Andrew G Haldane: The corridor of uncertainty
Speech by Mr Andrew G Haldane, Chief Economist and Executive Director, Monetary
Analysis and Statistics, Bank of England, at the Scarborough Business Ambassadors'
Dinner, Scarborough, 18 June 2014.
* * *
The views are not necessarily those of the Bank of England or the Monetary Policy Committee. I would like to
thank Gareth Anderson, Andrew Bailey, Maria Barriel, Charlie Bean, Venetia Bell, Stephen Burgess, Matt Corder,
Shiv Chowla, Jeremy Franklin, Jack Leslie, Bob Gilhooly, Varun Paul, Jon Relleen, Matt Roberts-Sklar, Jumana
Salaheen, Matt Trott, Martin Weale and Tom Wise for comments and contributions.
It is wonderful to be back in Scarborough. I say back because many of my earliest and
fondest childhood memories were of summer holidays spent here. Being a cricket fan, the
Scarborough Festival - the cricketing jamboree held at the end of August each year since
1876 - has always held a place in my imagination. Alas I have never been, but am hoping
one day to break my duck.
I want to discuss the economy and the role of monetary policy in supporting it. And with
apologies to the non-cricketers in the audience, to do so I will borrow a cricketing metaphor -
the "corridor of uncertainty". The corridor of uncertainty is every bowler's dream and every
batter's nightmare. It refers to a ball which pitches in such a position - the corridor - that the
batter does not know whether to be playing off the back foot or the front foot.
This, I will argue, is similar to the dilemma facing monetary policymakers on the Bank's
Monetary Policy Committee (MPC) today. Should monetary policy hold back until key
sources of uncertainty about the economy have been resolved? Or instead push forward to
prevent leaving it too late?
Playing off the back foot
Let's start with where we have been. Since 2007, the UK and global economy has faced a
barrage of financial bouncers of frightening pace and ferocity. The economy was on the back
foot for much of this period. Output growth in the UK fell short of the Bank's, and other
mainstream forecasters', expectations between 2008 and 2012. By the end of 2012, output in
the economy was still 3% below its 2007 level. This was indeed a Great Recession.
With the economy falling well short of expectations, monetary policy was required to shore
up its defences, to prevent recession morphing into depression. That meant interest rates
falling to unprecedentedly low levels, in the UK and globally - indeed, the lowest levels in the
Bank of England's 320-year history. This monetary medicine was then augmented with
£375 billion of asset purchases by the Bank from 2009 onwards, known colloquially as
Quantitative Easing or QE.
It is impossible to know for sure how the economy would have performed without this
extraordinary monetary medicine. But the Bank's estimates suggest it may have been more than
6% smaller than it is today. In money terms, we as a nation would have been between
£80-100 billion poorer - roughly, the GDP of Yorkshire and Humberside. As defensive
measures go, then, UK monetary policy for the past few years has been positively
Boycott-ian.1
Since the start of 2013, the economy has begun to respond to the medicine. UK output is
estimated to have grown by over 3% in the past year - that is, at the top of the league table
among the G7 nations. And growth this year and next is forecast by the Bank to remain
around 3%, again at or close to the top of the G7 league table. Output is now just about back
to its pre-crisis levels.
The employment picture has been even more positive. Over 1.5 million jobs have been
created in less than three years. Unemployment has fallen from a peak of 8.4% in 2011 to
6.6% today. It is expected to fall further, to below 6% by 2017. Over the same period,
inflationary pressures have abated, with inflation falling from a peak of 5.2% in 2011 to 1.5%
today, below the Bank's 2% inflation target. The Bank's forecasts suggest it is likely to hover
around that target in the period ahead.
This turnaround in the economy has prompted an active debate about when the Bank's
monetary policy stance should be shifted from back foot to front - in other words, whether
and when UK interest rates might rise. Market expectations of future interest rates have
already adjusted since the economy began growing. In January 2013, the first rise in UK
interest rates was expected in the third quarter of 2015. Now, it is expected by the end of this
year.
