Spencer Dale: 2010 - a progress report
Speech by Mr Spencer Dale, Executive Director and Chief Economist of the Bank of England,
at the Kent Business School 21st anniversary dinner, Canterbury, 1 December 2010.
* * *
I would like to thank Ryan Banerjee, Rohan Churm, and Geoff Coppins 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.
Introduction
It is an honour to be invited here this evening to help you and the Business School celebrate
its 21st anniversary. Birthdays are a natural time to pause and reflect - especially those that
mark a coming of age.
Reflecting on your first 21 years, much has changed since the Business School was
founded. Some of you may remember that 1989 was the year in which Nigel Lawson
resigned as Chancellor and the Berlin Wall fell. You may remember less well that it was also
the year that Kylie and Jason enjoyed four Number 1 hits and Coronation Street attracted its
largest ever audience to watch Alan Bradley meet his grisly end under a Blackpool tram.
How time flies.
The economy has also had its fair share of ups and downs since then. After the 1990s
recession, we enjoyed 63 quarters of consecutive growth, withstanding en route the effects
of Black Wednesday and the dotcom bubble. Inflation targeting was introduced, the Monetary
Policy Committee created and we benefitted from a sustained period of low and stable
inflation. But as you know, this period of Great Stability came to an abrupt end with the
largest financial crisis for at least a generation. Output fell like a stone and inflation was
buffeted by a series of price level shocks.
I want to continue this theme of reflection in my comments tonight. However, with 2010
drawing to a close, I will restrict my observations to events over the past year - and what
they may herald for the future - rather than your entire 21 years. A progress report for 2010.
This has certainly been a busy year. The UK economy continued along the road to recovery.
A new coalition Government was formed and set in train what is planned to be the largest
fiscal consolidation of the post-war period. The Government also announced a major reform
of the structure of financial regulation, assigning considerable new responsibilities to the
Bank of England. These events have taken place against a backdrop of strong global
recovery, but one in which some countries, most notably within the euro area, continue to
face acute fiscal and banking pressures, and large imbalances between surplus and deficit
countries persist across the globe.
You will be relieved to hear that I do not intend to consider all of these developments tonight.
Instead, my progress report will focus on two key issues. First, how much comfort should we
take from the recovery seen so far and what factors are likely to determine its future vigour?
And second, to what extent are the Bank's planned new responsibilities for macroprudential
policy likely to address the "missing instrument" problem exposed so painfully by the financial
crisis? I will conclude with some reflections on monetary policy.
The recovery so far
There has been a strong start to this recovery. After four consecutive quarters of growth, the
pace of the recovery to date compares favourably with previous episodes: output is
estimated to have grown by 2.8% over the past year, quicker than at the same stage of either
the 1980s or 1990s recoveries.
Some encouragement can also be taken from the composition of growth. Spending by
households and businesses has begun to pickup; this despite strains on private sector
balance sheets, muted disposable income growth and an impaired banking system. Over the
past year, this increase in private sector spending has helped offset a weaker net trade
performance, which has been particularly disappointing given the early and substantial
depreciation of sterling.
However, it is too soon to say we are out of the woods. Economic recovery has to be judged
in terms of the level of output, not the rate at which it is growing. It is the level of households'
incomes that determines their well-being. And it is the level of economic activity which
governs companies' profitability and their viability. The fall in output during this recession was
larger than that in either the 1980s or 1990s recession. One year of growth does not make a
recovery. We need to see a sustained period of robust growth for the economy to function
normally again.
So what are the prospects for demand and output, and how likely are we to achieve this
sustained period of growth?
The strength of the recovery over the next few years will depend on the balance of the
substantial headwinds and tailwinds buffeting our economy. Economic forecasting at the best
of times feels like a triumph of hope over experience. That is especially so in the current
environment in which the economy is subject to gale force winds blowing in both directions.
But it is at least possible to identify some of the key factors that will determine the future pace
of growth.
Headwinds and tailwinds
Consider first the main headwinds hampering growth.
Most obvious is the fiscal consolidation now underway in the UK. Public sector spending, as
a share of nominal GDP, is projected to fall by around 8 percentage points over the next
5 years.
