Charles Bean: The UK economic outlook
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
at the Society of Business Economists Annual Conference 2013, London, 22 October 2013.
* * *
Good morning! It is now more than five years since Lehman Brothers collapsed, ushering in
the worst phase of the financial crisis, followed by a sharp and synchronised contraction in
global economic activity. While growth was reasonable for the first year after output troughed
in the middle of 2009, the pace of expansion since then has proved disappointingly weak.
Just how disappointing is illustrated by Chart 1, which shows our August 2010 Inflation
Report
projection for GDP growth, together with the ONS's present estimates of what
actually happened. It is not a pretty sight. Whereas our central expectation was for a
cumulative rise in output of 9% over the following three years, the actual rise is presently
estimated to have been a miserable 2%. And we weren't alone. The performance of other
forecasting outfits was pretty similar.
At a global level, a similar story can be told. The IMF has consistently revised down its
projections for global growth. Back in October 2010, it was forecasting a cumulative
expansion in output of 14% over the following three years, whereas the actual figure was just
10%. Indeed, the Fund has revised down its world growth forecast for 2013 in every
subsequent World Economic Outlook: it now expects just 2.9%, against the 4.6% it projected
three years ago.
But there are at last signs that a recovery may be gaining traction. In the United Kingdom,
output rose by a little more than 1% in the first half of the year. And business surveys point to
something closer to 2% for the second half of this year, somewhat faster than the economy's
historical average rate of expansion. That is good news. But can we expect it to be
sustained? Or is there a danger that it will prove short-lived? That is the first issue I want to
address this morning.
A good place to start is by looking backwards, for if we understand the past, then there is
surely a better chance of getting future prospects right. Why, then, was the growth
performance shown in Chart 1 so disappointing? Back in the summer of 2010, our
expectation was that demand growth would be supported by a steady improvement in credit
conditions and a gradual decline in uncertainty. That would foster both an increase in
consumer spending as the saving rate fell back from post-crisis highs and a recovery in
business investment. Moreover, we expected net trade to provide a significant stimulus, as
global activity continued to recover and the 25% depreciation in sterling since the beginning
of the crisis worked its magic.
That was not quite how it worked out, of course. Chart 2 shows the cumulative contributions
of the main expenditure components to growth since the middle of 2010. Most of the growth,
such as it was, was down to private and public consumption, though the former was
nevertheless quite a bit weaker than we expected. Net trade was distinctly disappointing
relative to our expectations. And fixed investment continued to drag on growth. Lurking
behind this picture was: first, a much less pronounced improvement in credit conditions than
expected, with the spreads over Bank Rate of borrowing and lending rates actually
increasing for much of the period and only falling sharply after last summer; second, much
weaker global growth, as the problems of excessive indebtedness in the euro-area periphery
and the associated uncertainties concerning the resilience of European banks pulled the
region into a second recession; and, third, the kick to net exports from the depreciation of
sterling was apparently offset by a fall in foreign demand for business and financial services
triggered by the financial crisis.
As far as inflation goes, at the time of our August 2010 Inflation Report, CPI inflation was a
little over 3%, reflecting higher oil prices, the restoration of VAT to 17.5% and pass-through
from the depreciation of sterling (Chart 3). Our central expectation was for inflation to remain
elevated in the short term, as VAT was raised further to 20%, but then to fall back to well
below the 2% target when that rise dropped out of the twelve-month comparison. And with
growth turning out much weaker than expected, one might also have expected to see
inflation turning out even weaker than that in the medium term.
As Chart 3 shows, however, the outturn was in fact markedly higher than in our central
projection, with inflation peaking at 5.2% in September 2011. In large part, that was down to
higher than anticipated energy and import prices, as the strong recovery in the
energyintensive emerging economies, together with supply concerns, put upward pressure on oil
and other commodity prices. Higher energy and import prices also further depressed
UK domestic demand growth through their adverse impact on household real incomes.
The primary reason for believing that the nascent resurgence in growth that we have seen
this year will be sustained lies in the moderation of these past headwinds. First, UK banks
have made considerable progress in bolstering their capital positions, in part prompted by the
Prudential Regulation Authority's balance sheet exercise earlier this year. Price-to-book
ratios have risen back to around unity. And bank funding costs have fallen sharply over the
past year (Chart 4), aided by the Funding for Lending Scheme. UK banks are now well
placed to provide the credit necessary to support a recovery.