This prospect has sent shivers down some spines. But some context is important here.
When the first rate rise does come, it will be because the economy has recovered sufficiently
to thrive on smaller doses of monetary medicine. A normalisation of interest rates would
signal the economy having returned to the hospital ward, after six years in intensive care.
The economy would be switching channels, from ER to Casualty. That is something to
welcome, not fear.
At the same time, the Bank's policy guidance was introduced in August last year in part to
prevent interest rate expectations getting ahead of themselves and derailing recovery. From
our survey evidence, it appears that businesses listened and took heed. Investment rose
8.5% during 2013. This has meant the UK's recovery has not just been healthy but
reasonably balanced, with both households and companies contributing.
Today's uncertainties
None of this leaves the job of judging the future path of monetary policy an easy one. As it
emerges from its most severe set-back since the 1930s the economy remains, to quote
Churchill from the 1930s, a riddle wrapped inside a mystery inside an enigma.2 Let me give
examples of each.
First, the riddle. Data on the economy is riddled with uncertainties and beset by revisions. A
few weeks ago, we awoke to discover that we as a nation were £65 billion better off than we
had thought, courtesy of the Office for National Statistics. Alas, my excitement soon gave
way to mixed emotions: this windfall was in part the fruits of charitable, drugs and
prostitution-related activities, previously under-recorded. What a party that must have been.
A further set of systematic revisions to existing estimates of the National Accounts data is
planned later this year. It is well-known, and entirely understandable, that these data are
subject to revisions which are to some extent predictable. That is why, before the Bank even
starts forecasting the future of the economy, we begin by backcasting and nowcasting the
past and the present.
To give a current example, although the estimate of first quarter GDP growth is 0.8%, the
Bank expects the final estimate to be 0.9% given the strength of business surveys. The 90%
confidence interval around this estimate is 0.4% to 1.4%. Put differently, we can be 90%
confident that annual growth in the UK economy lies somewhere between 5.4% (a raging
boom) and 1.4% (an anaemic recovery). Hence the riddle.
Second, the mystery. Productivity in the UK - output per worker - is around 15% lower than
its pre-crisis trend and 4% lower than its peak in 2007. The fall has been greater, and the
recovery more protracted, than any post-war recession. Despite picking up since 2013,
productivity growth is almost a percentage point lower than the Bank expected last August.
The Bank has consistently over-predicted productivity growth since 2007.
This has been termed the "productivity puzzle". There is no shortage of candidate
explanations, some temporary, others more durable. They include output mis-measurement,
labour hoarding, the slowing of labour-saving technological investment, resource
misallocation and lender forbearance.3 Doubtless there are elements of each. Whether,
collectively, they fully account for the productivity gap is more questionable.
The resolution of this mystery has an important bearing on the economy's future fortunes.
Without a pick-up in productivity, any rise in demand in the economy risks bumping up
against a supply constraint sooner rather than later. This would likely put upward pressure on
wages and prices, imperilling the inflation target. That is why, when issuing its further policy
guidance earlier this year, the Bank focussed on measures of slack in the economy. But, to
be clear, without a clear explanation for productivity's earlier weakness, it is difficult to predict
with any accuracy its likely recovery. Hence the mystery.
Third, the enigma. Having never previously been this low, it is inevitably uncertain how the
economy will respond when interest rates do begin to rise. Various surveys have sought to
shed light on how UK homeowners may fare. For example, the Bank's NMG survey from
2012 found that a one percentage point rise in interest rates could result in almost half a
million households with a mortgage needing to take corrective measures. This rises to a
million households for a two percentage point rise.
A more timely guide may come from recent US experience. In the middle of last year,
longterm US interest rates rose by around one percentage point on the expectation of a tapering
in US monetary policy - the so-called "taper tantrum". This had a striking impact on the US
housing market, with housing sales 7% lower than a year ago and residential investment
falling in each of the last few quarters. This raises the possibility of borrowers reacting more
sharply to rate rises now than in the past. Hence the enigma.
