Rachel Lomax: The state of the economy
Speech by Ms Rachel Lomax, Deputy Governor of the Bank of England, to the Institute of
Economic Affairs 25th Anniversary Conference, London, 26 February 2008.
I am grateful to Gareth Ramsay for his help in preparing this speech, and to other colleagues at the Bank of
England for helpful comments.
* * *
When you met for this event a year ago, the UK economy had just posted its fastest rate of
growth in nearly two years, buoyed by a strong world economy and ample global liquidity.
Shoppers had been out in force over Christmas and the New Year, and the housing market
was booming. The main concern was consumer price inflation, which had just picked up to
3%. Most forecasters were looking forward to another year of healthy demand growth, with
the MPC's central projection at the top end of the range. The consensus view was that the
surge in inflation would be short-lived.
And that, broadly, is what happened. CPI inflation fell back to around the 2% target by the
second half of the year. Output growth for the year as a whole was in line with the MPC's
forecast. Short term interest rates now stand where they were a year ago - at 5.25% - after
briefly touching 5.75% last summer.
And yet the outlook for 2008 and beyond has changed dramatically. A year ago the prospect
was for a modest decrease in growth, consistent with inflation staying around target. Now,
inflation seems set to rise sharply in the near term. And our latest central projection is for
output to grow at below trend rates over the next two years - even on the conventional
assumption that Bank rate follows the market yield curve and falls to 4.5% during the course
of this year.
There is still relatively little in the headline macro data to support such a marked change in
view. CPI inflation, at 2.2%, remains close to target. And, on the output side, growth
weakened a touch in the fourth quarter last year, but was still around the post war average.
Indicators for the first quarter are mixed, but do not suggest that growth has stalled.
In other words, the change in our Inflation Report projections is a forecast. It is the judgments
underlying that forecast - and the attendant risks and uncertainties - which will be the main
focus of my remarks today.
So why have we changed our view?
Our latest forecasts reflect judgements about the possible future impact on the UK of two key
developments. First, the continuing financial crisis in advanced financial markets which has
been triggered by the slump in the US housing market; and second, the renewed build up in
global inflationary pressures, associated with soaring energy and food prices.
These developments are symptomatic of profound changes in the global economy, as world
growth has increasingly been powered by resource hungry emerging markets, and as
financial markets in developed countries have taken off and, in the process, become more
tightly linked to one another.
I will talk about both developments, before coming back to discuss the outlook for inflation
and growth in the UK, and the implications for policy.
Financial crisis
The crisis in financial markets last August was triggered by a slump in the US housing
market. This, of course, is acting as a direct drag on US activity. Any slowing in the US
economy stands to affect the UK in the traditional way, through influencing trade flows. The
size of this effect will depend on how other trading partners are affected and how
policymakers react.
But the really striking feature of recent experience has been how the US housing crisis has
reverberated through the highly integrated and sophisticated financial markets of North
America and Western Europe.
Six months after global securitisation markets seized up, in response to uncertainties about
the scale and location of losses arising from rising defaults on US sub prime mortgages,
some credit markets are still not trading at all, and others remain very illiquid. And each week
seems to highlight some new dimension of the ensuing disruption to core financial markets.
The crucial task of valuing and disclosing the impact of losses on core banking institutions is
still work in progress: important announcements are being made almost daily, and beyond
them lies the equally important task of repairing banks' balance sheets. The current shortage
of liquidity makes the pricing of complex assets even more difficult. At the very least, this
reinforces the need for transparency in providing estimates of losses, and descriptions of the
best-efforts processes used to produce these estimates.
The process of price discovery for many complex asset classes is unlikely to be completed
quickly. For assets directly related to US sub-prime, this is unlikely to be before the US
housing market stabilises. Other structured credit markets are likely to remain illiquid until
confidence in the banking sector has been restored, and large financial institutions are willing
to take more risk.
Clearly the situation is still developing. And its impact on the wider economic outlook - global
and domestic - will depend critically on what happens from now on. Here there are some
major uncertainties.
