Mark Carney: The spirit of the season
Speech by Mr Mark Carney, Governor of the Bank of England and Chairman of the Financial
Stability Board, to the Economic Club of New York, New York City, 9 December 2013.
* * *
Accompanying charts can be found at the end of the speech.
It is always a pleasure to be in New York during the festive season. At this time of year in this
city everything seems possible. However for some time now, appearances have deceived.
The hopes and dreams of the holiday season have gone unfulfilled as the bright lights of
December have given way to the grim realities of January.
Around this time every year policymakers, investors and economists take stock. For four of
the past five years, perhaps caught up in the seasonal spirit of goodwill, they have rendered
the same verdict: the outgoing year was disappointing but the incoming one will be better
(Chart 1). This year is no different. The IMF, the Bank of England and private forecasters all
predict faster growth in the advanced and global economies in 2014. Will such hopes again
be dashed once the New Year dawns?
More profoundly, as the string of disappointments lengthens, some are raising deeper
questions. It is being suggested that a malign spirit, a spectre of Christmases past, haunts
our future. In particular, no less an authority than Larry Summers has raised the prospect
that "secular stagnation" could be the root cause of past excess and current weakness.
Today, I want to explore those deeper questions and what they mean for policy. But before
raising the pessimists' challenge, let me first keep with recent practice by setting out this
year's reasons for optimism.
Grounds for optimism
The news from the UK is positive. Inflation has fallen, from more than 5% in 2011 to 2.2%
now, jobs are being created at a rate of 60,000 per month, and growth is - for the moment -
the strongest in the advanced world.1 This recovery is relatively recent, having started in
earnest during the second quarter of the year. Its timing and pace caught most unawares.
Certainly, the cumulative run of economic surprises has dwarfed those of the other major
advanced economies (Chart 2).
With the wisdom of hindsight, there were three main drivers of the recovery: a marked
reduction in extreme uncertainty (Chart 3); significant progress on repairing the core of the
financial system, with risk-weighted capital ratios doubling in recent years; and a marked
improvement in household balance sheets, where debt to income ratios have fallen by about
30 percentage points.
Together, improved access to finance and raised expectations of future prospects led to a
reduction in precautionary savings by households, a modest recovery in consumer spending,
a revival in housing investment from very low levels and an increase in business confidence
to a 15-year high.
The American and British experiences underscore that recovery is not possible without a
meaningful and transparent re-capitalisation of the banking system, and that households
need to de-lever before they have the confidence to consume again.
The question now is whether such progress is sufficient for durable, strong and balanced
recoveries over the medium term.
Growing pessimism
The pessimists would argue that it isn't. Their case starts from the observation that advanced
economy growth rates remain below pre-crisis trends, despite the scale of the fall and years
of emergency monetary stimulus. More fundamentally, pessimists point to the pre-crisis
period when (retrospectively) loose financial conditions did not generate a boom in output
and associated inflation.
They ask: could stagnation be the new normal?
Today I want to consider two possible explanations for why advanced economies may have
entered a low growth phase. First, on the demand side, they could be in a persistent liquidity
trap, making it difficult for resources to be fully utilized, and second, there may have been a
persistent deterioration in the supply side such that full utilisation of resources is consistent
with slower growth.
1. Persistent liquidity trap
A liquidity trap occurs when the short-term nominal interest rate hits the zero lower bound.
Typically in a liquidity trap, the equilibrium real interest rate is negative, creating a persistent
inability to match aggregate demand and supply.
Before proceeding, I should make clear what I mean by the equilibrium (or natural) real
interest rate. Let me use Roger Ferguson's definition: it is the level of the real policy rate that,
if allowed to prevail for several years, would place economic activity at its potential and keep
inflation low and stable.
For small open economies, like the UK, that equilibrium real rate is determined at the global
level by the balance of the supply of savings and demand for investment. In the run-up to the
crisis, that balance had shifted decisively as what Chairman Bernanke christened a "savings
glut" from emerging economies developed. The flipside of that was low demand for advanced
economy exports and low domestic demand in emerging economies. Only very low global
real interest rates could spur sufficient domestic demand in advanced economies to maintain
activity at its potential level.
The problem of course was that the expansion of demand in advanced economies largely
took the form of unsustainable consumption rather than business investment.
The ensuing financial crisis pushed the equilibrium real interest rate down further and, with
nominal interest rates stuck at zero and inflation low, monetary policy was unable to push
actual real rates to a level low enough to maintain full employment.
The danger in such a situation is that it can become unstable as weak demand and
uncertainty cause companies to hold back investment and households to postpone spending.
