Charles Bean: The UK economy after the crisis - monetary policy when it
is not so NICE
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy at the Bank of England,
to Alumni of Cambridge University, London, 16 March 2010.
* * *
Good evening! Tonight I want to talk about what the future might hold for the British economy
and draw a few lessons from the recent crisis for the conduct of monetary policy. As you will
no doubt recall, the Bank was given the operational responsibility for setting interest rates in
1997 by the incoming Labour government. In retrospect, the Monetary Policy Committee's
first decade can be seen to have been part of a golden era of steady growth and low and
stable inflation, which began in 1992 after the exit from the Exchange Rate Mechanism and
the subsequent adoption of the inflation target (Chart 1). Economists refer to this period of
benign macroeconomic outturns - which was not confined to the United Kingdom - as the
"Great Moderation", though the Governor has somewhat more colourfully referred to it as the
NICE (for Non-Inflationary Consistently Expansionary) decade.
Well, it is pretty clear that the NICE decade has come to an end, with a financial crisis
unparalleled in almost a century in its severity and reach, together with the sharpest and
deepest downturn in global activity experienced in the post-war period. Peak to trough,
output fell just over 6% in the United Kingdom, almost 4% in the United States, nearly 7% in
Germany and more than 8% in Japan. And in the eight months following the collapse of
Lehman Brothers, world trade collapsed by almost a fifth, a figure completely unmatched in
peace time.
Governments and central banks around the world responded by providing substantial
support to their banking systems, relaxing fiscal policy, slashing official interest rates and, in
some cases, introducing unorthodox monetary measures. This succeeded in avoiding the
worst of the immediate downside risks to activity and employment. China and some other
emerging economies have subsequently rebounded strongly, and during the second half of
last year, we saw growth resume, albeit at a moderate pace, in most of the advanced
economies. It appears to have taken a little longer for expansion to return here but, according
to the current vintage of official data, output rose 0.3% in the final quarter of 2009. Production
and trade are likely to have been adversely affected by the inclement weather in January, but
business surveys suggest that a similar rate of expansion will occur in the first quarter of this
year.
While a return to growth is certainly good news, it is clear that we still have a very long way
to go before recovery from the Great Recession of 2008-9 is complete. A large margin of
underutilised resources in the economy remains and it will take time before these are
returned to active use. How quickly that happens depends on the strength and durability of
the recovery. Some of the turnaround in growth here and elsewhere is mechanical in nature,
driven by a reduction in the rate at which businesses are running down their inventories. But
as far as the strength of the recovery over the medium term goes, one needs to look at the
underlying forces driving the demand for UK goods and services. On this score, there are
both reasons to be fearful and reasons to be cheerful.
The reasons to be fearful are several. First, the banking system here and elsewhere is still
dealing with the legacy of decisions taken before the crisis. The process of balance sheet
repair has some way to run and that is likely to continue to restrain the supply of credit.
Moreover, a key feature of the run-in to the crisis was an underestimation of risk and an
excessive compression of risk premia. We should not expect premia to return to where they
were before the crisis broke. The spreads on lending to businesses and households,
particularly riskier prospects, will be higher in the future than before the crisis.
Second, the housing boom has resulted in some households, especially younger ones,
carrying forward high levels of debt. Although the burden of servicing these debts is currently
manageable because of the low level of mortgage interest rates, concerns about future
servicing costs as interest rates normalise may lead the high stock of outstanding debt to
weigh on these households' spending. The possibility of unemployment may also encourage
saving, though happily unemployment has so far risen by less than many observers,
including the Monetary Policy Committee, feared. The relative robustness of employment,
given the depth of the decline in output, owes something to the willingness of employees to
accept low pay awards in the face of the downturn. Last year over a third of private sector
pay settlements were pay freezes, and a recent survey of their business contacts carried out
by the Bank's regional Agents points to a similar outcome this year (Chart 2).
Third, the Government allowed the fiscal deficit to rise in response to the downturn. That was
helpful in cushioning the fall in demand. But the deficit now looks set to be around 12% of
GDP this year, which is unsustainable in the medium term. That creates a difficult balancing
act. Cutting spending and/or raising taxes is likely to result in lower domestic demand,
though a failure to do so may lead long-term interest rates to rise, also hitting demand. The
recent depreciation of sterling appears to owe something to heightened fears about the UK's
fiscal prospects. Fortunately, all political parties recognise the need to put in place a credible
plan for the consolidation of the public finances over the medium term, even if their preferred
routes to doing so differ.