Tackling uncertainty
Although it is a touch depressing that our knowledge of the economy is this imperfect, the
Bank is making a renewed investment in research and data which will, over time, hopefully
help to reduce these uncertainties.
Back in 1987, Michael Fish famously failed to forewarn about an incoming storm, which then
caused havoc in parts of Southern England. The finger of blame was pointed squarely at the
UK Meteorological Office. In response, the Met Office made huge efforts to improve their
data capture and computing power as a basis for improving their weather forecasting. The
results have been dramatic.
Over the past 30 years, the Met Office's forecasts have improved significantly. Their
4-dayahead forecasts are now as accurate as their 1-day-ahead forecasts were 30 years ago.
These are improvements on a scale economic forecasters would give their left arm for
(unless, like me, it was their bowling arm). It suggests improved data can pay real dividends.
To that end, the Bank is investing in improving its own data architecture and analytics.
Perhaps a more timely reading of the economic and financial tea leaves can be found by
scraping the web or by semantic search on social media sites? Recent research has
suggested just that.4 These are the sorts of question the Bank's rocket scientists can help us
answer.
Uncertainties are no less acute when it comes to modelling the economy. Unlike rocket
science, economics has few, if any, physical constants or fixed laws of motion. Like cricket,
economics is a game largely played in the head; nine parts psychology to one part physics.
Understanding and modelling the brain has so far eluded neuroscientists, but this has not
stopped them trying.5 Economists are in the same boat, just with bigger holes.
Even for the natural sciences, dealing with physical constants and fixed laws of motion, the
voyage of discovery can sometimes be a lengthy one. It took a century before estimates of
the speed of light had converged to its true value. For much of this period, not only were
best-estimates biased but the estimated confidence intervals around them often did not
encompass the true value.6 Modelling complex, adaptive, socio-economic systems would
make these estimation problems pale by significance.
It is for these reasons that the Bank is also investing in its research capacity. For example, in
our quarterly Inflation Report the Bank now shows alternative scenarios for inflation and
output under different assumptions about how the world works. Alongside this, the Bank is
putting greater effort into developing a pluralist set of approaches to model-building, drawing
on other disciplines.
Operating in the corridor
In time, these investments in data and research will narrow the corridor of uncertainty. But for
now, the key public policy question is what to do when operating in it? Rocket-scientists, of
the real rather than metaphorical kind, have a clear answer to this question: avoid really bad
outcomes.7 This is sometimes called a "minimax" strategy - the aim being to minimise the
chances of the maximum possible loss. It is the policymakers' equivalent of the Hippocratic
oath - "do no harm".
So what, then, are these avoidable-at-all-cost scenarios? Let me consider three from a
potentially long list. They are chosen not because they are probable outcomes, but precisely
because they are improbable contingencies against which it would be useful to safeguard,
consistent with the Hippocratic oath.
One adverse scenario is that the economy could stall in its recovery, deflationary forces
could set in and monetary policy could be trapped for a protracted period at the zero lower
bound. This is not so much secular stagnation as secular deflation. And you do not have to
look too hard to find real-world examples.
The most widely studied is, of course, the Japanese experience since the bursting of its
bubble in the early 1990s. In the quarter-century since, nominal GDP in Japan has barely
budged. And while real GDP growth in Japan has averaged 0.7% per year since 1997, this
has been offset by a persistent fall in prices of, on average, over 1% per year. Similar
deflationary concerns, albeit on a lesser scale, have been voiced recently in the euro-area.
So how great are these risks in the UK today? At least to my ear, the mood music is different.
From its trough, real GDP in the UK has risen by 7% and nominal GDP by 19%. UK real
GDP has risen at or above trend for each of the past four quarters. It is expected to continue
doing so for the next 12 quarters. Japan has had no equivalent period of sustained growth at
or above its pre-crisis rate in the past 25 years.
