Paul Fisher: Inflation, interest rates and forward guidance
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, at State
Street Global Advisors London Pensions and Investments Breakfast Briefing, London,
23 January 2014.
* * *
The speaker is also chair of the ifs University College. Any views aired in this speech are
given in his capacity as a member of the Monetary Policy Committee of the Bank of England.
The speaker is grateful to Geoff Coppins for helping to prepare this talk and many colleagues
for comments, but any blame for the content is for the speaker alone.
This morning I would like to discuss some of the important issues currently influencing the
setting of monetary and financial policy by the Bank of England. Those policies may have a
direct bearing on pension funds; most obviously you might think via the yields on financial
assets but perhaps more importantly via the stability of the real economy.
Developments in inflation
First of all I want to note the importance the Monetary Policy Committee (MPC) attaches to
CPI inflation being close to its target of 2%. Indeed it is currently at exactly its target of two
point zero per cent for the first time since April 2006! (Although it did drop below 2% for a
time in 2007 and 2009). Although we can't expect inflation to be exactly 2.0% very often (just
four times since it was announced as the target variable in December 2003), inflation has
been above target for most of the past six years. Both the extent of the overshoot and its
persistence were greater than the MPC initially expected. The pain of that experience of high
inflation over the past few years should remind us all why the UK attaches so much
importance to keeping inflationary pressure under control and why we have an inflation
target.
Inflation is costly in all sorts of ways.1 It can destroy real incomes, for example by acting as a
hidden tax2, and destroy wealth through a misallocation of resources. Those on fixed nominal
incomes or who depend on savings income may be badly affected whereas it can inflate
away the debts of others. And it generates a variety of other economic costs and distortions
as changes in the general level of prices start to dominate the information contained in
relative or "real" prices. Many of these costs are pernicious by being implicit; for example in
businesses having to change price lists, or consumers having to spend more time looking for
real value.
The MPC could have set a tighter monetary policy to try and limit the rise in inflation. Why
didn't we? First, because we were pretty sure that the factors driving inflation higher were
going to cause changes in the price level rather than being consistent with, say, excess
demand generating persistently higher inflation. We expected inflation to fall back, once
those changes had passed through. And, second, to prevent even a temporary rise in
inflation consequent to those price level shifts, the MPC would have had to try to depress the
economy even further, by consciously pushing down on output, employment and nominal
wage growth - so real wage growth would have been weaker, not stronger - at a time when
the economy was already very weak. So, despite the costs of the inflation which were
experienced, the costs of the policy needed to counteract it would have been even greater in
this specific circumstance of one-off shocks and left the UK economy in a much worse
position now.
I want to stress that these calculations would not lead to the same conclusion were inflation
being driven by pressure arising from excess demand or if inflation had led to expectations of
above-target inflation in the medium-term. In those circumstances, where inflation would be
more persistent and hence much more costly, the benefits of bringing inflation back to target
would outweigh the short-run costs of doing so. The recognition of these different short-run
trade-offs, depending on the forces driving inflation, lie right behind the specification of the
Remit we have been given by the Government.
The fact that inflation has now returned to target confirms to me that we were broadly correct
in our underlying assessment that the factors pushing up on inflation would be temporary,
although the near-term path for inflation hasn't always been what we expected. It is very
difficult to anticipate the precise trajectory of prices and we have certainly learned more
about the dynamics of inflation during this difficult period: the effects of the 25% depreciation
in the sterling effective exchange rate between mid-2007 and early 2009 were larger and
longer-lasting than we anticipated for example3. But tightening policy in response would have
been a major mistake: a tighter policy then and we could now be facing the threat of deflation
and depression, rather than inflation around target and the prospect of real recovery.
The MPC's policy has been to keep short-term interest rates low, by setting Bank Rate at
0.5%, and to stimulate the economy through asset purchases and latterly through forward
guidance. Although asset purchases work through several channels, I want to spend a little
time on their contribution to depressing longer-term interest rates. Low interest rates - at all
maturities - have been necessary to help stimulate spending and so help set the conditions
for a recovery in the economy. But for many investors, such a policy generates low financial
returns which are difficult to cope with. Pension funds, for example, need relatively long-term,
low credit risk investments - such as gilts - and those have been generating lower than
normal returns for some years. In fact, the search for yield has tended to depress all financial
returns. But I want to reflect on the relationship between rates of return and the real
economy. As a general proposition, one cannot expect to earn high risk-adjusted real returns
from financial investments if the underlying real economy is not growing. For example, it is
business profitability which drives equity dividends and prices. The real "risk-free" interest
rate is also associated with real growth. Slow economic growth and low financial yields have
been a feature of most of the developed world in recent years because of the global nature of
the recessionary forces at work. Once a recovery in the UK economy has been firmly
established then one would naturally expect real financial returns to be higher, and the real
policy rate (i.e. Bank Rate minus expected inflation) can start to normalise.
