Paul Tucker: A few remarks on current monetary policy in a rebalancing
economy
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at The Joint 1900/City Club Lunch, London, 22 November 2011.
* * *
The outlook for economic activity has deteriorated over the past few months. The MPC has
responded with a further round of quantitative easing to underpin demand, and so reduce the
chance of inflation undershooting our target in the medium term.
Monetary credibility: accommodating the price level shocks
Our ability to provide and sustain that stimulus depends absolutely on the credibility of our
commitment to the 2% inflation target. If our credibility were to slip and medium-term inflation
expectations were to rise, we would have to run with a tighter monetary stance than
otherwise in order to put the genie back into the bottle. The Committee's most important
judgment over the past year or so has, accordingly, been that the elevated rate of inflation,
now about 5%, is temporary. We have had conviction in that judgment because of the
observable upward impulses to the price level from sterling's depreciation, the VAT increase,
and the rise in commodity prices. There is occasionally a rather odd debate about whether
the MPC could have avoided the consequent increase in inflation. Big picture, the answer is
that we could have done, but we chose not to. We have, in effect, accommodated something
like half of the cumulative impulse to the price level. We could have chosen instead to offset
the price level shocks by running a much tighter monetary policy. Had we done so, spending
in the economy, activity and employment would all have been squeezed. Conditions have
anyway been difficult for many households due to the squeeze on real incomes, but I think it
would have been worse if we had tightened policy. Our ability to sustain exceptional
monetary stimulus has, I should reiterate, depended on the credibility of our commitment to
low inflation over the medium term being preserved. I worried that chatter in the markets in
late 2010/early 2011 marked incipient signs of fragility in that credibility.
That was one of the reasons why, at the beginning of this year, I had expected to vote for an
increase in Bank Rate at our February meeting. The weak output data for Q4 2010 published
shortly before that meeting changed my mind, and the Committee's course, as they revealed
that the economy was softer than I had thought.
Escape velocity
In the months that followed, I made clear that, with inflation well above our 2% target, I would
be looking for an opportunity to begin the process of withdrawing the exceptional monetary
stimulus once the economy had achieved "escape velocity". By that, I meant that the
economy would need to be growing, and be set to continue to grow, at a rate that would
gradually absorb the slack in the economy. "Escape velocity" has not yet been achieved.
The principal sources of the deterioration lie overseas - from the squeeze on real incomes
due to the rise in commodity prices and, more recently, weakening global demand due
largely to the euro area crisis. Even if, as we all hope, a credible solution to the euro area's
problems can be put in place in the coming weeks, the traumas of the past few months will
take a while to overcome. Confidence has been sucked out of financial markets. Pressured
European banks are deleveraging by disposing of assets, or letting loans run off, elsewhere
in the world. Trade finance is again becoming impaired. Capital raising by companies has
declined.
And confidence has been drained out of the UK real economy too. Earlier in the year, we
faced a tug of war between a resilient corporate sector looking to expand when demand
picked up, and a fragile household sector worried about a rising cost of living, jobs and house
prices, with some households therefore saving more in order to strengthen their balance
sheets. In recent months, as confidence amongst businesses has flagged, they have been
tugging on the same end of the rope, with the MPC at the other end, in effect tugging back.
Part of that easing in monetary conditions has come through lower interest rates. In case that
sounds odd given that Bank Rate has been at 0.5% for over two years, I should underline
that, even in normal circumstances, monetary policy works through the expected path of our
policy rate. The markets now expect us to keep Bank Rate low for longer. Two-year risk free
money market rates are over 100bp lower than in the late spring. That has helped to offset
the rise in credit spreads, and so means lower borrowing costs in the real world. I place
weight on that, as my MPC colleagues know. Above that, we have decided to add £75bn to
our programme of Quantitative Easing (QE). The degree of monetary stimulus will slowly
increase as the agreed QE is executed. That money does not, as is sometimes suggested,
get stuck with the banks. The whole point of the Bank's operating framework for QE has
been to avoid that. All central bank money is ultimately held by banks: that is what a banking
system is. But by buying bonds from insurance companies, pension funds and others, we put
the money into their hands. It is money that, by construction, provides a meagre return
- negative in real terms - and so money that they will want to get rid of by purchasing other
higher-yielding assets. Policy still works through asset prices, increasing wealth and reducing
the cost of capital relative to where they would be otherwise.
Rebalancing: impediments
We recognise that the stimulus we have provided risks slowing further progress with the
necessary medium term rebalancing of the economy. Rebalancing will not, in any case, be
easy. The composition of demand in the UK was imbalanced for so long that the productive
capacity of economy is unbalanced. Crudely, the balance of aggregate demand needs, over
the medium term, to shift away from household and public consumption towards net trade
and investment. Up to a point, some of that has already happened. But domestic monetary
expansion will work partly through deferring some of the restructuring of household balance
sheets, underpinning consumption. And, looking ahead, the greater question is whether
rebalancing can be sustained as and when the economy returns to "full employment",
ie when the economy's spare capacity is utilised again.
