Spencer Dale: The UK's economic recovery - why now; will it last; and
what next for monetary policy?
Speech by Mr Spencer Dale, Executive Director, Monetary Policy, and Chief Economist of
the Bank of England, at the Confederation of British Industry (CBI) East of England Midwinter
Lunch, Newmarket, 13 December 2013.
* * *
I would like to thank John Lewis, Matt Trott and Gavin Wallis for their considerable help in preparing this speech.
The views expressed are my own and do not necessarily reflect those of other members of the Monetary Policy
Committee.
I thought I would start today with a short reminiscence about the late Eddie George, who was
Governor of the Bank of England between 1993 and 2003.
Soon after becoming Governor, Eddie gave an interview in which he was asked how he
would judge the success of his Governorship. Now this was before the advent of the
Monetary Policy Committee, so he couldn't frame his response simply in terms of hitting the
inflation target. Instead, Eddie replied that "My personal ambition is that the rate of growth of
output should be above the rate of inflation for three years in a row".1
At the time, this seemed a fairly tall order: prior to Eddie taking over, this hadn't been
achieved even once since the Second World War.
But as it turned out, growth was stronger than inflation in every single year of Eddie's 10-year
reign. And that continued for the next few years after he'd retired. Indeed, during the halcyon
days of the so-called Great Moderation that preceded the financial crisis, it started to seem
that Eddie's ambition was no longer quite so demanding.
But - as you all know - then came the crisis! That, combined with a commodity price boom
and a sharp depreciation in sterling, meant that the days of GDP growth outstripping inflation
quickly became a thing of the past. We've failed to live up to Eddie's ambition for each of the
past six years.
The good news is that recent developments - on both growth and inflation - mean that we
appear to be heading back towards an environment of which Eddie would have approved.
Over the past six months, output has grown at an annualised rate of almost 3%, almost a
quarter of a million new jobs have been created and indicators point to a continuation of
strong growth. At the same time, inflation has fallen sharply and, at 2.2% in October, CPI
inflation is as low as it's been for four years.
In terms of growth, the obvious question this raises is, why now? Why, after throwing
everything bar the kitchen sink at the economy over the past few years, has the economy
started to grow only now? Even more importantly, will the recovery last? Having seen a few
false dawns over recent years, has the recovery really taken hold this time? And what does
all this mean for monetary policy. In particular, what does the MPC's so-called forward
guidance, which we announced in the summer, mean for you - the businessmen and women
driving this recovery?
And that's the plan for today: to consider three key questions about the economic recovery
that we're now finally enjoying - why now, will it last, and what next for policy?
Why now?
First, why now? Why after several years of frustration and disappointment has the economy
begun to grow? It's hard to be certain: this time last year we were not predicting such a sharp
turnaround in growth and there's a danger of appearing to be wise after the event. But, at
least with the benefit of hindsight, two developments in particular seem important in driving
the turnaround: an easing in credit conditions; and a reduction in economic uncertainty.
Let me say a few words about each, starting with credit conditions.
Improved credit availability
Although it's still patchy and there's further to go, we've observed a marked improvement in
the ability of many companies and households to access credit over the past 18 months or
so. Some of that stems from a lessening of tensions within the euro area, which has helped
to ease pressures on banks both sides of the channel. It's also been aided by domestic
polices, including the Funding for Lending scheme, a series of regulatory actions to improve
the strength and resilience of our banking system and, more recently, the Government's
Help-to-Buy policies.
I fully recognise that the ability of many SMEs - perhaps many of you here today - to access
credit at reasonable rates still remains impaired. But even here my sense is that some
progress has been made. That's the message from surveys of small businesses, from
reports by the Bank's Agents, and indeed that I get from my own conversations with many
businesses around the country. We're not there yet - and the Funding for Lending scheme
remains in place to encourage banks to lend more to companies, particularly SMEs - but we
have taken a step in the right direction.
For households, the improvement has been more marked. Interest rates of new mortgages,
especially those for fixed-rate mortgages and those with higher loan-to-value ratios, have
fallen by well over a percentage point since the summer of 2012. Unsecured personal loan
rates have fallen by even more. The greater ease with which many families can access credit
has fed through to the housing market, which until recently had been in a state of deep
freeze. Housing transactions fell very sharply in the wake of the financial crisis and
subsequently flat lined. Nominal house prices moved sideways for several years. But over
the past six months or so, there's been some thawing. Housing transactions and mortgage
approvals have started to show signs of life. House prices have picked up.