Second, the euro area is no longer in existential crisis, in part as a result of the willingness of
the European Central Bank (ECB) to take redenomination risk off the table through its
Outright Monetary Transactions programme. The countries of the euro-area periphery have
also made progress in restoring competitiveness and rebalancing the composition of
demand, though there is still quite a way to go. Member states are working towards the
creation of a functional banking union, which has the potential to break the link between
sovereigns and banks. And in preparation for becoming the euro-area banking supervisor,
the ECB is planning a rigorous review of the quality of banks' assets, to be followed by a set
of stress tests and, if necessary, recapitalisation. Provided these carry credibility with the
market, this could do much to restore confidence in the euro-area banking system.
But while some headwinds are abating, others remain. The need to restore the public
finances to sustainability means that fiscal consolidation will continue for some years yet.
And, for some households, the past accumulation of debt may weigh on spending. Finally,
even though the cloud of uncertainty may be lifting, businesses are likely to remain cautious
about increasing their investment spending until it is clear that the recovery in demand will be
sustained. So the pace of the recovery is likely to remain fairly modest by historical
standards. That will mean that it is likely to be some time before the economic slack that built
up during the recession has been brought back into use. I will say a little more about that
later.
It is against this background that the MPC in August decided to provide some explicit
guidance about the considerations that will inform our policy decisions over the coming
months. In particular, we wanted to signal that we would not immediately begin to withdraw
the considerable monetary stimulus injected after the financial crisis simply because growth
had picked up. Rather we wanted to make clear our intention to maintain the stance of policy
until it was clear that the recovery was well entrenched and the margin of economic slack
had been substantially reduced, provided doing so did not entail material risks to price
stability or financial stability.
As you will all know, we implemented that by committing not to raise Bank Rate until after the
unemployment rate has fallen to 7%. This is a little higher than our current estimate of
around 6.5% for the medium-run equilibrium rate of unemployment - that is, the sustainable
unemployment rate once nominal rigidities and other transient factors have worked their way
through. In the long run, one would expect the sustainable rate to be even lower, as workers
who have become disconnected from the labour force are encouraged back into it.
Specifying our guidance in terms of the unemployment rate, rather than, say, some estimate
of the output gap, makes particular sense because of the uncertainty surrounding the
achievable level of productivity in the economy. Since the start of the crisis, output per hour
worked has fallen by around 5%, leaving it more than 15% below where it would have been if
it had simply continued growing at its pre-crisis trend rate. As discussed in past Inflation
Reports, as well as numerous speeches by MPC members, there are a variety of
explanations for this weak productivity performance. These include: specific factors, such as
the decline in North Sea oil production and an exaggeration of productivity growth in the
financial sector before the crisis; the hoarding of overhead and skilled labour through the
downturn; unusually low rates of investment on the back of heightened uncertainty about the
outlook; the adoption of more labour-intensive production techniques, encouraged by the
high degree of wage moderation; thick-market externalities, which make it easier to find and
transact business when demand is strong; and a misallocation of credit as banks repair their
balance sheets, with heightened forbearance shown on existing loans to low productivity
firms, coupled with caution as regards lending to risky businesses that offer the prospect of
higher productivity.
Some of these mechanisms depressing productivity can be expected to unwind naturally as
demand recovers. But others might take longer and require the restoration of the banking
system to full health. And some of the lost productivity growth may prove to be permanent,
for instance because of the foregone opportunities for learning by doing. Now while we have
several explanations for this "productivity puzzle", I think it is fair to say that none of them yet
seems to provide a completely convincing explanation. And although different MPC members
place different weights on the possible explanations, we all agree that there is considerable
uncertainty as to how productivity will evolve as the recovery proceeds.
Unemployment is certainly not a perfect guide to slack in the labour market. For instance, the
recent increase in the number of workers wanting to work more hours suggests it
understates the absolute level of slack1. But it is not unreasonable to expect this margin of
"potential hours worked" to move in line with unemployment. And, unlike in the 1980s, we
have not seen a substantial movement in the labour force participation rate, which suggests
changes
that the number of discouraged workers has not risen markedly. So overall, in the
unemployment rate are, we think, likely to provide a reasonable guide to the evolution of
labour market slack.
Now consider what will happen if the weak productivity performance of recent years is simply
a consequence of the weak state of demand and so reverses as the recovery proceeds. In
that case, businesses will be able to supply the extra demand without greatly expanding their
workforces and unemployment will be slow to fall. In these circumstances, it is indeed
appropriate to keep monetary policy loose as potential output is well above actual output.