My central view is that the direct impact of this reduced spending, via the impact of lower
government procurement and smaller transfer payments, is unlikely to derail the recovery.
The spending cuts will certainly dampen growth. And some households and companies
directly affected by the cuts could suffer significant hardships. But the substantial stimulus
from monetary policy and the lower level of sterling should ensure that the recovery
continues.
The impact of the fiscal consolidation may be partially mitigated if it causes businesses and
households to become less uncertain about their prospects and so behave less cautiously.
But the reverse is also possible. In that regard, it is perhaps notable that, following a brief
revival, measures of consumer confidence have fallen back since the spring of this year.
The importance of Keynes' animal spirits has been demonstrated all too clearly by recent
events. Although the recession was triggered by a financial crisis, the speed and severity of
the downturn was greatly amplified by the accompanying collapse in confidence, as
companies and families pulled back on spending and increased savings. More recently, the
pickup in private sector spending has occurred alongside a fall in the household saving ratio
and a stabilisation in company saving.
A recent survey carried out for the Bank provides some evidence on households' attitudes
towards the fiscal tightening.1 90% of survey respondents said that they thought the fiscal
consolidation would have some impact on them. Perhaps surprisingly, a majority of these
households said they had not yet taken any actions in response to the consolidation. But it's
clearly still early days in this process and there is a chance they will react more as the impact
of the austerity measures increases. This is something that the MPC will continue to monitor
carefully.
A second headwind tempering the pace of progress is that UK banks are still not in a position
in which they can lend normally. As many of you know only too well from your own
experiences, the banking crisis led to a marked tightening in credit conditions, making it
difficult for businesses and households to borrow.
UK banks have made significant strides over the past year in strengthening both their capital
and funding positions. However, the extent to which that has led to increased access to
credit appears to have varied across different sectors of our society.
For large businesses, conditions do appear to have improved. For such companies, with
strong cash flow and good credit ratings, the corporate bond markets have in recent months
been open with yields close to historical lows. Furthermore, the Bank of England's Credit
Conditions Survey indicates that the availability of bank credit has increased and spreads
have fallen.2 This thawing in credit conditions for large firms is important since they account
for the majority of investment in our economy.
But for smaller companies, who are typically more dependent on bank finance, progress has
been more glacial. Smaller businesses regularly tell our Agents that they continue to have
difficulty in accessing affordable finance. And this is not really disputed by the major lenders,
who report in the Bank's survey of credit conditions that the availability of credit for small
firms has increased only slightly.
The tightening in credit conditions contributed materially to the severity of the recession. But
the extent to which continuing constraints on the supply of bank credit are likely to impede
the recovery is less clear.
On the one hand, banks still face significant challenges, especially in terms of the ease and
cost at which they can refinance maturing funding. This is undoubtedly affecting the ability of
some small firms to borrow at affordable rates.
On the other hand, many companies started this recovery with increased levels of savings
and so are in a position to finance increased investment if and when they wish to. And we
have seen "creditless" recoveries in the past. For example, the corporate sector in aggregate
repaid bank lending in each of the first three years of the 1990s recovery.
I'm hopeful - but by no means certain - that strains within the banking system will exert
increasingly less drag on the economy going forward.
But what of the tailwinds that are pushing against these factors and ensuring that the
burgeoning recovery continues?
The most significant factor is the highly accommodative stance of monetary policy. As you
know, Bank Rate remains at 0.5% and the stock of asset purchases - quantitative easing -
has been maintained at £200 billion. Although monetary policy has not been eased
substantially further over the past year, the stance of policy remains highly stimulatory and
continues to provide significant support to economic activity.
The level of sterling following its substantial depreciation through 2007 and 2008 should also
aid the recovery by encouraging a rebalancing of our economy towards external demand.
However, at first blush, the support provided by the lower level of sterling over the past year
looks distinctly underwhelming. Yes, the most recent data suggest that net trade made a
positive contribution to growth in the third quarter of this year and this is encouraging. But
these early estimates are noisy and prone to revision. Stepping back, net trade has detracted
from growth over the past year. And within that, the growth of exports has underperformed
expectations, especially when judged against the acceleration in global demand.
However, the story is somewhat different if we look at the performance of goods and services
exports separately.
