Andrew Sentance: Sustaining the recovery
Speech by Mr Andrew Sentance, Member of the Monetary Policy Committee of the Bank of
England, at the British American Business Council in association with RSM Tenon, London,
13 October 2010.
* * *
I would like to thank Tomasz Wieladek and Abi Hughes for research assistance and I am also grateful for helpful
comments from other colleagues. The views expressed are my own and do not necessarily reflect those of the
Bank of England or other members of the Monetary Policy Committee.
I am delighted to be giving this speech this evening here in the heart of Westminster and I
am grateful to the British American Business Council for hosting this event and to RSM
Tenon for sponsoring it. As an active member of the Church of England, I am also very
pleased to be giving this speech at its headquarters in Church House. The Church of
England plays a vital role in supporting the spiritual health of our nation, just as the Bank of
England has a key responsibility in underpinning its economic and financial health.
A healthy economy is normally a growing economy. So ensuring the right conditions for a
sound and sustained recovery is a key challenge for UK monetary policy at present. And it is
that challenge that I want to discuss in my speech to you this evening.
The current recovery in context
The UK economy has been recovering for about a year now. So it is relatively early days to
pass judgement on how the current recovery is proceeding. However, the performance of the
British economy over the first year of this recovery does provide some grounds for
encouragement.
The recovery has been somewhat uneven. As Chart 1 shows, after a couple of quarters of
rather subdued growth at the end of last year and early this year, GDP picked up strongly in
the second quarter - producing the largest quarterly rise in GDP for nearly a decade.
We do not yet have an official estimate of growth for the third quarter, but the National
Institute of Economic and Social Research estimates that GDP rose by 0.5% in this period.
That would produce an annual growth rate of 2.5% for the first year of the economic
recovery - in line with the historical average growth trend and somewhat stronger than the
rebound we saw in the early stages of the previous two economic recoveries, in the early
1980s and early 1990s.1 The fact that growth has been uneven from quarter to quarter
should not be a great surprise as uneven growth is not unusual as an economy begins to
recover from recession.
This return to economic growth must be seen against the background of a sharper fall in
output than we experienced in previous post-war recessions. But two more positive aspects
of the early stages of this recovery are worth highlighting. First, employment has been more
resilient than in past recessions and appears to have turned around more quickly than in the
previous recoveries. The total number of people in employment in the UK has increased by
over 300,000 since last winter, according to the official Labour Force Survey.2
Chart 2 shows this contrast with previous economic cycles very clearly. Employment is down
by not much more than 1% on its level at the peak of the cycle in 2008, compared with a
decline of around 5% at the equivalent phase of the early 1980s and early 1990s cycles. This
employment picture points to a rather mild recession in terms of the labour market, which
contrasts with the much larger fall in GDP relative to previous UK downturns.
The resilience of employment through the recession should help to sustain consumer
confidence. It is also a positive indicator about medium-term economic prospects - as
companies would not be retaining and taking on workers if they were not reasonably
optimistic about their future business prospects. The recent growth of employment has been
driven by the private sector and that should also give us encouragement that the private
sector can generate job growth that will more than offset the public employment cuts that
may be in prospect following the spending review. I will come back to this point later.
A second positive feature of the early stages of this recovery is that we have seen some
evidence of rebalancing in the UK economy. Manufacturing output is growing much more
strongly than the services sector, reversing the pattern of services-led growth that prevailed
in the decade before the financial crisis. Over the last year, we have seen the strongest rate
of growth of manufacturing output that the UK has experienced in over 15 years - as Chart 3
shows. According to the latest data, manufacturing production is 5% up on a year ago
compared with growth of just 1.5% in the services sector over the same period.3
While some of this rebound in the manufacturing sector may reflect temporary factors - such
as the turnaround in the global stock cycle - it also shows that British industry is able to take
advantage of the recovery in the global economy with the additional support of a competitive
exchange rate. The ability of British manufacturing industry to provide strong impetus to
private sector growth will be an important offset to the drag to domestic demand from the
rebalancing of public finances over the next few years. There is also evidence that strong
growth in the global economy is benefiting parts of the services sector. Earlier this week, the
airport operator BAA reported a 7.6% annual rise in traffic volumes at Heathrow Airport in
September - driven by strong business travel growth to Asia and other emerging markets.