Conversely, suppose that the financial crisis and subsequent recession has wrought lasting
damage to productivity. In that case, unemployment is likely to fall faster as demand grows,
meaning that unemployment will reach the 7% threshold sooner. Then it will be appropriate
to tighten policy sooner in this case, as potential output will be lower. The only case where
the linkage of policy to unemployment is potentially problematic is where there is scope for
productivity to increase as demand recovers, but for some reason firms take on extra labour
before
the increase in productivity takes place. But this seems rather unlikely to me.
In any case, it is important to realise that the 7% threshold does not constitute a trigger for
the MPC to raise Bank Rate. Rather it represents a prompt for the Committee to undertake a
broad assessment of the prospects for demand, supply and inflation. If it appears that there
is still a substantial degree of slack in the economy which can be absorbed without
threatening the achievement of the 2% inflation target in the medium term, then there will be
scope to maintain the existing stance of monetary policy longer, perhaps re-setting the
unemployment threshold to a new lower level at the same time. In any case, as a breach of
the threshold becomes imminent, it seems likely that the Committee will wish to provide
further guidance on the future determinants of policy in order to reduce any uncertainty
surrounding our reaction function.
Can we say anything yet about the effectiveness of the introduction of forward guidance? As
already noted, the primary objective is to give confidence to business and households that
policy will not be tightened until there is a material reduction in economic slack (assuming
that neither price nor financial stability are threatened) and to prevent an excessive
snapback in market interest rates taking place simply because a recovery is under way.
As far as the broad message to businesses and households goes, contacts of the Bank's
Agents suggest that businesses have got the message that the MPC will only begin to
tighten policy once the recovery is entrenched and slack has been materially reduced. And in
the period after the MPC's announcement, the Markit Household Finance Index suggested
that households expected Bank Rate to rise later than before, although the date has since
come back in again, perhaps reflecting the continued flow of positive data.
At first sight, the evidence from market interest rates is more equivocal. Chart 5 shows the
instantaneous forward yield curve in May, August and today. Yields have risen substantially
since May. On the face of it, that appears to suggest that the guidance has not been very
effective at influencing the expectations of market participants. Interpreting movements in
market rates is, however, complicated by the fact that other factors influencing yields have
not been constant.
First, the recent run of UK data has been unusually strong relative to market expectations.
That should generate upward pressure on market interest rates as, other things equal, a
reduction in the degree of monetary stimulus would indeed become appropriate sooner if
growth turns out stronger than expected. Bank staff have constructed a time series for the
news in the incoming data by calculating, for 14 different data series, the deviation of the
outcome from the market's expectations (as recorded by the median expectation of
economists polled by Bloomberg), normalised by its standard deviation. An aggregate
timeseries measure can then be obtained by taking an (unweighted) average across the most
recent observations for each series. Chart 6 shows such a measure back to 2006, together
with analogous series for the United States and the euro area. The series for the United
Kingdom recently reached its highest level over this period, emphasising just how much
upside news there has been here recently. Moreover, although both the United States and
euro area have also generally seen upside news of late, it has been nowhere near as strong
as in this country. Market interest rates should therefore have been expected to rise, and by
more here than in the other two jurisdictions.
Second, yields rose globally in the summer on the back of expectations that the US Federal
Reserve was about to taper its asset purchase program; more recently they fell back when
the Federal Open Market Committee (FOMC) unexpectedly decided not to begin phasing out
its asset purchases at its September meeting. Given the relatively high degree of
substitutability between UK gilts and US treasuries, and assuming that long-term inflation
expectations are anchored in both countries, it is reasonable to expect a high degree of
correlation of UK long rates with US long rates. But one might expect the correlation to be
less pronounced at the short end of the curve, where differences in cyclical positions - and
therefore differences in monetary stances - should come to the fore. Strong co-movement
should only be seen if either the shock is common in nature, or the international transmission
of a shock from one country to the other is strong.
Now, as it happens, measures of co-movement have generally been high since the start of
the financial crisis. In the earlier phase of the crisis, when contagion through financial
markets was particularly strong, it was reasonable to believe that what happened in the
United States was critical to the outlook here. That seems less plausible now, given the
substantial progress in repairing the banking systems in the two countries. This thinking lay
behind the Committee's decision to issue a statement after its July meeting that the recent
upward movement at the near end of the yield curve was "unwarranted". More generally, the
explicit guidance provided in August should also serve to emphasise that UK monetary policy
decisions are taken with reference to the domestic outlook and will only be influenced by
developments elsewhere in so far as they affect that outlook.
