earnings rise significantly this year in real terms, particularly when measured against retail price inflation, which is already in negative territory. The unemployment constraint on spending is genuine; the earnings constraint is not.
What about savings? As the economy turned down sharply in the final quarter of last year, the saving ratio rose strongly, to nearly 5%. Not so long ago it was less than zero. We do not have the figures yet, but it is quite likely to have risen further in the first quarter. It seems odd that people are saving more when many savings accounts pay next to nothing. It seems unlikely we have become precautionary savers.
Much more likely, and the Bank alludes to this, is that the saving ratio is rising because people are borrowing less, either because they are unable to or because activity in the housing market, always the main driver of borrowing, is only gradually recovering from very depressed levels. If that is how it turns out, the adjustment to household balance sheets could be less painful than feared. The effect of very low interest rates is important.
As the Bank puts it: “The lower level of Bank rate has reduced the debt-servicing costs faced by many households and should, in aggregate, boost household spending, given the likely higher propensity to consume from current income of borrowers, relative to savers.” Against that, rising unemployment, repossessions and the fear of higher taxes may force people to rein back. Weak domestic demand could coexist with an uncertain recovery in world trade.
It could go either way and the Bank does not know which. So far, retail sales have held up better than many feared, despite a downward nudge in the official figures on Friday, though purchases such as cars have been weak and the impact of the scrappage scheme is keenly awaited. In general, though, you write off British consumers at your peril. Spending will fall this year but they may yet prove themselves to be instinctive spenders, not savers.
PS: Inflation targeting is in the dock, including in a strange Centre for Policy Studies’ pamphlet, The Myth of Inflation Targeting, by Lord Saatchi. The framework the Tories created out of the wreckage of ERM (exchange rate mechanism) membership in autumn 1992, reinforced by Bank independence in 1997, is blamed for leading us up the garden path.
An Institute of Economic Affairs’ pamphlet, Verdict on the Crash, risks giving that venerable think tank a bad name by blaming “central bankers, government and over-regulation” for the crisis but not the banks or the markets. It puts part of the blame on UK monetary policy.
What is to be done? Mervyn King said last week more committees and working groups than you could name were looking at how you could improve on simple inflation-targeting for the future.
Those of us who believe that for 15 years it was the most successful UK monetary policy framework in the modern era have to hope the baby is not thrown out with the bathwater. The worst thing the government could do is announce it is scrapping the Bank’s inflation target.
Fortunately, help is at hand. The other day I came across a piece from three years ago drawing on a paper by William White, who was economic adviser at the Bank for International Settlements. The title is a mouthful, Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?, but the message straightforward.
What we need, he said, is “augmented” inflation targeting, in which the central bank tolerates periods of very low inflation or even deflation if it thinks interest rates need to be high for other reasons. The focus should also be on a “macroprudential regulatory framework, that puts more emphasis on the health of the financial system as a whole, rather than individual institutions”. We will hear a lot more of this.
Originally published at David Smith Economics UK and reproduced here with the author’s permission.
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