Finally, question marks remain about the durability of the recovery in the rest of the world
and particularly in the UK's main export markets. Some of the advanced economies face
headwinds similar to those facing the United Kingdom. The fate of the euro area, the
destination of more than half our exports, is particularly important. The recovery there all but
stalled in the fourth quarter and business surveys point to only moderate growth in the first
part of this year. Moreover, Greece and some other euro-area countries face significant fiscal
challenges. The necessary fiscal consolidations are likely to depress overall euro-area
demand unless offset by demand expansion elsewhere.
But as I noted, there are also reasons to be cheerful. Two factors in particular should provide
a boost to the demand for UK goods and services. First, there is a substantial policy stimulus
still working through the economy. Bank Rate remains at a historical low of 0.5%, while the
Bank has bought some £200 billion of assets, mainly gilts, financed by the issuance of
central bank reserves (think of these as Bank of England IOUs that are held by the
commercial banks) - so-called "quantitative easing". Even though we have called a pause in
our asset purchase programme, the effects of past purchases will continue to work through
the economy for some time to come. The aim of quantitative easing is to boost the supply of
money, push up a wide range of asset prices and facilitate finance through the capital
markets, thus raising nominal demand in the economy.
How well is quantitative easing working? Chart 3 shows, for the two days following each
successive announcement about the scale of the asset purchase programme, the
movements in: average gilt yields; the expected average level of Bank Rate over the same
maturity (from Overnight Indexed Swap rates); and the spread between them1. That
suggests gilt yields are lower as a result of the programme by a total of around one
percentage point. Moreover, since the programme began, investment-grade corporate bond
yields have fallen by almost four percentage points, equity prices have recouped half their
losses and capital market issuance has been unusually strong. Finally, nominal demand
growth recovered to an annualised rate of around 4% in the second half of last year.
Although we cannot be sure what would have happened without our asset purchases, these
2
movements do at least g o in the expected direction .
Some commentators have pointed to the weakness in bank lending and argued that this
shows that quantitative easing has not worked. While the substantial increase in bank
deposits and bank reserves as a result of the asset purchase programme could indeed
encourage banks to extend more credit, such an effect was always likely to be quite weak, as
at the current juncture banks are seeking to repair their balance sheets and to de-leverage.
Rather, the objective of quantitative easing is to work around an impaired banking system by
stimulating activity in the capital markets.
Of course, some businesses, especially small and medium-sized enterprises, will not find it
possible to access funds through the capital markets. But the right response is then to get
the banks back into a position to lend normally as soon as possible. The array of measures
introduced by the Government to support the banking system - injections of new capital,
insurance against losses on toxic assets, guarantees on bank debt - plus the Bank's Special
Liquidity Scheme, which allows banks to swap illiquid mortgage-backed securities for liquid
treasury bills, have all been aimed at that objective.
The second reason to be hopeful lies in the substantial depreciation of the sterling effective
exchange rate, which has fallen by around a quarter since the middle of 2007. Prior to that,
the MPC had already drawn attention to the need to re-balance the economy away from
domestic spending towards net exports and so reduce the UK's current account deficit. A
real depreciation, boosting the competitive position of UK producers in both domestic and
overseas markets, is part of the mechanism to bring such a rebalancing about. And an
increase in net exports will, of course, help to fill the hole made by the crisis-induced
reduction in private and, potentially, public spending.
Unfortunately, there is little sign so far of a significant impact of the depreciation on the
volumes of exports and imports, which have moved broadly in line with the movements in
overall demand abroad and at home respectively (see Charts 4 and 5). Moreover,
commentators have noted that exporters have responded to the depreciation by expanding
their profit margins rather than cutting their foreign currency prices in order to boost market
share. Does this mean that the depreciation will prove ineffective at boosting demand? I do
not think that would be the right conclusion. Experience after previous large depreciations,
such as following sterling's exit from the Exchange Rate Mechanism in 1992, suggests that it
is normal for the initial impact to be seen mainly in expanded profit margins and only after
some while does one see an impact on market shares. One reason for that may be that
expansion in overseas markets requires some investment and businesses are likely to be
cautious about making that expenditure until they are sure the improvement in profitability will
be maintained. For that reason, I expect to see the contribution from net exports gradually
building as the global recovery proceeds.
The path of the recovery will be determined by the balance between these two sets of forces.