There is a widespread - and in my view largely correct - view that the US housing crisis
acted as the trigger for an overdue correction in financial markets, after a long period of
plentiful liquidity during which risk premia of all sorts had become unduly compressed, asset
prices had become detached from reality, financial innovation had run ahead of risk
management, and unsound business models had led to a deterioration in credit monitoring
and, in some areas, underlying credit quality.
Many people - including the Bank of England - foresaw that some form of correction in
financial markets was highly likely, even inevitable. But it was another matter altogether to
predict the precise nature and timing of the present crisis. The extent of the reverberations
across different markets was certainly not fully appreciated.
But the "accident waiting to happen" description of the current situation, however plausible at
a general level, lends itself to a wide range of predictions about the possible course of events
from now on, from the relatively benign to the frankly apocalyptic.
The interesting question is: where do we go from here?
Might slowdowns in other housing markets have the same potential to impair loan books and
dent overall growth as in the US? What is the likely impact of a further falls in global equity
markets? What further scope for amplifying financial shocks lies buried in the highly
leveraged and tightly interconnected world created by the heady pace of financial innovation
over the past decade? And - going to the apocalyptic end of the spectrum - if the global
macro economy does turn very sour, at what point might falling asset prices and mounting
banking losses start to feed on each other to push economies into a deflationary downward
spiral?
History does not give a clear steer. There have been financial and banking crises before, but
not on the present global scale, and this must surely be the largest ever peacetime liquidity
crisis. To take two extreme possibilities, is what we are seeing closer to a repeat of the US
Savings and Loans crisis (whose real economy impact was small and shallow) or to Japan in
the early 1990s (characterised as a "lost decade" of growth)? Or is it something else again?
How much does it matter that this is one of the first crises where a credit boom has died of
"natural causes", rather than being choked off by some external macroeconomic or policy
shock?
The substantial equity cushions built up in the years of plenty should act as shock absorbers
in the years ahead. Even the most pessimistic estimates of the total losses from sub-prime
mortgages - around $400 billion - compare with total global financial assets of at least $110
trillion1. But there may be more shocks to come. The focus of current concerns is how far
other assets may be impaired, as a result of the broader economic impact of this period of
financial stress.
This brings me to the other big uncertainty: how far will tighter credit conditions affect the
wider economy - in the UK and the rest of Europe as well as in North America? It seems
highly likely that growth was supported by easier credit over last few years. But to what
extent? When it comes to quantifying the effect of changes in credit conditions, our
workhorse economic models still cannot help us very much.
As far as the UK economic outlook goes, our central judgement is that financial stress will act
as a significant drag on demand over the next two years. But there is a high level of
uncertainty about this; and, as we now see it, the risks, as they affect output, are tilted to the
downside. These are two fold: first, that the financial crisis will persist and possibly intensify;
and second, that over time tighter credit conditions and asset price weakness will combine,
and in the worst case feed off each other, to sap the strength of overall demand, and put
downward pressure on inflation in the medium term.
Higher costs
Let me come now to the other major area of risk: the upward pressure on inflation from
higher external costs.
The most recent build up of global cost pressures is just the latest episode in a remarkable
period of soaring commodity prices. Oil prices have more than trebled since the start of 2004,
and metals and food prices have more than doubled. Strong demand, particularly from China
has clearly been one major factor. But there have been supply side issues too. And the
strength of some commodity prices also reflects their status as an investment class at a time
of low global interest rates.
Over the past year alone, oil prices have risen by around 60% in dollar terms and agricultural
food prices by around 50%. Imported cost pressures in the UK will also reflect the fall in the
effective exchange rate, down by 9% since the beginning of August last year - the largest
such decline since sterling left the ERM in 1992. There are few reasons to expect this to be
rapidly reversed. As a result of these developments, producer input and output prices are
now increasing faster than at any time since 1990, and import prices have picked up sharply.