With the balance of savings and investment deteriorating, the equilibrium real interest rate
falls even further. At the same time, wages and prices are forced down, pushing actual real
interest rates higher. A deflationary spiral results.
That is not the only danger. Attempts to reach a very low or negative equilibrium real interest
rate - both through conventional reductions in short-term interest rates and through
unconventional asset purchases - can risk generating unbalanced, unsustainable demand.
In particular, as my predecessor Mervyn King has emphasised, by encouraging spending to
be brought forward from the future and debt to be accumulated in the present, a greater
shortage of demand tomorrow will develop unless the income of those who have taken on
the debt picks up.2 If it does not, monetary policy will have to "double down" in order to
sustain demand. Such compounding stimulus could promote financial vulnerabilities through
an indiscriminate search for yield, a compression of risk premia to unsustainable levels or via
extrapolative expectations of future asset prices. Perceptions of a "central bank put" - where
the market interprets all bad news as good news because it will be met with more central
bank stimulus - can reinforce these risks. When the inevitable correction finally occurs, the
shortfall in demand and scale of the liquidity trap is insurmountable.
To what extent does this sketch resemble the current situation in the UK?
As its policy stance reflects, the Monetary Policy Committee (MPC) judges that the
equilibrium real interest rate has been, and continues to be, negative. Despite very low
interest rates, resources are not fully employed. 850,000 more people are out of work than in
the years before the crisis and GDP is around 20% below an extrapolation of its pre-crisis
trend.
As bad as these figures are, the scale of the mismatch between aggregate supply and
demand has not been large enough to generate a deflationary spiral. Despite persistently
weak nominal wage growth, rising import prices and weak productivity growth have meant
that the UK's problem has been the need to bring inflation back to the target from above. In
this regard, there has been welcome progress. Headline inflation has fallen back much
sooner than we expected at the start of the year, and core inflation measures are running
close to but slightly below the 2% target.
What then of the risks of unbalanced growth? This is more delicate. Despite admirable
progress by British households in recent years, aggregate debt levels remain high at 140% of
incomes. In addition, housing activity is picking up and price growth appears to be gaining
momentum. Moreover, the UK current account deficit is near record levels.
These developments merit vigilance but not panic. The housing recovery could reflect higher
future income expectations, prompted by the nascent recovery, and better credit conditions.
Although the current account position underscores the need for the recovery to shift over
time towards investment and export growth, it would be unreasonable to expect that to have
happened already. Recoveries are seldom led by investment and strong demand from the
UK's major trading partners, including the euro zone, appears some way off. Ultimately, a
sustained recovery in the UK will require a more robust and balanced global recovery.
In summary, the UK has been in a situation where the equilibrium real rate of interest has
been negative, but with monetary policy gaining traction, there is early evidence that the
liquidity trap will be escaped over time. That is not to suggest the warnings are without merit,
that interest rates can return to normal soon, that the risks to financial stability arising from
the emergency stance of monetary policy are not real, or that escape would bring the
freedom to grow at historic rates.
It is in this last respect that the second story for a "secular stagnation", persistently weak
supply, is most relevant.
2. Supply pessimism
In many advanced economies, despite persistently disappointing output growth,
unemployment rates have remained surprisingly low. Based on a simple Okun relationship,
the current UK unemployment rate would be expected to be closer to 14% and the US rate to
be around 10%. In fact, they are 7.6% and 7.0% respectively (Chart 4).
These discrepancies have reinforced the worries of some that weak potential supply growth
will constrain the pace of recovery. Possible explanations for such weakness range from
demographics to a slowing in the rate of technological progress.
It seems unlikely that communicating in 140 characters - useful discipline though that is -
represents the apex of human progress. Nor should central banks always and everywhere
take supply as exogenous. Central banks can affect people's decisions about how much to
work and firms' decisions about how much to invest. When the outlook is particularly
uncertain, as it is in the wake of a major financial crisis, this influence could affect potential
supply. Monetary policymakers must consider the extent to which their decisions affect, not
just depend on, the path of output.3
In the US this question has been the subject of much debate. A recent Federal Reserve
Board paper argues that potential supply growth is likely to respond to demand as the
economy recovers, for example through capital deepening, as well as the behaviour of the
labour market.4
The rise in unemployment here in the US has been tempered by a fall in the rate of labour
force participation and a slowdown in productivity growth (Charts 4 and 5). It is quite possible
that, with a recovery in demand, those discouraged from looking for work will return to the
labour force. Given the risks of hysteresis, that is more likely to happen the more quickly
demand recovers. This dynamic suggests scope for a strong recovery in which falls in
unemployment are much more limited than usual.