Our central expectation, as laid out in our February Inflation Report, is for four-quarter GDP
growth to gradually strengthen as the year proceeds (Chart 6). But the quarterly path is sure
to be uneven and there remains a risk of setbacks. And even if things turn out well, it is likely
to be a considerable time before the substantial margin of underutilised resources in the
economy developed in the downturn is whittled away (Chart 7).
That brings me naturally to inflation, the MPC's mandated target. One might expect that, after
such a sharp downturn, inflation would have dropped back. Indeed, inflation had fallen as low
as 1.1% last September. Since then, it has moved up sharply, reaching 3.5% in January and
triggering an open letter of explanation from the Governor to the Chancellor. That volatility in
inflation can be explained in terms of a variety of factors impacting on the price level: the
restoration of the standard rate of VAT to 17.5%; recent movements in the oil price and a
year earlier; and the pass-through into consumer prices of the higher import prices
associated with the depreciation in sterling. When setting monetary policy, the MPC looks
through effects that can be expected to affect inflation only transitorily, to the underlying
determinants of inflation in the medium term: inflation expectations; and the margin of slack
in the economy.
Despite recent volatility in actual inflation, inflation expectations, according to a variety of
measures, have remained stable and reasonably well anchored at levels consistent with the
target. There is, however, considerable uncertainty about the extent of the downward
pressure on inflation from economic slack. With output some 10% lower than it would have
been if pre-crisis growth rates had been maintained, it would appear that the margin of spare
capacity ought to be large. But the evidence from past sharp downturns after banking crises
is that they can have a significant impact on the economy's supply potential (Chart 8).
Downturns typically lead to less investment, more capital scrapping, fewer business start-ups
and more business closures and a restriction in the availability of credit is likely to aggravate
these effects. Moreover, lower employment can lead to skills atrophying and the long-term
unemployed becoming disconnected from the labour market.
Business investment has fallen sharply in this recession - down more than a quarter from its
peak - though only part of that is likely to reflect a restriction in the availability of credit.
Heightened uncertainty is also likely to have played a part. But against that, both business
closures and, as noted earlier, unemployment have risen less than feared. So the overall
impact of the downturn on the present and future supply potential of the economy is rather
uncertain.
In addition, in present circumstances the extent of the downward pressure on inflation from
spare capacity is also uncertain. Once one allows for the effect of transient factors such as
the restoration of the VAT rate, oil price movements and the likely impact of sterling's
depreciation, underlying inflation has been surprisingly resilient. That could be because the
impairment of effective supply as a result of the credit crunch is large. Or it could be that the
spare capacity is exerting little downward pressure, because businesses with limited access
to credit are unwilling to run the risk of reducing their cash flow by cutting prices in order to
boost market share. Moreover, even though pay growth has been muted, unit wage costs
have nevertheless risen quite sharply because businesses have held onto skilled labour
through the recession, rather than lay it off. So the firmness in underlying prices may just be
the flipside of the better-than-expected labour market outturns.
Despite these uncertainties, it seems likely that the margin of spare capacity will be sufficient
to pull inflation back towards the 2% target from its present elevated level, as the near-term
effects of the restoration in VAT and sterling's past depreciation work through. Our latest
projections, contained in the February Inflation Report, are shown in Chart 9. The risks of
inflation being above or below the target are roughly balanced by the end of the forecast
horizon.
It should, I hope, be clear from my remarks that, although a recovery of sorts may have
commenced, there are still considerable doubts about its strength and durability and about
the accompanying path of inflation. The road ahead is likely to be bumpy and there is still the
risk of further adverse shocks. All we can do on the Monetary Policy Committee is stand
ready to react to those risks if and when they crystallise, either resuming asset purchases if
further stimulation is required, or tightening policy through Bank Rate increases and
ultimately asset sales.
Let me now step back from the UK's immediate economic prospects, to ask what recent
experience has taught us about the broader monetary policy framework. After such a
cataclysmic economic event, people have unsurprisingly questioned whether inflation
targeting is the right regime or whether it needs to be modified or even abandoned. A variety
of changes have been mooted.
First, some commentators have suggested that the focus on inflation is misplaced at the
current juncture, when surely the aim ought to be to get output up and unemployment down;
at the very least the Committee's objective ought to include a measure of activity, as, for
instance, in the US Federal Reserve's "dual" mandate. In my view, this criticism is misplaced
as the Chancellor's remit to the MPC already incorporates a subsidiary objective to support
the Government's aims with respect to growth and employment, providing that it does not
jeopardise meeting the inflation target.