The lower level of sterling does appear to have supported goods exports, which have
increased by well over 10% over the past year. Perhaps more tellingly, the increased
competitiveness of our goods exports has succeeded in arresting the persistent decline in
our share of world export markets seen over the past 15 years or so.
In contrast, exports of services - at least as measured - have fallen. These declines are
concentrated in exports of financial and business services, areas in which the UK has
particular expertise. It would not be surprising in the current environment if this weakness
partly reflects reduced global demand for these types of services. If that is the case, our
prospects for net trade will depend in part on the extent to which demand for financial and
business services revives as the recovery in world demand continues and the functioning of
the financial system gradually returns to normal.
Where does all this leave us?
Judging the net impact of these opposing forces on the growth outlook is very difficult. The
pattern of growth from quarter to quarter is quite likely to be choppy. But smoothing through
this, my central view is that over the next few years the economy is likely to grow at rates
around or a little above its historical average, supported by monetary policy and the lower
level of sterling. This is similar to the outlook in the November Inflation Report. But to repeat
the point I made earlier: the depth of the recession means that output and employment are
likely to remain below what would feel like normal levels for many companies and families for
some considerable time. I will return to the monetary policy implications of this growth
outlook in a while.
The missing instrument problem
But before doing so, I want to report on the progress that has been made in strengthening
the macroeconomic policy framework in the UK in response to some of the fault lines
exposed by the financial crisis.
Much analysis and soul searching has been conducted in the aftermath of the crisis, and the
lessons and implications for different aspects of economic, financial and other areas of public
policy are wide ranging.
In terms of the lessons to be learnt for monetary policy, many commentators and
policymakers - myself included - told a variant of what could be termed the missing
instrument problem.3 This analysis argues that the case for an inflation targeting framework
remains sound: the focus on a clear numerical target for monetary policy has served our
economy well, and low and stable inflation remains a cornerstone of our long-term prosperity.
However, it acknowledges that control of short-term interest rates - the main tool of
monetary policy - is a relatively blunt instrument best deployed maintaining a broad balance
between nominal demand and supply. In particular, movements in short-term interest rates
are not well suited to managing risks from credit cycles and other imbalances within the
financial sector. As such, a key lesson from the financial crisis is the need to expand the
range of instruments available to policymakers, so they are better equipped to ensure the
resilience of the financial system.
This missing instrument problem provides the backdrop to the Government's announcement
earlier this year that it intends to create a new policy committee in the Bank - the Financial
Policy Committee - which will have responsibility for conducting macroprudential policy. In
2010, quantitative easing was entered into the Oxford Dictionary of English, along with chillax
and defriend (don't ask!). I predict that 2011 may be the year of macroprudential policy.
The legislation determining the precise tools and objectives of macroprudential policy is still
to be enacted. But as the Governor recently emphasised, the over-riding objective is to
ensure the resilience and stability of the banking system.4 If successful, macroprudential
policy will represent a significant advance. As we have seen repeatedly through history and
across countries, banking crises come hand-in-hand with deep and costly recessions.
Promoting the resilience and smooth functioning of the financial and banking system in bad
times as well as good would contribute greatly to our future economic stability.
But it would be wrong to conclude from this that macroprudential policy is likely to solve the
missing instrument problem entirely. That is for at least three reasons.
First, macroprudential policy is not the instrument that will solve the problem of global
imbalances. Charlie Bean - the Bank's Deputy Governor - likened the various factors
contributing to the financial crisis to a murder in an Agatha Christie novel in which everyone
had a hand in it.5 But a central character in almost any telling of the financial crisis story are
the huge capital flows associated with the imbalances between surplus and deficit countries.
These capital flows affected the price of financial assets and distorted the incentives of
borrowers and creditors. These global imbalances remain and are forecast to get bigger.6
Macroprudential policy should mean that the tensions associated with these imbalances
manifest themselves in different ways, in particular in ways that are less damaging to the
stability of the banking system. But it does not address the underlying problem. Solving
global imbalances requires international coordination and we are still missing the instruments
that will truly deliver that.