Potential growth in the UK could also be pro-cyclical but for different reasons. In Britain, the
employment rate has fallen only a third as much as in the US (Chart 6). The flipside of that
strength has been exceptionally weak productivity growth (Chart 7). Will UK productivity
growth pick up alongside demand? The fundamentals are promising. Given the flexibility of
its labour market, the continued openness of the economy and the credibility of macro policy,
it is hard to think of any reason why there should have been a persistent deterioration in the
rate of potential growth in Britain.
This hypothesis holds particularly now that the UK financial system is beginning to function
more effectively. Until recently, the weakness of the banking system limited the reallocation
of capital and labour from less to more productive activities. Indeed, whereas half of all
productivity growth at the economy-wide level in the years prior to 2008 occurred through this
channel, reallocation appears to have made no contribution to productivity growth in recent
years.5
There are other reasons to think that growth itself should bring a supply side improvement.
As the economy recovers, investment should pick up and part-time workers should shift into
more productive full-time work. With the sharp fall in real wages during the recession (Chart
8), employees effectively priced themselves into low-productivity work at a time of weak
demand. To the extent that this allows skills to be retained and reduces costs of replacing
particularly skilled employees as the recovery takes hold, the recovery could generate
greater supply capacity and real wage growth as it proceeds.
It would be unreasonable to expect these positive outcomes to materialise immediately.
Weak growth may have meant that companies have missed out on productivity advances
that would otherwise have been made through learning by doing. Skills have atrophied
through underemployment rather than unemployment. The recovery will therefore need to be
sustained for a period before productivity - and real wage - gains can resume in earnest.
That picture is borne out in the latest UK data, which show that the early phase of recovery
has been accompanied by some productivity gains but also by further strong employment
gains.
In summary, while the UK's experience does not rule out the possibility that supply growth
has slowed, the thesis is only beginning to be tested. And the nature of the slowdown,
particularly in the labour market, suggests that supply will likely increase with demand for
some time.
Policy implications
The risks to supply and the risks associated with the liquidity trap imply that central banks
need to deploy a wide range of policies in a coordinated fashion.
The most obvious implication is that monetary policy should respond aggressively. To
prevent the liquidity trap from becoming a coffin, central banks have set monetary policy at
emergency levels by reducing short-term interest rates to their lowest feasible levels,
undertaking large-scale asset purchases, and pursuing targeted interventions to ease
funding and credit conditions. The possibility that potential supply will itself depend on the
speed of recovery reinforces this policy bias.
Forward guidance is integral to the response. It reduces uncertainty by providing
reassurance that monetary policy will not be tightened prematurely before the recovery is
sufficiently entrenched to sustain higher rates. This helps give households and businesses
the confidence to spend and invest. And, by setting a threshold for the unemployment rate,
guidance helps us to test the endogeneity of supply. If supply responds to recovering
demand, unemployment will fall more slowly than otherwise and the point at which we will
re-evaluate the stance of monetary policy will come later.
What of unbalanced growth? The Bank of England is alive to the risks of extended stimulus,
and given its responsibility for macro-prudential policy, it can act in a timely fashion to
mitigate them. The Bank demonstrated this flexibility recently with a package of measures
targeted at the housing market, and it has outlined a broad range of additional tools if further
action were required.
The synergies of combining the monetary and macro-prudential authorities in one institution
could be considerable. By sharing analysis and clearly assigning a hierarchy of
responsibilities between them, the Bank's MPC and its financial policy equivalent, the FPC,
are ensuring that measures are timely, proportionate and targeted. For example, the Bank's
Funding for Lending scheme, originally put in place for monetary policy purposes, was
refocused from household to small business lending for financial stability purposes. Similarly,
both committees have made it clear that monetary policy is the last line of defence against
financial stability risks, thereby establishing clear lines of responsibility and accountability.
This coordination is particularly important if either of the "secular stagnation" stories is
relevant. By addressing risks to financial stability, the Bank's FPC helps ensure that
monetary policy can remain as stimulative as necessary for as long as necessary to achieve
its objectives. In doing so, it reduces the risk of a deepening liquidity trap caused by
compounding debt-fuelled consumption. And it helps to lay bare more clearly the underlying
growth potential of the economy.
The third aspect of the policy response is better financial regulation and supervision. In both
the US and UK, the repair of the financial sector was a prerequisite for recovery. Indeed, one
of the reasons behind a persistently negative equilibrium real interest rate has been the
restricted supply of credit from a damaged banking system. Going forward, financial reforms
will help guard against excessive pro-cyclicalities that could emerge in a "low for long"
environment.