When the economy experiences a contraction in demand, as in the wake of the collapse of
Lehman Brothers, other things equal, inflation tends to fall. The objectives of maintaining full
employment and stabilising inflation are therefore aligned, and there is no inconsistency in
these circumstances between boosting growth and meeting the inflation target.
Things are more complicated when an adverse supply shock occurs, such as the sharp rise
in oil prices that we saw during the first half of 2008. That tends to lower output at the same
time as it raises inflation, so there is a tension between maintaining high growth and meeting
the inflation target. But under the present regime, the MPC has "constrained discretion" to
look through the inflationary impact of such a shock, provided it is temporary. What the
regime does not permit is for such a shock to be accommodated in a persistently higher rate
of inflation. That is what happened in the Seventies and I do not think we want to go back
there.
The essential point that critics of the current set-up need to bear in mind is that an adverse
supply shock will always leave the policy maker with a difficult judgement, as the appropriate
monetary policy response depends on the extent to which it is likely to lead to compensating
increases in wages and other prices. Changing the objective does not alter that basic
dilemma, but compensating increases in wages and other prices will be less likely if people
already expect inflation to remain low and stable.
Finally, as was illustrated in Chart 1, the inflation targeting period was, until the past two
years, also a period of unusually steady growth. So, from a practical perspective, there was
no obvious conflict between stabilising inflation and stabilising output.
A second suggested change to the framework has come recently from the IMF. While not
questioning the basic framework, they suggest3 that inflation targeting central banks should
aim to hit a rather higher inflation rate of around 4%, so as to give more room to cut official
interest rates in the face of a collapse in demand before they hit their natural floor of zero.
Thus, during the years leading up to the crisis, Bank Rate averaged around 41⁄2%-5% and
inflation averaged around 2%, so the real interest rate averaged 21⁄2%-3%. If instead,
inflation had been averaging 4% and Bank Rate 61⁄2%-7%, i.e. the same real interest rate as
before, then we would have been able to lower Bank Rate by another two percentage points
before it approached its lower limit.
The thinking behind this seems entirely reasonable. But, aside from ignoring the fact that
monetary policy, in the shape of asset purchases4, can still be effective even when the policy
rate reaches zero, it underplays the costs of higher inflation. Inflation at 2% or less is
generally felt to be low enough that businesses and households do not have to consciously
plan for rising prices - it is "close enough" to price stability, in other words. While 4% may not
sound much higher than 2%, the difference is large enough that people would have to
consciously take account of inflation in their decision making. Moreover, it is unexpected
movements in inflation that are particularly costly and capricious in their impact, and there is
a well documented empirical relationship between the level and the volatility of inflation (see,
for instance, Chart 10). There is a risk that even a modest increase in the target, such as the
IMF advocates, would lead to a corresponding increase in inflation volatility. Such an
increase in the target should not be regarded as costless.
Moreover, it would be particularly dangerous to raise inflation targets at this juncture, as one
should expect nominal interest rates to rise roughly in line. Even if expected long-term real
interest rates were thus unchanged, the fall in bond prices would lower wealth and worsen
the already-impaired balance sheets of financial institutions. So raising the inflation target
represents a risky way of providing more room for manoeuvre in the face of a
once-in-acentury financial crisis, whose potential repetition is any case best prevented through other
means, as I will explain below.
A more potent challenge to the regime comes from the charge that, while the
inflationtargeting regime may have delivered the goods during the Great Moderation, it singularly
failed to prevent the build-up of the financial imbalances which are now unwinding so
painfully. Indeed, an even stronger version of this argument is that the very success of the
regime contributed to the decline in market participants' perception of risk and encouraged
them in the leveraged acquisition of risky assets. According to this view, the MPC ought to
put independent weight on credit and asset price developments and should have kept policy
tighter during the years leading up to the crisis. That would have generated an undershoot of
the inflation target in the near term but reduced the likelihood of a disruptive unwinding of the
financial imbalances further out.
The first point to make is that interest rates affect the whole economy through a variety of
channels. Raising Bank Rate in order to curb a credit boom would be fine if that credit boom
was also associated with excessive demand growth and overheating in the real economy.
But that, by and large, was not the case during the years leading up to the financial crisis.