We can express this thought in a different way. Would it have helped financial investors to
have had higher nominal interest rates over the past few years? If that had meant a deeper
recession, deflation and an even longer-lasting malaise in the economy, then very few
UK-based medium-term investors would have been better off as demand and activity would
have dropped off further, credit risk crystallised and a range of credit investments went bad.
Those with longer term investment horizons - such as everyone in this room should have -
will appreciate that the best outcome for UK monetary policy is for it to be set at the right
level to lay the foundations for a stable economy.
In that regard, we should bear in mind that the economy will always be subject to unforeseen
shocks which tend to push it away from stability for a period of time. The job of the MPC is to
react to those shocks by bringing inflation back to target and, subject to that primary
objective, in a manner which helps sustain output and employment.
As well as inflation back around target, we have also seen a resurgence in growth over the
past year. It was difficult to explain the suddenness of the change in sentiment which
accompanied the recovery during 2013 but growth in itself should not be regarded as
surprising. It is the near stagnation from 2010-12 which was harder to understand. We have
been stimulating the economy with historically extreme levels of monetary policy for a long
time and a variety of headwinds (including the problems in the euro area, a tightening of
credit conditions, the drag on activity from fiscal consolidation, and a squeeze in household
real incomes resulting from the fall in productivity and higher energy and commodity prices)
have all contributed to limit the effect of that stimulus. What seems to have happened in 2013
is that at least some of those headwinds were perceived to have diminished, allowing the
policy stimulus to come through and the resulting growth has generated the renewed
consumer and business confidence which reinforces demand.
We are very conscious that the headwinds have not gone away: much of Europe and some
other parts of the world continue to struggle for sustained growth; fiscal consolidation in the
UK (and elsewhere) is likely to continue for a while to come; and the financial sector still
needs some rebuilding. Indeed, the official production and construction data released earlier
this month were rather disappointing, reminding us that strong growth from here on is by no
means guaranteed. But to varying degrees perhaps the very worst of the storms may be
behind us. Just a tailing off in some of their negative impacts may have been sufficient to
allow the economy to start growing again.
Interest rates and forward guidance
So why aren't we moving to tighten policy straight away, why did we issue forward guidance
around monetary policy? The answer is in the levels of output and employment, not their
growth rates. After nearly 6 years since the start of the crisis, the level of output in the
economy is still 2% below its peak in 2008. A conservative extrapolation of the pre-crisis
trend would suggest that UK output is some 15-20% below where it would have been
expected to be by this time in the absence of the crisis. It seems unlikely that we will recover
much of that gap and in any case the calculation is getting less precise and less relevant.
Eventually, economic historians may work out what happened to potential output and we
should establish a new reference point. As things stand today, it is difficult to know precisely
where the new sustainable growth path of the economy lies (especially as data for the past
few years are still likely to undergo significant revision by the ONS). But with unemployment
still elevated, and diminishing signs of inflationary pressure in both goods and labour
markets, we can be reasonably confident that the economy needs to grow strongly for some
time to come, to regain a stable and sustainable medium-term trajectory.
The challenge for the MPC is to assess when inflationary pressures will be building and thus
when we need to start withdrawing stimulus, so that once we have eliminated slack in the
economy, monetary policy is consistent with stable, sustainable growth and hence stable
inflation around the target (subject of course to the other forces acting on the economy at the
time). That's an extremely optimistic expectation of what policy can achieve, so let me put it
slightly differently. The realistic challenge for the MPC is to avoid a big mistake either by
choking off the recovery too soon, leaving the economy in a quagmire, or by allowing
inflationary pressures to build excessively, requiring a sharp tightening in interest rates (and
the potential for another recession) to bring inflation back under control.
Forward guidance is a policy framework designed, amongst other things, to help avoid big
mistakes. We can encourage and probe growth in the economy by committing not to tighten
policy until the economy has used up more of its spare capacity. On one view the policy is
simple - we must give the economy plenty of time to establish the recovery before we start to
raise interest rates or unwind asset purchases. At another level, some critical judgements are
going to be needed because the timing is inevitably uncertain. Given those uncertainties,
forward guidance delivers a framework within which the MPC can explore the scope for
economic expansion without putting price and financial stability at risk. That guidance should
help to give confidence to businesses and households and help to support demand growth.
By reducing uncertainty about our reaction function, guidance should also have helped to
counteract the pressure in financial markets to price in the chance of a rapid increase in
Bank Rate.
We chose unemployment as the threshold indicator not because it was ideal - far from it -
but because other indicators were all less attractive. Of course, no sooner had we
announced a policy linked to the unemployment rate than it began to fall unusually
precipitously. But what is there not to like about sharply falling unemployment? After all,
getting the economy back to a medium-term path quickly, allowing policy to normalise, would
be a good thing? Right?