A healthy housing market is good for our economy and will help to support the recovery.
Most importantly, it will underpin further increases in house building, which has played an
important role in driving the economic growth we've enjoyed this year and which, as a nation,
we need to see. It will foster greater labour mobility by allowing people to move more easily
to where new jobs are being created. It will help to support consumer confidence.
But let's not be naive. Anyone with more than a passing interest in British economic history is
aware that the UK housing market has a sort of microwave type quality to it, with a tendency
to turn from lukewarm to scalding hot in a matter of a few economic seconds. The Bank is
fully aware of this risk. The good news, however, is that it's far better equipped to respond to
these types of risks than in the past. In particular, the new Financial Policy Committee (FPC)
- the sister Committee to the MPC - has explicit responsibility for maintaining the resilience
of the financial system. And, together with the other regulatory bodies, the FPC has the
policy instruments which can address potential excesses in the housing market - and in
other markets - which pose a threat to the stability of the financial system.
So although there are risks and there is further to go, particularly for SMEs, credit conditions
for many companies and households have eased over the past 18 months and this has
helped to stimulate activity, particular so within the housing market.
Consider next the reduction in economic uncertainty which has probably played a greater
role in turning the economy around this year.
Reduced economic uncertainty
It seems clear that economic uncertainty has diminished over the past year or so. Think
back, for example, to the middle of last year, when the euro area appeared once again to be
teetering on the edge. Or even as recently to the beginning of this year, when all the talk at
home was of the possibility of a triple dip.
To some, appealing to "reduced uncertainty" as a driver of the economic recovery may sound
rather vague and nebulous. A convenient ex post rationalisation perhaps for something we
don't really understand.
But it seems clear to me that uncertainty and fear greatly amplified the initial impact of the
financial crisis.2 How else, for example, can we explain the speed with which a failure of a US
investment bank in September 2008 led to output and orders up and down our country, and
indeed around the world, "falling off a cliff" within a matter of months?3
More generally, speaking to companies over recent years, I've been left in no doubt that
heightened uncertainty has served as a significant brake on their activity and plans for
expansion. And for good reason.
Most obviously, when faced with greater uncertainty about the economic outlook, many
companies may hold off undertaking new investments or starting new ventures and wait for
the uncertainty to be partially resolved before deciding whether or not to go ahead. The value
of waiting - or keeping your options open - is especially marked when considering lumpy
investment projects which are hard or costly to reverse once made.4
Uncertainty may delay actions and investment within companies, even if managers are not
waiting for it to be resolved. Take, for example, a company deciding whether to invest in, say,
a new IT system. It may be that at current levels of orders and activity, it's too close to call
whether this investment will pay off, and so the decision is put on hold until orders increase
sufficiently to tip the balance decisively. But suppose the economic outlook is particularly
uncertain, so the company is very unsure whether, even if orders were to rise, that strength
would continue. In that case, the company is likely to require an even bigger increase in
orders before taking the plunge. As a result, heightened levels of uncertainty will tend to push
down on aggregate investment.5
More generally, many companies faced with a more uncertain economic outlook may adopt a
defensive strategy, hunkering down to ensure that they survive the economic storm. Sure,
this may mean deferring potentially profitable business opportunities for a while, but better
that than risk your long-term future. In this context, it's worth remembering that it's the most
2
For more a detailed discussion of the role increased uncertainty may have played in contributing to the depth
of the recession, see the recent article by Abigail Haddow, Chris Hare, John Holley and Tamarah Shakir
(2013) in the Bank of England's Quarterly Bulletin.
3
This phrase was used by Mervyn King in evidence to the Treasury Select Committee in November 2009: "At
the beginning of the year we had experienced two quarters when the world economy, in the words people
around the world have used, fell off a cliff".
4
For example, Dixit and Pindyck (1994) show that for a company to undertake an investment project its net
present value must not merely be positive, but must be greater than the implied option value of waiting until
the next period.
5
Bloom (2009) shows that higher uncertainty tends to lead to lower investment because it widens the "zone of
inaction" associated with companies waiting for the economic environment to move decisively in once
direction or the other. The partial irreversibility of investment means that there are more companies at the
margin deciding whether to invest than those at the corresponding disinvestment margin. Widening this region
of inaction causes more new investments than disinvestments to be cancelled, and hence lowers total
investment.
successful companies with the brightest futures that are likely to be most affected in this way,
since they have the most to lose.6
As I said, the good news is that the cloud of uncertainty has started to lift. And just as
heightened uncertainty greatly amplified the downturn, this reduction in uncertainty can
provide a powerful spur to the recovery.