As for deflationary threats, one guide is found in market measures of medium-term inflation
expectations. At the 3-5 year horizon, consensus inflation expectations in Japan have
averaged around 1% over the past 15 years. In the euro-area, inflation expectations have
recently fallen to around 1.8% on deflationary fears. In the UK, meanwhile, inflation
expectations have remained relatively stable at around the 2% target throughout the crisis
period. Financial markets, at least, do not appear to be fearful of deflationary ghosts in the
UK.
A second uncomfortable scenario, the flip-side of the first, would be if inflationary pressures
instead took hold. Again, it is important not to dismiss this risk out of hand. Monetary policy is
in unknown territory. The most extraordinary dose of monetary medicine perhaps
everwitnessed has been administered to a patient now whistling their way around the hospital
ward. An over-reaction to the drugs cannot be ruled out.
There are already some signs of the economy's pulse quickening. The confidence fairy is
back, after six years in rehab. Levels of consumer confidence are now above 2007 levels,
retail spending is rising at its most rapid rate since 2004 and levels of job security are at their
highest since at least the 1990s. This feel-good factor is adding momentum to the UK
housing market.
Businesses, too, have rediscovered their mojo. Surveys of output intentions are close to
record highs. Quarterly employment growth is running at its fastest rate since the series
began. Surveys of skills shortages point to the possibility of upwards, if localised, wage
pressures. Output growth in 2014 Q1 is nearly 1% higher, and unemployment rate close to
1 percentage point lower, than the Bank expected last August. If history is any guide, these
errors tend to be positively correlated, upside as well as down.
Yet at the same time, the inflationary risks posed by such a scenario should not be
overstated. As output and unemployment have surprised on the upside by 1%, average wages
and inflation have surprised by the same amount on the downside. Real wage growth has
been positive in only six months in the past six years. And inflation expectations remain well
anchored to the inflation target. Inflationary ghosts are hard to find.
A third uncertainty concerns the financial side of the economy. Global appetite for risk is, at
present, voracious. Measures of financial market uncertainty are at or below pre-crisis levels
across a range of asset classes. Many asset prices have rocketed and spreads plummeted.
Two years ago, yields on Italian and Spanish debt were around five percentage points above
US Treasuries. Today, they are 30-40 basis points below. Yields on corporate bonds, both
high and low grade, are close to all-time lows.
In short, the search for yield has broadened and deepened. We have, in one sense, been
here before. Pre-crisis, low volatility justified high prices and high prices low volatility. The
constellation of asset prices appeared consistent. Larry Summers famously commented that
finance theory tells us how to price two bottles of ketchup, assuming you know the price of
one bottle.8 Pre-crisis, the second bottle of ketchup looked fairly-valued relative to the first.
But even if asset prices are consistent among themselves, this need not imply they are
consistent with reality. So it was pre-crisis, as the price of risk became far too cheap relative
to fundamentals. With the first bottle of ketchup woefully over-priced, finance theory ensured
that the second bottle was similarly marked up. In this way, the seeds of the crisis were
sown.
The risk of this cognitive dissonance is once again rising. Low volatilities are being used to
justify high valuations and vice-versa. The ketchup bottle looks fairly valued relative to other
sauces. But what about the price of ketchup relative to fundamentals? Is the price of risk
again becoming too low? Or is it the price of safety which this time is too cheap? I do not
have clear answers, but I do know these are serious questions.
In one sense, rising risk-taking is evidence of the monetary medicine working. If there are
adverse side-effects, then an alternative drug can be called upon - macro-prudential policies.
These are an important new addition to the central bank armoury. When risks are localised -
say in the UK housing market - macro-prudential measures can act like a targeted lightning
strike. The Bank's Financial Policy Committee (FPC) is discussing these risks. I will not,
tonight, steal their lightning.
But if risk-taking becomes broadly-based, a broadly-based response may at some stage be
appropriate - a rumble of thunder rather than a strike of lightning. The case for doing so is
stronger, the greater the chances of an asymmetric asset price response - a sharp
snapback in volatility and asset prices - which could imperil recovery.9 The MPC's guidance gives
monetary policy a role as a last line of defence if macro-prudential actions cannot contain
these risks. As they evolve, the MPC and FPC will need to assess these risks carefully.