There is mixed evidence thus far on whether guidance has helped to de-couple movements
in UK short-term rates from those overseas. The prime exhibit against this having happened
is the high degree of correlation between UK and US interest rates at the time of the FOMC's
unexpected decision at its meeting on 17/18 September not to begin to taper its asset
purchases. As far as market participants were concerned, this was surely primarily news
about the FOMC's policy reaction function, not about the US economic outlook. So it ought
also to have had little impact on UK interest rates. As Chart 7 shows, however, the
movement in UK one-year interest rates two years ahead was almost as large as for the
corresponding US series. That, together with the high co-movement prior to the September
FOMC meeting when US interest rates rose, suggests that market participants may have not
yet grasped the extent to which decisions over the level of Bank Rate will be driven by the
domestic outlook.
There is, however, other evidence which suggests that some de-coupling may have taken
place. Chart 8 shows the correlation between UK forward interest rates and the UK and
US data surprise series that I described earlier, split by time period. That the responsiveness
of forward interest rates to data news was particularly low during the 2009-April 2013 period
is not surprising as Bank Rate was constrained on the downside by the zero lower bound, so
that the distribution of policy rates was truncated. That is still relevant today, but economic
news has been more consistently to the upside recently, attenuating the impact of the
constraint. Importantly, there is some evidence that the response of UK rates to US data
surprises has declined since the introduction of the MPC's forward guidance, although the
small sample in the most recent period means that the coefficients are not that precisely
estimated.
A final piece of evidence, which is at least consistent with the central aim of the MPC's
guidance, is presented in my final chart. As I noted earlier, a prime concern was to convey
the message that a return to growth did not imply an early withdrawal of stimulus. Rather, if
slack was substantial, then it should be possible to maintain the highly stimulatory monetary
stance for some while before price stability - as embodied in the inflation target - is
threatened. Historically, and particularly in the pre-crisis period, there was a reasonably
strong correlation between indicators of growth and the slope of the yield curve at the short
end. This is illustrated in Chart 9, which plots the composite Purchasing Managers Index and
the spread between the two-year swap rate and the overnight rate.
Now it is not too surprising that there should have been such a relationship during the period
before the crisis, as growth was generally steady, with inflation close to target and output
close to potential. A period of strong (weak) growth could then be expected to lead to excess
demand (supply) and a tendency for inflation to move above (below) the target.
Consequently it was quite rational for market participants to expect the MPC to increase
(reduce) Bank Rate. But things are different now, as there is potentially a substantial margin
of economic slack that needs to be absorbed. In that case, the steepening in the short end of
the yield curve ought to be far less pronounced. Fortunately, that is exactly what we see in
the most recent data. The curve has steepened alongside the sharp increase in the PMI, but
by far less than similar episodes of rising growth in the past would suggest. This too may be
an indication that the guidance has had some effect in preventing unwarranted movements
at the short end of the yield curve2. I am sure, however, that there is scope for much more
analysis of the impact of our guidance on the behaviour of market interest rates and, indeed,
on the broader economy.
That guidance is, of course, qualified by three overrides or "knockouts". Two of these relate
to the risks to price stability. One of these stipulates that our own projection for inflation
18-24 months ahead should be at least as likely to fall below 2.5% as to be above it. The
other asks whether there is any evidence that measures of the inflation expectations of
households, businesses and market participants have become insufficiently well-anchored to
the target. At this stage, we do not see anything to worry about on this score.
The third override condition, delegated to the Bank's Financial Policy Committee, relates to
whether the monetary policy stance is resulting in the build-up of dangerous financial stability
risks. If the FPC cannot contain these risks using the range of recommendations and powers
at its disposal, then it will alert the MPC, who will then decide whether an increase in Bank
Rate is called for. Increasingly noisy commentary that a new housing bubble is brewing
- and concerns that the second stage of the Help to Buy scheme will add fuel to the fire -
may mean that this condition becomes material. I do not have time left today to do justice to
this issue. But it is important to remember that mortgage approvals for house purchase are
still running at a little over half their pre-crisis average and, outside London, house price
inflation is still quite modest. So we appear to be still some way off seeing an unsustainable
house-price boom on the back of excessive credit growth. That said, neither the MPC nor the
FPC can afford to be complacent.
The past five years or so have presented the policy makers here and elsewhere with many
difficult challenges. We have discovered that we knew even less about the workings of the
economy than we thought we did. And we have moved into policy territory that we could
scarcely have imagined during the halcyon days of the Great Moderation. Happily, there are
signs that a recovery is at last starting to gain traction here in the United Kingdom. But there
is still a long way to go before we can say the economy is mended. Until that is the case,
monetary policy will need to remain supportive and the guidance we issued in August was
intended to make that clear. Thank you!