Rebalancing is already impeded by tight credit conditions. Although our banking sector has
done much to strengthen capital and liquidity over the past few years, it would still have
ground to cover in rebuilding balance sheets even if the external environment were more
propitious. With instability from the euro area crisis threatening the UK, our banks cannot
avoid being exposed to outsized risks. That is reflected in elevated funding costs, which they
pass on to their customers to a greater or less extent. The gradual improvements in credit
conditions seen until the summer, and documented in the Bank's quarterly Credit Conditions
Survey, have been arrested for now.
In my book, this is not only bad for the needed cyclical recovery in aggregate demand. I
suspect that it will impede the rebalancing of the economy's productive capacity. Firms
wishing to enter or expand export markets, or compete against importers, often need credit.
Finance is the oil that lubricates the allocation - and so, in current circumstances,
reallocation - of capital in our economy.
This is manifestly affecting SMEs. My hunch is that housing market conditions are a factor
too. As long as anyone can remember, a crucial element of SME finance has been the
capacity of entrepreneurs to pledge their home at the outset of a loan or, contingently, if and
when their business hits choppy waters. Uncertainties about the path of house prices do not
make that a comfortable backdrop for lenders in current conditions.
Rebalancing will affect labour market conditions too. Perhaps the greatest surprise to the
MPC over the past few years has been subdued productivity growth. One could think of this
as firms maintaining employment at higher levels than would have been predicted given the
fall in the level of output. Labour hoarding. That squares with business managers explaining
that they worry about "structural" skill shortages and so are loathe to lose employees who
they will need when their markets recover. But it does not really square with surveys of
business conditions reporting that firms say they are carrying relatively little spare capacity.
We have scratched our heads about this. One possible explanation is that, in an economy
based heavily on the production of services, firms have been putting their teams to work on
marketing and sales to drum up business against a backdrop of weak overall demand. Those
teams may well be working hard. In that case, it may not feel to managers, when filling in
surveys, as if they have lots of spare capacity, But, as I have described it, those staff would
be working on inputs rather than outputs - making productivity across the economy as a
whole look weak.
Nor does labour hoarding square obviously with relatively healthy growth in private sector
employment over 2010 and the first half of 2011, before the recent slowing. In our internal
debates, I have posited that this could be a symptom of the economy's necessary
rebalancing. Firms facing expanding markets and demand may be hiring. Whereas, against a
backdrop of a very low policy rate and some forbearance by banks, individual firms in
contracting sectors could be holding out, either not recognising that their market is
contracting or believing and hoping that it will be their competitors rather than themselves
that end up cutting capacity or closing. It can be argued against that that rising employment,
and weakness in productivity, is spread fairly evenly across the private sector. But I suspect
that we have to dive down into the data to get a more disaggregated picture than we, as
macroeconomic policymakers, usually need. I am glad to say that my colleagues
Ben Broadbent and Martin Weale are now working with Bank staff on just that. While we
cannot yet tell whether a clear message will emerge, it is the kind of work that is needed
when the real economy is undergoing a degree of structural change.
Policy
The uneven and unavoidably difficult path for rebalancing in the real economy makes it
harder than usual to read the signals of cyclical conditions. But, by the same token, our
monetary accommodation can help to ease the costs to firms and households of adjusting.
By smoothing the path of aggregate demand, the impact on capital resources and on human
livelihoods can be limited somewhat.
In the Committee's latest forecasts, the central projection is for inflation to be under the 2%
target in two-to-three year's time. But it also has inflation rising back towards target through
that period as monetary stimulus gradually helps the economy to achieve escape velocity,
reducing slack in firms and the labour market. Given the ferocity of the shocks that have
already hit the economy, and the pervasive uncertainty that persists about global economic
and financial conditions, these are circumstances where taking longer than usual to
reachieve the 2% target is warranted. It will help to mitigate the risks of the economy's supply
capacity being impaired.
But that is to look ahead to the most likely path of inflation in a year or two. In the meantime,
inflation is uncomfortably high, and an absolute precondition for maintaining our support to
demand is the credibility of monetary policy. Over the next few quarters, the Committee's
most important judgment call will be put to the test. We will all discover whether inflation
declines rapidly from 5% towards 3% as the effects of the price level shocks wane.
Finally, let me stress that the gloom should not be overdone. The record is that flexible
economies with sound macroeconomic regimes recover from almost any crisis. The UK will
recover. Meanwhile the MPC will continue to underpin demand, consistent with getting back
to the 2% inflation target and so with sound money.