This leads to our second question for today: will the recovery last?
Will it last?
The reduction in uncertainty and the easing of credit conditions appear to have started to
unlock pent-up demand and so fuel a recovery.
That recovery to date has been largely driven on the household side: high-street sales have
increased modestly as consumers have spent a greater share of their pay, and investment in
residential housing has increased significantly. The dominant role of the household sector in
the early stages of the recovery is not particularly surprising: businesses are likely to need a
sustained pickup in demand before they have either the need or the confidence to increase
capacity. But the durability of the recovery will depend on the baton of growth being handed
over to the corporate sector, whose spending and investment will help to foster stronger
growth in productivity and real incomes.
And here the reduction in uncertainty may continue to play an important role. It's perhaps
easy to see how reduced uncertainty may help to prompt a one-off increase in business
spending, as companies move away from defensive, wait-and-see strategies and blow the
cobwebs off plans for deferred investment projects. But the impact of diminished uncertainty
may stretch beyond simply a short-run boost.
In part that reflects the possibility that the combination of reduced uncertainty and increased
spending by households and companies may become self-reinforcing: reduced uncertainty
helps to spur additional spending and investment, which in turn further reduces uncertainty
about future demand and so on.7
Movements in uncertainty can amplify the recovery just as they amplified the downturn.
This virtuous circle may be enhanced by the benefits reduced uncertainty can have for the
supply-side of our economy. Increased investment will add to our productive capacity. A
strengthening labour market may give employees confidence to move jobs, so better aligning
available skills with vacancies. Companies may lift
the shutters and start to take the types of risks and entrepreneurial activities necessary for
our long-run prosperity.8 Such improvements in the supply performance of our economy
would greatly enhance the durability of the recovery.
Diminished uncertainty may also bolster the impact from the past easing in monetary policy.
The MPC has loosened monetary policy aggressively since the financial crisis, both by
cutting Bank Rate to historically low levels and by the use of more unconventional tools, such
as Quantitative Easing and the Funding for Lending scheme. But if, over recent years, many
companies have been largely focussed on survival, waiting for some of the uncertainty to be
resolved before actively considering opportunities to invest and expand, it's possible that the
easing of borrowing costs brought about by these policies has not yet fully translated into
spending decisions. As uncertainty lessens, past monetary policy actions may gain greater
traction, thus further supporting the recovery.
So there are good reasons for thinking that the reduced uncertainty may help to facilitate this
handover to business spending we need to see, and that some of those effects may be long
lasting.
But we also need to be alive to the possibility that the events of the past few years may
colour and contaminate business behaviour for many years to come. It may be a long time
before companies look ahead with the same confidence that they did during the period of
remarkable stability prior to the crisis. Before their trust is restored that the authorities are
able to stop really bad things from happening. Before they rebuild their relationships with
their banks.
On this final point, many companies were let down by their banks during the financial crisis,
and I fear that many will be reluctant to return to a business model which relies on their
banks providing liquidity and support in times of need. The reluctance today of some
companies to borrow from their banks may be less a lack of demand and more a breakdown
of trust. Although an understandable response to the events of the past few years, an
increased prevalence of self-insurance is not good for the efficient functioning of our
economy.
The scarring effects of the financial crisis and the uncertainty it brought with it, together with
the fiscal consolidation and the weakness of the euro area, are likely to continue to weigh on
the recovery over the next few years. Yes: our economy appears to have turned a corner.
And yes: there are good reasons for optimism that the recovery will persist. But we can't take
it for granted: there's still a long way to go. And that sense of how far there is to go underpins
the policy guidance provided by the Committee earlier this year and takes us to our third and
final question: what next for monetary policy?
What next for monetary policy?
The primary objective of monetary policy remains to hit the Government's 2% target for CPI
inflation. Despite missing the target for much of the past five years, I've no doubt that the
credible nominal anchor it provided served our economy well during the crisis. Indeed,
without that credibility it wouldn't have been possible to loosen monetary policy as
aggressively as we did in order to support output and jobs.
As we have seen, the good news is that inflation has fallen sharply over the past few months
and the 2% target is now in sight for the first time in over 4 years. But this isn't a time for
complacency. To repeat, inflation has been above the 2% target for most of the past five
years. There are good reasons why policy wasn't tightened in order to bring inflation back to
target more quickly. But ultimately, the MPC will be judged by the success of our actions, not
the elegance of our arguments. We need to demonstrate our commitment to bring inflation
back to target and to keep it there.