But financial reform is about much more than fixing the failings in advanced economies; it is
one of the keys to rebalancing the global economy. The global savings glut will not disappear
in the absence of further financial liberalisation in China. That will only proceed if there is a
transparent, resilient global financial system worth joining, and will only be completed by
further internationalisation of the renminbi. Those realities are key reasons why the Bank of
England is so engaged in the work of the Financial Stability Board and has moved to support
London as a hub for renminbi clearing.
Conclusion
For the first time in a long time it seems reasonable to expect the hopes and dreams of the
holiday season to be fulfilled.
The Ghost of Christmas Present is a cheerful spirit. As uncertainty diminishes, credit
conditions improve and balance sheet repair progresses, monetary policy is gaining traction.
The strength of the UK recovery and the fall in its unemployment rate suggest that the
equilibrium real interest rate is now rising gradually back towards zero.
The Ghost of Christmas Past should not be forgotten. A recovery may be gaining pace but
our economies are a long way from normal. Leverage is still high and weak demand for
advanced economy exports could persist for some time.
The Ghost of Christmas Yet to Come suggests that it is unlikely that equilibrium interest rates
will return to historically normal levels any time soon. This prospect puts a premium on
macro-prudential policies and financial reforms to manage the associated risks without
abandoning the need to keep interest rates in line with the equilibrium level.
So while it is unsurprising that the ideas behind secular stagnation are being revived, it would
be a mistake to rush to a more extreme macroeconomic response. There is a long history of
pessimism in economics, from Thomas Malthus through Alvin Hansen to Robert Gordon.
Such worries have proven misplaced in the past and scepticism is warranted now. Don't
forget that the US economy is more than 13 times larger than when Hansen first formulated
his ideas.
Similar performance must again be possible. Central banks are playing a catalytic role to
help deliver it but their contribution will ultimately be limited. The most important drivers of
long term prosperity will be measures taken by others to increase the growth of supply,
particularly those that reinforce an open, global economy. Such good deeds will truly merit
the goodwill of all men and women.
Thank you.
Annex
Chart 1: Chart 2:
Persistent disappointment in advanced Cumulative surprise in UK activity indicators
economies' GDP growth since May 2013 has dwarfed that of US and
euro area1
Standard deviations from mean
Calendar year growth (%)
4.0
4
Outturns1
United Kingdom
3.5
3
3.0
2
2.5
Euro Area
1 2.0
1.5
0
1.0
United States
-1
0.5
IMF October WEO forecasts:
-2
0.0
2008 2009 2010
2011 2012 2013 -0.5
-3
-1.0
-4
May Jul Sep Nov
2009 2010 2011 2012 2013 2014
2013
1
1
Outturns are taken from October 2013 WEO, 2013
Shows the cumulative sum of normalised differences
point is a forecast.
between selected indicators of economic activity and their
expected value as surveyed by Bloomberg, divided by the
Source: IMF
square root of the number of releases.
Sources: Bloomberg and Bank calculations
Chart 3: Chart 4:
Measures of uncertainty in the UK have US unemployment rate has fallen by more
fallen sharply1 than UK
Standard deviations from mean (1985-2012)
5
14
4
12
3
10
2
8
1
6
0
-1
4
-2
2
-3
0
-4
2000 2004 2008 2012
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Swathe of uncertainty indicators
UK Unemployment Rate
First principal component
US Unemployment Rate
1
For further details, including of the indicators used and Source: ONS, BLS
sources, see Haddow, A, Hare, C, Hooley, J and Shakir, T
(2013), "Macroeconomic uncertainty: what is it, how can we
Bank of England
measure it and why does it matter?",
Quarterly Bulletin, Vol. 2, No. 2, pages 100-109.
Chart 5: Chart 6:
US participation rate falling, UK rate rising US employment rate has fallen by more
than UK rate
%
%
68 67
66
67
65
64
66
63
65
62
61
64
60
59
63
58
62 57
2000 2004 2008 2012
2000 2004 2008 2012
UK Participation rate UK Employment Rate
US Participation rate
US Employment Rate
Source: ONS, BLS
Source: ONS, BLS
Chart 7: Chart 8:
UK productivity exceptionally weak UK real wages have fallen
£ at 2010 prices £ at 2010 prices
40 600
550
35
500
30
450
25 400
350
20
300
15
250
10 200
1977 1982 1987 1992 1997 2002 2007 2012 1977 1982 1987 1992 1997 2002 2007 2012
Output per hour worked
Real wages per week
Trend
Source: ONS, Bank of England calculations Source: ONS, Bank of England calculations