These cost pressures have not yet fed through fully into consumer prices, but from next
month CPI inflation is likely to rise more sharply, in particular reflecting the impact of higher
utility bills. There is essentially nothing the MPC can do about this immediate impact on the
inflation rate. But its implication for policy depends on whether people recognise the
temporary nature of the pick-up in inflation.
The MPC's remit in setting interest rates is clear - to keep inflation at 2%. But we have
discretion to decide how fast to return inflation to target, if it is thrown off course by a sharp
shock, such as the current surge in world energy prices. So we are not required to raise
interest rates sharply to counteract the rise in inflation which we expect over the next few
months. We can decide what is appropriate in the light of all the circumstances. And the
purpose of the Open Letter regime is to give us an opportunity to explain how we propose to
use our discretion.
Over the years the MPC has explained that it seeks to achieve its inflation objective in the
medium term by varying interest rates to steer overall demand relative to supply. If price and
wage setters do recognise that the imminent pick-up in inflation will be short-lived, then the
implications of the spike for monetary policy, and for the necessary balance of demand
versus supply, should be limited.
But if price and wage setters start to expect higher inflation to persist, then the Committee
will need to restrain demand, and so generate some slack in the economy, in order to bring
inflation expectations, and inflation itself, back down.
Clearly therefore it is a matter of intense interest to understand how people form and revise
their expectations.
Unfortunately our understanding is very incomplete. One relevant area of active research is
why inflation expectations seem to have been so stable over the past decade - the period of
the so-called Great Stability.
One supposition is that well anchored expectations reflect the introduction of credible
inflation targeting regimes - people have understood that central banks are focussed on
keeping inflation low, and will take action to reduce it if necessary. Another view is that
people's expectations reflect simpler rules-of-thumb based on actual inflation rates: if that's
the case stable expectations could simply be due to the fact that, over the past decade and a
half, inflation itself has been low and stable.
These alternatives are hard to distinguish empirically, on the track record so far. But it may
make a great deal of difference which is true when it comes to forecasting what will happen
to inflation expectations, if we have to deal with a future in which inflation is likely to be much
more variable.
If people put their trust in the regime, or a "credible central bank", they are unlikely to revise
their expectations about future inflation much, especially if the nature of the current situation
is well and honestly explained, including how long it will take inflation to return to target. But if
they forecast future inflation using simple rules of thumb based on past actual inflation rates,
anything that dislodges inflation from target will affect what people use as their best forecast
for future inflation.
Or to put it another way, if the credibility of the monetary policy framework itself has been
key, then inflation expectations may prove rather resilient to short term shocks.
But if maintaining an excellent track record has been crucial, the situation may be more
fragile.
In the context of the current outlook, the real risk facing the Committee is that a further period
of above target inflation, prompted by a cost shock over which it has no immediate control,
will lead people to revise their expectations about future inflation, and to act accordingly. This
will make it more costly to bring inflation back to target.
What does all this mean for policy?
The MPC has frequently stressed that policy is not based simply on its central projections of
the economic outlook - what matter just as much are the risks around it. The Bank has
pioneered the use of fan charts to illustrate the probabilistic nature of any forecasting
subjective
exercise. The fact that these fan charts reflect the Committee's judgements about
the uncertainties it faces means that they can be quite revealing about its thinking.
This is particularly true now. Policy needs to balance two significant risks - first, that financial
stress will precipitate an unduly sharp slowdown in demand, which will bear down so heavily
on inflation that it undershoots the target; and second, that temporarily high inflation will lead
to inflation expectations persisting at too high a level.
I find it helpful to distinguish between two aspects of uncertainty, both of which are relevant
to setting policy. First, the balance of risks around the central projection, and second the
general level of uncertainty.
The Committee regularly comments on the extent to which it believes the risks around the
central projection are skewed - that is, tilted to the upside or the downside. And it has
sometimes explained changes in interest rates by reference to changes in the balance of risk
rather than changes in the central projection. In the latest Inflation Report, we commented
that risks on our latest inflation forecasts were balanced, but those around the forecast for
output were tilted to the downside.