From the position a year ago - when demand had fallen sharply at home and abroad in the
wake of the financial crisis - this turnaround is impressive. So my verdict on the recovery
would be "so far, so good". But we have to recognise that we are still at an early phase of the
upswing. It is not surprising, therefore, that growth is uneven across sectors and from quarter
to quarter, and that confidence is still somewhat fragile.
The state of confidence is not helped by the negative tone of much of the economic
commentary at present - which seems to reflect a high degree of nervousness about the
progress of the recovery. But this raises the obvious question: if things are so good, why do
they feel so bad - to some people at least?
There are three elements which appear to be underpinning these concerns about the
sustainability of growth in the current economic climate: the prospects for the global
economy; the prospective impact of the government's fiscal tightening; and the legacy of the
financial crisis. I will discuss these three issues in turn before coming back to the crucial
issue of how the Bank of England's monetary policy can best support the recovery.
The global economic outlook
A serious setback for the global economy would have major repercussions for the growth of
the UK economy. Our economy has a very international focus, and exports, international
business activity and the financial sector all play a part in creating strong linkages from the
UK to other major economies elsewhere in the world. The sharp drop in business and
financial sentiment across international markets in late 2008 and early 2009 - and the
ensuing downturn in the global economy - played a major part in tipping the UK into
recession two years ago. Similarly, the rebound in the global economy has helped to support
our recovery over the last year or so.
However, a serious downturn in global growth does not seem very likely at the moment.
According to the IMF, global growth this year is now projected to be nearly 5%, compared to
a projected growth rate of less than 2% just eighteen months ago.4 As Chart 4 shows, this is
a return to the strong growth rates seen in the mid-2000s, which was regarded at the time as
a period of robust growth across the world economy. Though the IMF expects growth to slip
back to 4.2% in 2011, this is still above the average global growth rate in the 2000s prior to
the recession.
An important driving force behind this global recovery has been growth in Asia and other
emerging markets. As Chart 5 shows, annual growth in the seven largest Asia-Pacific
economies, an economic bloc on a par with the US and the European Union in economic
size, has averaged around 7-8% in the first half of this year, slightly ahead of the pre-crisis
rate of growth in this region. Growth in the more mature advanced economies of the US and
the European Union has also picked up - though not as strongly as in Asia, reflecting the
greater maturity of these economies and hence their lower potential for productivity and
labour force growth. In the past year, growth in the US and the European Union has been 3%
and 2% respectively. These rates of growth are broadly in line with the trend growth rates we
experienced in the US and Europe before the crisis.5
The latest evidence suggests that the strong momentum of growth in Asia and other
emerging markets is being maintained. In Asia, there are many indications that domestic
demand has been a powerful driver of its recovery and that growth in this region is becoming
more autonomous and less dependent on export demand from the western economies.
In the US and Europe, the indicators are more mixed. Within the European Union, Germany
grew very strongly in the first half of this year, recording the biggest rise in GDP since
unification in the second quarter and more recently the lowest rate of unemployment since
1992. German unemployment has been falling since the mid-2000s, with the exception of the
recession period, which points to an improvement in the structural performance of its
economy, which should help to sustain consumer spending and investment. Some of
Germany's neighbouring economies - including the Benelux countries - are also sharing in
this pattern of healthy growth. A strong performance from these "core" European economies
should help to offset the dampening effect of financial and fiscal problems in countries on the
European periphery, including Ireland.
Currently, the United States appears to be in a "soft patch" where growth is disappointing.
But the most recent indicators - including the widely followed Purchasing Managers' Indices
(PMIs) - still point to continued growth. Indeed, the latest readings from the
nonmanufacturing PMI last week showed a surprising pick-up in growth. The latest US data on
retail sales and industrial production are also reasonably positive and help offset some of the
more downbeat indicators from the housing market. In the US, just as in the UK, we have to
recognise that the data may be somewhat variable at this stage of the cycle. We should
therefore beware of interpreting this variability in the economic indicators as a sign that
the recovery is seriously faltering in the United States, or anywhere else in the global
economy.