The UK economic outlook
Society of Business Economists Annual Conference
Charlie Bean, Deputy Governor for Monetary Policy
22 October 2013
Chart 1: GDP projection in August 2010
Percentage increases in output on a year earlier
7
6
5
4
3
2
1
0
-1
Latest vintage of data
-2
-3
-4
-5
-6
-7
06 07 08 09 10 11 12 13
Chart 2: Cumulative change in GDP since 2010Q2(a)
Percentage points
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
(b)
Net trade Change in inventories -1.0
Investment Government consumption
Consumption GDP
(a) Chained-volume measures. Components may not sum to total due to chain-linking, the statistical discrepancy and the alignment adjustment.
(b) Excludes the alignment adjustment.
Chart 3: CPI inflation projection in August 2010
Percentage increase in prices on a year earlier
6
Outturn
5
4
3
2
1
0
-1
-2
06 07 08 09 10 11 12 13
Chart 4: Indicators of bank funding spreads
Percentage points
4.0
Initial FLS
Secondary market bond spreads(a)
announcement
3.5
3.0
Fixed rate retail bond
2.5
(average of 2 & 3yr
spreads)(b)
2.0
1.5
1.0
Covered bond 0.5
Five-year CDS premia(c)
spread(d)
0.0
Jan Jul Jan Jul Jan Jul Jan Jul
10 11 12 13
Sources: Bloomberg, Markit Group Limited, Bank of England and Bank calculations.
(a) Constant-maturity unweighted average of secondary market spreads to mid-swaps for the major UK lenders' five-year euro senior unsecured bonds.
(b) Sterling. Spread over the relevant swap rate for fixed-rate retail bonds.
(c) Unweighted average of the five-year senior CDS premia for the major UK lenders.
(d) Constant-maturity unweighted average of secondary market spreads to mid-swaps for the major UK lenders' five-year euro-denominated covered bonds, where available.
Chart 5: Instantaneous forward yield curves(a)
Percentage points
5
May IR Aug IR Latest
4
3
2
1
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Sources: Bank of England and Bloomberg.
(a) The May and August Inflation Report curves are based on the final day of the respective 15-day averages. The latest curve is from the 17
October.
Chart 6: Economic 'surprise' indicators(a)
Standard deviations
0.8
United States Euro area United Kingdom
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
2006 2007 2008 2009 2010 2011 2012 2013
Sources: Bloomberg and Bank of England calculations.
(a) Moving average of unweighted data surprises over a 60-day rolling window. Data surprises for each variable are scaled by the historical
standard deviation of surprises for that variable. Variables are selected according to the number of Bloomberg alert subscriptions, but data on
consumer prices, producer prices and wages are excluded.
Chart 7: Interest rate reaction to FOMC meeting 18/9/2013(a)
Change since 12pm (bps)
UK US
15
Bernanke's
conference ends
10
FOMC
5
0
-5
-10
-15
-20
-25
-30
-35
12:00 15:00 18:00 21:00 08:00 11:00 14:00 17:00
18 Sep 2013
19 Sep
Source: Bloomberg.
(a) 1-year OIS rates, 2-years forward.
Chart 8: Sensitivity of UK interest rates to economic news(a)
Basis points per
one standard
Sensitivityof UK 2y1y government yields to UK economic surprises deviation surprise
Sensitivityof UK 2y1y government yields to US economic surprises 10
8
6
4
2
0
-2
-4
-6
-8
2006 - 08 2009 - Apr 2013 May 2013 - latest Aug 2013 IR
-10
14 Oct 2013
Sources: Bloomberg and Bank of England calculations.
(a) Based on bi-variate regressions of daily yield changes on the daily average surprise in the variables within the Economic Surprise Indicators.
The diamond shows the regression coefficient and the bars indicate plus or minus two standard deviations.
Chart 9: Composite PMI and spread between 2-year swap and
overnight rates
Net balance Percentage points
65 2.0
1.5
60
1.0
55
0.5
50 0.0
-0.5
45
-1.0
Spread between 2-year swap and
(a)
40
overnight rates (right-hand scale)
(b) -1.5
Composite PMI (left-hand scale)
35 -2.0
1998 2000 2002 2004 2006 2008 2010 2012
Sources: Bloomberg, Markit Economics, ONS and Bank calculations.
(a) Three-month moving average of the end-month spread between the 2-year swap rate and the SONIA rate.
(b) Based on the Markit/CIPS manufacturing and services PMIs.
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