Well, falling unemployment is undoubtedly a good thing for the individuals who are back in
work and on many other social counts. It could only be a purveyor of the dismal science who
found rapidly falling unemployment disappointing! Yet, in order to see rising living standards
on average, it is crucial to see rising output per head (i.e. rising productivity) - which
ultimately drives real national income per head and hence how well off we are as a country.
So we need to see rising employment accompanied by even faster growth in output.
The implied productivity performance of the UK economy has, in fact, remained poor -
according to the official statistics, output simply doesn't appear to be growing fast enough to
support the employment growth recorded as well as generate the rapidly rising real incomes
one would like to see. Something has to give. I hope that it will be that output grows faster -
either through upwards revisions to recent growth rates or faster growth in future. If, on the
other hand, the UK economy uses up all its spare capacity, without having had a substantial
rise in real national income, then we should all be disappointed.
The weakness in productivity growth has been well documented, but a convincing
explanation remains elusive. There are many plausible explanations of factors which could
have contributed to the weakness, but each explains only a small part of the whole puzzle. I
don't have time to get into that debate today, but we do offer a variety of candidate
explanations in recent Inflation Reports.
One better feature of the current situation is that price pressures seem to be subsiding, not
growing. Despite good rates of employment growth, there is no sign of nominal wages
overreacting to general tightness in the labour market. Other price pressures also appear to be
easing somewhat. Month by month there have been a series of small downside surprises in
the inflation rate as oil prices have been relatively stable; the effects of administered and
officially regulated prices now seem to be a bit less than previously expected; inflation
expectations remain well anchored and the exchange rate has been rising which may help
keep a lid on imported costs for a while (but importantly, at the cost of less balanced growth
which is a separate problem). Taking the inflationary news together, it would appear that we
have a favourable situation in which to explore how much more capacity the economy has,
before inflationary pressures begin to build.
Another positive factor supporting our probing strategy is the emergence of macro-prudential
policy. Monetary policy has a difficult challenge ahead, as I have outlined. It will help
enormously if financial policies can help deal with, or at least mitigate the risks from, some of
the imbalances that are arising in the economy while the MPC aims to restore medium-term
stability in the economy as a whole. The housing market is an example of where monetary
and macro-prudential policies can helpfully interact and the November 2013 Financial
Stability Report sets out some of the policy measures that are underway or could be called
on if necessary.
Funding for Lending Scheme
One decision that has been implemented is in relation to the Funding for Lending Scheme
(the FLS). The FLS contributed to a substantial fall in bank funding costs after it was
launched in July 2012. This fed through to a significant improvement in household credit
conditions. Rates on new household lending have fallen markedly since mid-2012, with falls
of more than 100 basis points in some representative mortgage rates. Both gross secured
lending and repayments have picked up strongly. And the number of approvals for house
purchase has risen significantly, indicating higher mortgage lending in future. The Scheme
has probably been one of the driving influences behind the resurgence of business and
consumer confidence - although there are many other factors behind the sort of swing we
have seen.
Partly because of its own success, there is no longer a need for the FLS to provide broad
support to household lending. It is not the case that net lending for mortgages by UK banks
is, as yet, excessive. Indeed, the annual rate of growth in the stock of secured lending to
individuals was under 1% in November 2013. But sharply rising house prices are a potential
source of instability and we should not risk adding policy oil to that particular fire. Credit
conditions for smaller businesses have also improved, but to a lesser extent, and lending to
businesses overall remains muted. The FLS extension will therefore provide continued
substantial support for lending to businesses, with incentives in the scheme skewed heavily
towards lending to small and medium-sized enterprises (SMEs). As the MPC noted in the
minutes of its December 2013 meeting, the changes to the FLS provided support to the
MPC's policy guidance by reducing the risk of triggering the financial stability knockout.
Conclusion
Yesterday, the Labour Force Survey headline unemployment rate for the three months to
November was published at 7.1%, after another large fall. But even if the 7% unemployment
rate threshold were to be reached in the near future, I see no immediate need for a tightening
of policy. The MPC has been clear all along, that upon reaching the 7% threshold we will
have to consider what the medium-term pressures on the economy are and make an
appropriate judgement about the direction and pace of policy, and any further guidance that
we may choose to issue in future. It is probably best to think about that in the context of our
medium-term inflation projections published in the Inflation Report.
Overall, the macroeconomic outlook is much more comfortable than it was - but we still have
much to do and much to concern us. There is no room for complacency. Can the UK keep
growing at the sort of rate consistent with recovery if our key European export markets
remain so sluggish? How much more adjustment is needed in the financial sector and in the
fiscal position? Have households sufficiently rebuilt their balance sheets to be able to
withstand a normalisation of policy? Many of these considerations argue against being hasty
in tightening monetary policy. But the inflation target remains our primary objective and we
will have to be careful not to allow pressures to build up from excess demand. It would be a
relief, probably for both you as investors and for us as policy makers, to get back to more
normal policy conditions, but my own judgement is that we are still some way off the point
where it is appropriate to start raising Bank Rate and that when it is time, it would be
appropriate to do so only gradually.