There is, however, a flip side to the strong rebound we have seen in the global economy
since the middle of last year. While the growth of the global economy is helping to sustain the
recovery in UK economic activity, it is also putting upward pressure on global energy and
commodity prices, along with the impact of a number of weather-related events affecting the
supply of commodities. And in a world affected by climate change, we may expect to
experience these weather-driven upward price shocks more often.
These upward shocks to UK inflation from import prices - amplified by the relative weakness
of the pound - have contributed noticeably to the recent experience of above-target UK
inflation. With commodity price inflation running at over 25% annually in sterling terms, a
renewed surge in the oil price and evidence that manufacturers' input costs are picking up
again, I believe we are likely to see continued upward pressure on inflation from global price
pressures as the recovery in the world economy continues.
Fiscal tightening and financial restructuring
So while we should not rule out further volatility from the global economy, the most likely
outcome is that the world economy is likely to provide a helpful backdrop to UK growth, with
Asia and emerging markets contributing particularly powerfully, though with the associated
risk of more upside shocks to inflation. However, the UK recovery also faces domestic
headwinds from the rebalancing of public finances and the continued restructuring of the
financial sector. Here too, however, it is important to put current concerns in perspective.
In relation to the prospective fiscal tightening, the first point to make is that the overall public
spending plans appear much less draconian than the view projected in the media debate
over the summer - when 25% or even 40% departmental cuts were being discussed.
Individual areas of public spending may face a significant squeeze to allow growth in areas
where commitments to increase spending have been made - such as pensions and health.
But taking all these swings and roundabouts into account, the total amount of government
spending is still set to increase over the next five years in cash terms. Using the broadest
measure, Total Management Expenditure - which captures all areas of public spending, the
Budget projects an average spending increase of 1.7% per annum in the five years to
2015/16. Should inflation remain at around the 2% level over the next five years, that would
imply that government spending in aggregate is likely to be broadly flat in real terms. While
that represents a change from the very significant increases seen over the last decade, it
points to a milder drag on growth than some of the more lurid headlines about the spending
review have been suggesting.
On the detail for individual spending areas, we will learn more next week following the public
spending review that has been going on over the summer. And that will hopefully help to
remove some of the current uncertainty around future public spending which has been
affecting business and consumer confidence in the UK recently.
A second point to note about the impact of the government's deficit reduction plan is that all
previous recoveries in the UK economy - in the late 1970s and in the 1980s and 1990s -
have taken place against a background of fiscal austerity and public spending restraint. It is
true that the level of public borrowing has now reached a higher level than in previous
downturns - peaking at 11% of GDP, compared to just under 8% of GDP in the early 1990s
and 5% in the early 1980s. But the planned reduction in the deficit set out in the Budget
plans is comparable with the fiscal consolidation we saw in the mid-1990s, when the public
spending share of GDP was also cut significantly as the economy recovered, as Chart 6
shows.
Though the latest Budget plans imply a somewhat bigger fall in the public spending share of
GDP than in the mid-1990s, this is offset by a smaller rise in the tax burden. Taking tax and
spending together, the projected impact is broadly similar. Public borrowing fell by over
8 percentage points of GDP between 1993/4 and 1998/9, compared with a 9 percentage
point fall projected in the latest Budget over the next five years.6
That period of public spending squeeze in the mid-1990s was also accompanied by a
significant reduction in employment in the public sector, not dissimilar to the figures currently
being discussed in the context of the current spending review.7 However, the UK economy
grew reasonably healthily over that period, with annual GDP growth averaging nearly 3.5% a
year in the five years 1994 to 1998. Unemployment also fell because the private sector
generated many more jobs than were lost in the public sector. As Chart 7 shows, the private
sector created around 2 million extra jobs in the mid-1990s, dwarfing the reduction in public
sector employment. The challenge facing the UK economy in the years ahead is to ensure
that the private sector can once again become an engine of job creation and growth as the
public sector rebalances, repeating the positive experience of the 1990s recovery.
There is, however, one important difference between the situation now and the mid-1990s in
that the flow of finance to support the growth of private sector businesses has been affected
by the impact of the financial crisis on the banking sector. For many businesses and
individuals, the terms on which they can access lending are much less favourable than
before the crisis. In one sense, this is very appropriate in that credit was too freely available
in some parts of the financial system in the mid-2000s and this created the conditions for the
global credit boom which preceded the financial crisis.8 But if the pendulum swings back too
far and access to credit becomes too restrictive, that could become an impediment to growth
over this recovery.