Second, it is unlikely, at least as currently conceived, that macroprudential policy will be
designed to prevent equity-financed bubbles. These types of bubbles have a long and
colourful history: from the 18th century South Sea bubble, the 19th century railway mania to
the more recent 20th century dotcom bubble. Importantly, equity-financed bubbles are not
associated with credit cycles and increased banking exposures and so are unlikely to
threaten financial stability, which is the focus of macroprudential policy.7 Moreover, because
the effects of these types of bubbles are not amplified by financial instability, they typically
have a smaller impact on output.8 But that does not mean that equity-financed booms and
busts cannot have sizeable macroeconomic consequences via other channels, such as
misallocating resources, wealth effects and their impact on confidence. In the 5 years
following the dotcom bust, GDP growth in the US averaged almost two percentage points
lower than in the preceding 5 years; this despite a very aggressive easing in monetary policy.
Third, as Claudio Borio of the Bank for International Settlements and others have stressed,
actions necessary to preserve the resilience of the banking system may not be sufficient to
prevent credit cycles altogether.9 A much-studied example of this comes from Spain. Since
2000, Spain has had a system of dynamic provisioning whereby banks had to put aside more
capital as they increased lending. This increased the resilience of the Spanish banks, but it
did not prevent a large run-up and subsequent crash in house prices in the Spanish property
market. If - and it is a big if - macroprudential policy could be used to prevent such credit
cycles it could potentially have even greater benefits for our economy. But we need to be
careful not to expect too much from this new set of policy instruments, especially at the
outset as the newly formed Financial Policy Committee learns about the use and
effectiveness of its policy tools. Just as monetary policy does not attempt to eradicate the
business cycle, so macroprudential policy is unlikely to be able to eradicate fully credit
cycles.
The creation of the Financial Policy Committee with the responsibility for conducting
macroprudential policy represents a major advance in responding to the missing instrument
problem. Ensuring the stability of our banking system will contribute greatly to our future
prosperity. But macroprudential policy is not - nor is it intended to be - the solution to all
problems associated with financial markets and the international monetary system. Unless or
until effective instruments can be found to manage these other issues, vulnerabilities will
remain, to which monetary policy will need to stay vigilant.
Monetary policy
So what does all this imply for monetary policy?
The job of the Monetary Policy Committee is to hit the 2% inflation target. Judged against
that objective, we might not appear to have done a very good job recently. CPI Inflation stood
at 3.2% in October. Over the past 4 years, inflation has been above target for 39 of the
48 months and has averaged almost 3%. And inflation is likely to remain above target
throughout 2011, elevated by the increase in VAT to 20% at the beginning of next year.
But despite inflation being above target, monetary policy remains highly stimulatory. Interest
rates are close to zero and we've injected a huge sum of money into the economy via
quantitative easing. This uncomfortable juxtaposition of high inflation and loose policy has led
some people to put two and two together and make five. The MPC has gone soft on inflation,
they claim. It has taken its eye off the ball.
I understand why some people think this. But it is simply not true.
The deep recession that we have all just endured has led to a degree of spare capacity
opening up in our economy. That's evident in the increase in unemployment we have
suffered. It's also evident in the relatively low levels of productivity within firms. There is a
very real question as to exactly how much spare capacity there is and what impact that's
likely to have on costs and prices. Even so, it seems clear to me that there is some degree of
spare capacity and that this is likely to damp inflationary pressures. This is most apparent in
the labour market, where annual private sector earnings growth has averaged below 11⁄2%
since the start of the recession, around a third of its rate in the preceding five years.
But this downward drag on headline inflation has been offset by a sequence of large shocks
- to energy and other commodity prices, to VAT, and to the value of sterling - which have
increased the level of prices. Any of you that have read the Bank's Inflation Report or heard
other MPC members speak will know that we have made this point repeatedly over the past
few years. My concern is that although many people understand the basic argument, it is
easy to forget the sheer size of the effects.
Let me give you some idea of the magnitudes involved. CPI inflation averaged 3.1% in Q3.
Some rough back-of-the-envelope calculations suggest that of that 3.1%, increases in energy
prices may have contributed between 0-0.5% points, the increase in VAT earlier this year
0.5-1% points and the increase in import prices associated with sterling's depreciation
around 1-2% points.