But we have also needed to trade off the speed with which we bring inflation back to target
against the support that monetary policy can provide to the recovery. The MPC's forward
guidance gives greater clarity about our view of the appropriate trade-off.
More important for us today, our guidance is rooted in the recognition that it's a long way
back to the economy being fully recovered. The damage and losses associated with the
financial crisis and the years of frustration and disappointment that followed won't be
reversed simply by one or two quarters of strong growth. Our guidance makes clear that we
intend to maintain the current exceptionally stimulative stance of monetary policy until we've
seen a sustained period of strong growth and the margin of slack in the economy has
narrowed significantly, as long as this does not pose risks to either price or financial stability.
As you may know, our guidance was framed in terms of so-called thresholds and knockouts.
The MPC intends not to raise Bank Rate or reduce the stock of asset purchases at least until
the unemployment rate reaches a threshold of 7%, subject to three knockouts designed to
guard against risks to price and financial stability.
But abstracting from the details of these thresholds and knockouts, our message to you - the
businessmen and women driving this recovery - is clear. You can plan for the future in the
knowledge that the MPC intends to keep interest rates low until we have seen a prolonged
period of strong growth, unemployment is significantly lower, real incomes are higher.
Based on some of the reporting, you might be forgiven for thinking that forward guidance is
far more complicated than this. To take just one example, let me read to you the opening
sentence of an article last month reporting on the MPC's November Inflation Report. Under
the headline "Forward guidance fails", the article began: "The Bank of England now expects
the economy to grow strongly next year, highlighting the fact that its policy of forward
guidance has effectively failed."
Strong growth, falling unemployment: if that's failure, I wish I'd failed long before now!
The aim of the Committee's guidance isn't to provide a commitment that interest rates won't
rise until some particular date in the future. Monetary policy has to respond to the changing
state of the economy. We can no more commit to keeping our prices and quantities
unchanged irrespective of economic circumstances than you can. Rather, our guidance
should reassure you that, absent risks to either price stability or financial stability, we will
tighten policy only when we are well along the road to recovery. Yes: interest rates will rise at
some point. But only against a far stronger economic backdrop, when your output is higher,
your order books are fuller, and you and your customers are better able to withstand a rise in
borrowing costs.
Moreover, although still some way in the distance, we shouldn't look at the prospect of an
eventual rise in interest rates with a sense of dread and fear. Assuming that interest rates
rise due to the vigour and durability of the recovery, rather than concerns about either
inflation or financial stability, we should see interest rates beginning to rise as a sign of the
strength of our economy. As a sign that that we are well on the way to making a full recovery.
As a sign that the emergency life-support measures put in place since the crisis are no
longer required.
The MPC is fully aware that extraordinary low interest rates are likely to be needed for some
time yet. But when they cease to be, this will be a sign that we have finally turned the corner
for home.
Conclusion
Let me summarise
At long last, we appear to be moving back to an economic environment of which Eddie would
have approved. One in which the economy is growing robustly and inflation is close to target.
A recovery appears to have finally taken hold, spurred by reduced uncertainty and easier
credit conditions. There are good reasons for optimism that the recovery will be durable. But
the journey back to full recovery is long and many challenges still remain. Monetary policy is
there for the long haul. That is the essence of our forward guidance.
References
Haddow, A., Hare C., Holley, J., and Shakir, T. (2013) "Macroeconomic uncertainty: what is it,
how can we measure it and why does it matter?", Bank of England Quarterly Bulletin, 2013 Q2.
Ben Haim, J. (2010) "Info-Gap Economics: An operational introduction", Palgrave McMillan
Bloom, N. (2009) "The Impact of Uncertainty Shocks", Econometrica 77:3, pp 623-685
Bloom, N., Bond, S. and Van Reenen, J. (2001). "The dynamics of investment under
uncertainty", IFS Working Paper, No. W01/05.
Bond, S.R. and Lombardi, D (2004) "To buy or not to buy? Uncertainty, irreversibility and
IMF Working Paper no. 04/104.
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Disney, R, Haskell, J and Heden, Y (2003), "Restructuring and productivity growth in UK
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Princeton University Press
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investment dynamics", 2010 Meeting Papers No. 1285, Society for Economic Dynamics.
NBER Working
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Paper No. 17910.
Miles, D. (2013), "Monetary Policy and Forward Guidance in the UK", speech given at
Northumbria University, Newcastle, 24 September.