The monetary policy stance
Faced with these uncertainties, what would be a prudent course for monetary policy in the
period ahead? The first thing to say is that there is consensus across the MPC on three key
elements of our monetary strategy: that any rate rise need not be immediate, that when rate
rises come they are intended to be gradual and that interest rates in the medium-term are
likely to be somewhat lower than their historical average.
This message appears to have largely been understood by financial markets. Despite the
upwards revision to growth, financial markets' best guess of how rapidly the first percentage
point of tightening will take place is essentially unchanged over the past year - around
20 basis points per quarter. So too is their best guess of where interest rates may settle in
the medium run - around 2-3%.
Views may in time differ across the MPC on the preferred lift-off date for interest rates, as
you would expect at a difficult-to-predict turning point in the cycle. These will reflect individual
members' different reading of the runes, not their individual preferences. That is a real
benefit of the MPC's committee-based structure, with individual member accountability.
It is not difficult to see why this choice over timing is a difficult one. The policymaker in this
situation faces the self-same dilemma as the batsmen facing a ball pitching in the corridor of
uncertainty. In that situation, the coaching manual no longer offers a clear guide. Two
strategies are equally justifiable.
The first is to stay on the back foot and play late. This has the advantage of giving the
batsmen more time to get a read on the trajectory of the ball as it swings and darts around. It
avoids the risk of lurching forward and then needing hurriedly to reverse course if the first
movement is misjudged. This is the way, Joe Root, the Yorkshire and England batsmen,
plays his cricket. If he were on the MPC, he'd be called a dove.
But this strategy is not riskless. Playing late relies on having an uncannily good eye and
strong nerve. It runs the risk of having to react fast and furiously to avoid missing the ball
entirely. An earlier front foot movement would avoid that risk, allowing a more gradual
movement forward. This is the way Ian Bell, the Warwickshire and England batsman, plays
his cricket. If he were on the MPC, he'd be called a hawk.
So which is the better strategy? Benjamin Disraeli told us there are lies, damned lies and
statistics. Here my analogy between cricket and the economy breaks down. Economic
statistics, as we know, do sometimes lie. Cricket statistics, typically, do not. They tell us that
Joe Root averages 43 in test matches to Ian Bell's 45. In other words, it is a close run thing
with the odds at present slightly favouring the front foot. But a good run of scores from either
player could easily tilt the balance. That, in a nutshell, is where the MPC finds itself today.
Thank you.
References
Anderson, A and Maule, B "Assessing the risk to inflation from inflation expectations", Bank
of England Quarterly Bulletin 2014Q2.
Barnett, A, Batten, S, Chiu, A, Franklin, J and Sebastia-Barriel, M "The UK productivity
puzzle", Bank of England Quarterly Bulletin 2014Q2.
Bunn, P, Domit, S, Piscitelli, L, Rostom, M, Worrow, N "The financial position of British
households: evidence from the 2013 NMG Consulting survey", Bank of England Quarterly
Bulletin 2013Q2.
Farmer, D and Hepburn, C (2014) "Less precision, more truth: Uncertainty in climate
economics and macroprudential policy", Institute for New Economic Thinking, forthcoming.
Hansen, L and Sargent, T (2010) "Wanting robustness in macroeconomics", Handbook of
Monetary Economics.
Met Office (2014) "How accurate are our forecasts?":
http://www.metoffice.gov.uk/aboutus/who/accuracy/forecasts.
Stein, J (2014) "Incorporating Financial Stability Considerations into a Monetary Policy
Framework", speech given at the International Research Forum on Monetary Policy,
Washington DC.
Summers, L (1985) "On economics and finance", Journal of Finance, 40(3)
Tuckett, D, Smith, R and Nyman, R (2014) "Tracking Phantastic Objects: A Computer
Algorithmic Investigation of Narrative Evolution in Unstructured Data Sources", Social
Networks.
Varian, H (2014) "Big Data: New Tricks for Econometrics", Journal of Economic
Perspectives, 28(2).