Now these estimates come with two very significant health warnings. First, they are highly
uncertain and other plausible assumptions would give different ranges. Second, it is not
possible simply to sum these different impacts together to calculate how much lower inflation
would have been in the absence of these factors. If these events had not happened, many
other aspects of the economy would have been different. But the scale of these effects does
suggest that, had these shocks to the price level not occurred, inflation would have been
substantially lower and almost certainly below target.
But who cares you may say. Inflation is inflation. Your job is to hit the inflation target based
on the factors affecting inflation. Not based on what would have happened to inflation had it
not been affected by a series of unfortunate events.
That is a perfectly fair argument. The Committee's mandate, as given to us by the
Government, is an inflation target of 2% at all times. The onus is on us to explain why, in the
face of persistently above target inflation, we are not tightening policy.
My current approach to policy is based on the judgement that as long as these price level
shocks aren't repeated, and aren't reflected in medium-term inflation expectations or wage
setting, they are unlikely to have implications for inflation in the medium term. They lead to
an increase in the level of prices, not to a persistent increase in inflation. If a significant
degree of spare capacity persists in the medium term, inflation is likely to fall below target.
The current focus of monetary policy is on providing the stimulus necessary to support the
recovery so the degree of spare capacity in our economy is gradually reduced. That is critical
if we are to hit the inflation target in the medium term.
To have tried to have used monetary policy to offset the impact of these price level shocks
on headline inflation would have required us to have tightened monetary policy in the depths
of the recession. That would have led to an even bigger fall in output, an even bigger rise in
unemployment, and an even bigger risk of materially undershooting the inflation target in the
medium term.
But there are clearly significant risks to this strategy of looking through the temporary impact
of price level shocks on inflation. Most importantly, if the strategy causes companies and
households to question the MPC's competence or its commitment to maintaining low
inflation, and this starts to be reflected in wage and price setting. If that were to happen, we
would be forced to tighten policy, potentially aggressively so with all the output costs that
would entail, in order to avoid a return to the bad old days of the 1970s and 80s with truly
high and volatile inflation. My single most important message to you this evening is that the
MPC remains as hard-nosed as ever in its determination to hit the inflation target. That is the
remit given to us by Government, and for which we are accountable to Parliament and the
public.
To sum up my progress report for 2010: it has been a busy year; substantial progress has
been made, both in terms of starting along the road to economic recovery and responding to
some of the fault lines exposed by the financial crisis; but there is still a long way to go.
There will be as much to do in your 22nd year as there was in your 21st. Happy birthday.
References
Bean, C. (2009), "The Great Moderation, the Great Panic and the Great Contraction"
Schumpeter Lecture at the Annual Congress of the European Economic Association in
Barcelona on 25 August 2009, available at:
http://www.bankofengland.co.uk/publications/speeches/2009/speech399.pdf
Borio, C. (2010), "Implementing a macroprudential framework: blending boldness and realism"
http://www.bis.org/repofficepubl/hkimr201007.12c.htm
Dale, S. (2009), "Inflation Targeting: Learning the Lessons from the Financial Crisis", Speech
at the Society of Business Economists' Annual Conference, London on 23 June 2009,
available at: http://www.bankofengland.co.uk/publications/speeches/2009/speech395.pdf
Haldane, A. (2009), "Rethinking the Financial Network", Speech delivered at the Financial
Student Association in Amsterdam on 28 April 2009, available at:
http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf
IMF (2010), "G-20 Mutual Assessment Process - IMF Staff Assessment of G-20 Policies"
http://www.imf.org/external/np/g20/pdf/111210.pdf
King, M. (2010), "Banking: From Bagehot to Basel, and back again", Speech given at the
Second Bagehot Lecture Buttonwood Gathering, New York City on 25 October 2010,
available at: http://www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf
Mishkin, F. (2008), "How Should We Respond to Asset Price Bubbles?"
http://www.federalreserve.gov/newsevents/speech/mishkin20080515a.htm
Tucker, P. (2009), "The Debate on Financial System Resilience: Macroprudential Instruments"
At Barclays Annual Lecture in London on 22 October 2009, available at:
http://www.bankofengland.co.uk/publications/speeches/2009/speech407.pdf