Raising interest rates enough to have had a material impact on the credit boom would most
likely have resulted in an even higher value of sterling, markedly weaker activity and higher
unemployment. Would businessmen, households and Parliament have accepted this as a
price worth paying to bring down credit growth with the hope of forestalling a hypothetical
future financial crisis? I suspect the answer to this would be No, even though equipped with
20/20 hindsight we might take a different view. The fact is that policy has to be made in
ignorance of how the future will turn out, and one has to weigh certain near-term costs
against uncertain longer-term gains.
Moreover, it seems unlikely that higher interest rates in this country alone would have
prevented us experiencing a severe recession. Events in the United States would have
proceeded in much the same way, regardless of what the MPC chose to do. And, as we
have seen, the downturn has been global in nature, not confined to those economies with
overblown financial or housing markets.
Would it have helped if our target variable had, say, included a measure of asset prices,
particularly house prices? There is certainly a good case for including a measure of
owneroccupied housing costs in any consumer price measure, as for many households it
represents their largest single expenditure. And, depending on the measure used, that could
have resulted in higher inflation figures during the years leading up to the crisis. That does
not, however, translate directly into a higher level of Bank Rate. Monetary policy affects
inflation with a long and somewhat variable lag and there is little the MPC can do to offset
unanticipated movements in near-term inflation. Instead, we have to look at inflation
prospects two or three years ahead. But it is in the nature of asset prices, including house
prices, that one can say rather little about their likely direction of movement that far ahead.
Most of the time, the best projection of asset prices at that horizon is for them to be broadly
flat. Consequently, I suspect that our policy choices would not have been radically different
had we been tasked with targeting an inflation measure that included a measure of
owneroccupied housing costs.
Finally, there is something of a logical error in moving from the indubitably correct
observation that successful inflation targeting is insufficient to guarantee either
macroeconomic stability or financial stability to the conclusion that monetary policy should in
addition, or instead, be focussed on some other objective. There is a real danger in
overburdening monetary policy if it is expected to achieve both price stability and financial
stability simultaneously. With two objectives, one needs two independent means of achieving
them. The assignment of instruments to targets then revolves around which instrument is
most effective at achieving which objective.
Though loose monetary policy, particularly in the United States during 2001-5, arguably
contributed to the build-up of the financial imbalances, it was but one of many causes,
including a plethora of failings within financial institutions. These include: inadequate care in
the extension of loans to risky individuals, when those loans are then sold on; the
inappropriate use of off-balance-sheet vehicles to circumvent capital requirements; reward
packages that encouraged an undue focus on short-term returns; excessive complexity and
opacity in some asset-backed securities; and distorted incentives facing ratings agencies.
Although regulators and supervisors conspicuously failed to address these issues during the
run-up to the crisis, prudential regulation and supervision should surely be the first line of
defence, as they can be focussed directly on the source of the problem. Regulatory policies
have a comparative advantage in combating excesses in financial markets. By contrast,
inflation is, in the long run, a monetary phenomenon, so it is more naturally suited to the
pursuit of price stability.
Beefing up the regulatory regime so it is better suited to preventing the re-emergence of
financial excesses is very much work in progress. There are sound arguments for forcing
banks to build up more capital and reserves during the good times, which they can then draw
down if things turn bad, so improving the general robustness of the system - so-called
"macro-prudential regulation". Under instruction from the G20, the Financial Stability Board,
together with the Basel Committee on Banking Supervision, is therefore developing an
appropriate set of cyclically-varying regulatory requirements on financial institutions5,
together with a range of other changes to improve the stability of the global financial system.
Of course, no regulatory regime will be perfect, and financial institutions have an incentive to
try to circumvent requirements that they perceive as onerous. So there may be times when
monetary policy will need to work alongside regulatory policy in order to restrain excessive
credit and asset price growth, even though the achievement of the inflation target may not
immediately appear threatened. But, in my view, that is best facilitated by retaining the clarity
of the present remit, rather than muddying the waters by introducing another objective for
monetary policy. The onus would then lie with the Monetary Policy Committee to explain that
it was permitting a temporary deviation from the inflation target so as to reduce the likelihood
of future financial disruption and improve its chances of meeting the inflation target further
ahead.
The past two and a half years have certainly been tumultuous for both the economy and for
policy makers. After such an event, we should certainly examine how the overall
policymaking framework should be re-made in order to reduce the chance of a repetition. But we
should be careful not to throw the baby out with the bathwater. The inflation targeting
framework served the real economy well for a decade and a half before the financial crisis. In
addressing the shortcomings in the overall policy framework revealed by the crisis, we
should be careful not to discard those parts that functioned satisfactorily. Thank you.
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