The width of the fan chart is an indication of the MPC's level of uncertainty about the outlook.
It's significant that the MPC widened the GDP fan charts in November, and the CPI fan
charts further out, and maintained these wider fans in February.
Another way of presenting the same information is this bar chart (conditioned on market
interest rates as in the February Inflation Report). This brings out the significant probabilities
ascribed to outcomes which are some way away from the central projections.
So, for example, there is a less than a one-in-three chance that GDP growth will be in the
range containing the Committee's central projection - between 2 and 3% - in two years'
time. We see a greater probability - around two-in-five - that growth will be somewhere
below 2%. On inflation, there's only around a one-in-four chance that inflation will lie close to
the central projection - that is, between 2 and 2.5%, but a more than one-in-three chance
that it will be above 2.5%, and an almost 1 in 5 chance that it will be below 1.5%.
As this illustrates, one implication of widening the fan charts has been to increase the
perceived risk of some rather unattractive outcomes - either that growth slows too sharply, or
that inflation does not return to target following an upward spike. In particular both the upper
tail of the inflation forecast - where inflation expectations might well come seriously adrift -
and the bottom tail of the output forecast - where there could be a risk of setting off a
deflationary spiral - are to be avoided, if at all possible.
In this situation, it is not unreasonable to suppose that the Committee will be more sensitive
than usual to changes in the balance of risks.
Since neither of the key risks to the outlook is readily modelled or measured, monitoring
them is not going to be easy. But we do have a framework for thinking about them, and a
variety of timely surveys and indicators which can act as early warning signs.
On the impact of the credit shock, we will be monitoring our new quarterly credit conditions
survey of lenders, and special surveys from our own Agents, as well as the full range of
indicators of the price and quantity of credit.
On inflation expectations, we pay close attention to a wide range of information drawn from
surveys, and financial market prices, recognising that they are all, in different ways, tricky to
interpret. We also need to be mindful of the risk that any further increases in the prices of
everyday items like food and energy will heighten public perceptions of inflation, and raise
expectations about the future overall rate of CPI inflation.
Conclusion
The outlook for the economy looks very different now from a year ago. We are seeing some
powerful global forces playing out, in financial markets, in commodity markets, and in the
world's largest economies. Their impact on the UK is highly uncertain, partly because they
are hard to understand and to predict, and partly because much will depend on the way
policymakers around the world respond.
The MPC will need to respond continuously and flexibly to its assessment of the changing
balance of two key risks. On the one hand, there is a risk that demand will slow too sharply,
but on the other there is a risk that a temporary shock to inflation will prove persistent.
A temporary pick-up in inflation - by itself - does not mean that the Committee needs to
tolerate a significant weakening in demand. But if inflation expectations appear to be
persistently elevated, then the Committee will need to tolerate more slack to keep inflation on
target. And that means it will have less scope to respond to slowing demand - the risk posed
by the current turmoil in financial markets.
Annex: Charts2
Chart 1: CPI fanchart from February Chart 2: GDP fanchart from February
2007 Inflation Report, and outturns 2007 Inflation Report, and outturns
Percentage increase in prices on a year earlier Percentage change in output on a year earlier
4 6
5
CPI outturns
GDP outturns
3
4
3
2
2
1
1
0
0 -1
02 03 04 05 06 07 08 09 10 02 03 04 05 06 07 08 09 10
Chart 3: CPI fanchart from February 2008 Chart 4: GDP fanchart from February 2008
Inflation Report Inflation Report
Chart 5: Commodity price developments Chart 6: GDP growth probabilities from
February 2008 Inflation Report
US $ per barrel
Index, 2000=100
100 250
90
Economist food price index
80 (right hand axis) 200
70
60 150
50
40 100
30
20
50
10
Brent dollar oil price (left hand axis)
0 0
1990 1993 1996 1999 2002 2005 2008
Chart 7: CPI inflation probabilities from
February 2008 Inflation Report