Most of the excitement in Mervyn King’s speech last week was generated by his comments on banking supervision.
The Bank, if it is to carry out the financial-stability role now enshrined in legislation, wants more than the governor’s eyebrows as an enforcement tool. King, while hoping for a return to economic normality, thinks it should not be business as usual for the banks, which turned his “nice” decade very nasty.
He is on the “small is beautiful” side of the debate on bank size, arguing they should not be too big to fail, holding the financial system to ransom. Alistair Darling, the chancellor, seems more laissez faire, suggesting banks can be big if they are properly run. Both agree, however, on the need to ensure big institutions can be wound down in an orderly way.
We cover these issues in detail elsewhere. But there was also, in King’s Mansion House speech and other recent output from the Bank, evidence that the ground is being prepared for a shift of policy. The question, which you hear a lot, is how long can interest rates remain so low? Bank rate since March has been 0.5%, a level thought of as impossible even a year ago. How long, too, can other unconventional measures — quantitative easing, liquidity provision and the rest — continue?
For the markets, the question of whether the Bank will add to its £125 billion of quantitative easing — it can do another £25 billion without Treasury permission — is as important as the interest-rate issue.
King, stressing it was too soon to reverse the “extraordinary policy stimulus that has been injected into the UK economy” added it was not too soon to be preparing “exit strategies”, implying the Bank is doing so.
The minutes of this month’s monetary policy committee (MPC) meeting had a similar message, saying the Bank “could and would tighten policy” when necessary. What will this mean? The governor was clear: “When appropriate the MPC will raise Bank rate and gradually run down its portfolio of assets in a manner consistent with maintaining orderly markets.”
Alongside this, MPC members have been defending the inflation-targeting regime, insisting it would be a mistake to throw the baby out with the bathwater.
Paul Fisher, the Bank’s executive director for financial markets, told a conference that no monetary-policy regime could have prevented the current crisis or headed off the recession. Under inflation targeting “the UK experienced the most stable domestic macroeconomic conditions, in terms of low and stable inflation and steady output growth, that it has ever experienced”.
When should we expect to see the start of the exit strategy, involving higher rates and then the reversal of quantitative easing?
Inflation is important. We are seeing another drawback of shifting from the old target measure to the consumer prices index (CPI). This is falling glacially and at 2.2% is still above the 2% target. RPIX inflation (the retail prices index excluding mortgage interest payments) is in contrast at 1.6%, well below its former 2.5% target and fractionally above the point where the governor would have had to write a letter explaining why it had tumbled so far.
Falling inflation will be the story for some time yet. The decline in Britain has been slower because of sterling’s earlier fall, now partly reversed (the pound is up 13% this year). Eurozone inflation is zero while America’s consumer price index is 1.3% down on a year ago.
This does not prevent some in the markets fearing this is the lull before the inflationary storm. But a lengthy report from Rob Carnell, chief international economist at ING, takes on these arguments. Recessions are good at destroying inflation and policymakers would have to mess up spectacularly for it to come back any time soon.
As he puts it: “There will be no Zimbabwe-style hyperinflation or 1930s Germany with wheelbarrow-loads of cash. There is probably not even going to be a significant sustained increase in core inflation from the trends preceding the current crisis — at least not unless the policymakers are extremely careless.”
He sees low inflation — 2% or less — for two years at least, as does the Bank. Will rates stay at 0.5% that long? The consensus among economists is that Bank rate will be at this level at the end of the year and only creep up to 1.5% during 2010. The era of ultra-low rates, it appears, is here to stay. Until January, remember, we had not seen Bank rate below 2% for three centuries.
It may not, however, be quite so simple. The MPC has changed. By September it will have three newish members: Fisher, David Miles and Adam Posen, from Washington’s Peterson Institute. We do not yet know what its “reaction function” will be.
In normal circumstances, before summer 2007, the Bank raised the rate when the economy was growing above trend — if, say, the rise in quarterly gross domestic product (GDP) was above 0.6% or 0.7%.
These days, we do not know what the Bank thinks trend growth is. We do not know if it agrees with the Treasury that the recession has caused a permanent loss of 5% of GDP. These things are important.
But there is another point. We are, as I say, in once-in-300-years territory. King and his colleagues have been the equivalents of medics in the emergency room, using paddles and injections in a desperate attempt to keep the patient alive. At some stage the economy has to come out of ER.
Put more prosaically, real interest rates are negative — Bank rate is below the rate of inflation — something the MPC is unlikely to be comfortable with for too long. Existing and past members have made speeches pointing out that monetary policy errors in the past were often made by allowing real rates to go negative and stay there.
So it seems to me the MPC may start to push rates back up towards the norm — 5% is a reasonable estimate — faster than people think. The first rises could come this year but the continued weakness of bank lending argues against it and is the main barrier to recovery. However, next year there could be a sharper rise in interest rates than the City expects.
Next week, barring unexpected developments, I shall look at recovery prospects in Britain in the light of a tightening of both monetary and fiscal policy.
PS: The political debate over public spending is an appetiser for what we can expect for the next 12 months. In the past I used to do a party political broadcast watch during campaigns, exposing statistical horrors inflicted on voters in the heat of the polling battle. These days it would be hard to keep up.
That is the challenge for Straight Statistics (http://straightstatistics.org), a campaigning body launched last week. I should declare an interest, being a member of its advisory council. This puts me under extra pressure not to commit any statistical horrors of my own.
In the meantime, here’s one to get your teeth into. Who is doing better on the jobs front, people born in Britain or people born overseas? The answer, it appears, is both. UK-born employment fell to 25.28m in the first quarter, down 451,000 on a year earlier. Non-UK employment rose 129,000 to 3.81m.
If you are born in the UK, however, you have a better chance of being in work; the employment rate is 74.1%, compared with 68.4% for non-UK born. But the hardest-working group is not from here, eastern Europe, or even America. That accolade goes to Australians and New Zealanders — 85.8% of them who are of working age are in jobs. Strewth.
Originally published at David Smith’s EconomicsUK Blog and reproduced here with the author’s permission.
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