In terms of the cost of funds, monetary policy has provided a powerful offset to any lending
constraints. As Chart 8 shows, the cost of mortgage finance for households and the
average rate on business borrowing has come down significantly. The current level of
interest rates - even allowing for higher spreads on mortgage and business loans - is much
lower than those prevailing over the recovery in the 1990s and at the current inflation rate the
average loan rates shown in Chart 8 are close to zero in real terms.9
There have been concerns registered about access to finance by individual businesses and
business groups, though the banks also point out that the demand for new lending is
subdued because of the natural caution of businesses about investment at present. In recent
visits I have undertaken to businesses around the country, the general picture for
manufacturing and services companies appears to be that they can get the finance they
need, but it is more difficult and is taking longer and absorbing more management time.
Lending related to property and construction appears more constrained, with some of the
major banks seeking to substantially reduce their exposure to these sectors.
I believe it is an open question on how serious a constraint the financial sector will prove to
be on the recovery. But there has been some recent encouraging evidence. Over the last few
quarters, the Bank's regular surveys have been pointing to an easing of credit conditions.
And the CBI's quarterly Industrial Trends Survey has showed a sharp fall back in the
proportion of companies citing access to external finance as a constraint on output, exports
and investment. As Chart 9 show, these indicators have returned to around pre-crisis levels
from the very elevated and unprecedented levels we saw at the peak of financial crisis in late
2008 and early 2009.
The importance of the supply side
All these factors - the global economy, the impact of fiscal tightening and the effects of the
continued adjustment in the financial sector - will have a bearing on the growth of the UK
economy through the recovery and hence on monetary policy. But there is another element
which is crucial to the progress of the recovery which we need to acknowledge. This is the
flexibility and health of the supply side of the UK economy. Key issues relating to the
supplyside performance of the economy include: how efficiently labour markets operate; how
dynamic and entrepreneurial UK-based firms are; how various forms of regulation affect
investment plans and the climate for doing business; and how efficiently the economy can
reallocate resources away from declining activities to new areas of growth.
I have been generally impressed by the supply side performance of the UK economy through
this recession and the early phases of the recovery. Most businesses have showed
resilience in the face of a big shock to demand, and the flexibility of wages and hours worked
was used to protect jobs. Company failures have been lower than we have seen in previous
recessions.10 And the economy has turned round from the very worrying situation we faced
in the middle of last year and has generated over 300,000 new jobs since last winter,
according to the latest Labour Force Survey results.
But there are some puzzles on the supply side of the economy too, and these have an
important bearing on the judgements the Monetary Policy Committee is making at the
moment. Capacity utilisation appears quite high given the early phase of the recovery.
Chart 10 shows the responses from the CBI's Industrial Trends Survey on capacity utilisation
in manufacturing, where it is perhaps easier to assess than in the services sector. Currently,
the amount of spare capacity appears to be close to historical averages, which is not what
we might expect when the economy is in such an early stage of recovery from recession.
This, and other evidence, casts doubt on the degree of spare capacity in the economy and
on how significant this factor will be in dampening inflation from its currently elevated level.
Another puzzle is a surprising drop in productivity we have seen over the recession.
Unusually, the decline in output appears to have been much bigger than the decline in
employment when normally we observe the opposite result. In terms of the impact on
unemployment, this has been a good thing, helping to dampen the cost of the recession in
terms of lost jobs. But this raises further questions about how much slack there is in the UK
labour market as the economy begins to grow and generate new jobs. The behaviour of
productivity in the recession also raises the question of whether the UK productivity growth
trend over the medium term has shifted. If it has, we may make big mistakes basing our
assessment of underlying growth on past productivity trends.
In my view, these puzzles mean we should be particularly circumspect and cautious at the
moment about the assumptions we make about the growth of the supply-side potential of the
UK economy and the related issue of the margin of spare capacity. The late 1990s and
2000s saw a wave of supply-side optimism about UK economic performance - but in my
view this reflected one-off shifts in labour market performance rather than an improvement in
the underlying trend rate of productivity.11 Given the evidence of weaker productivity growth,
it makes sense for policymakers to make relatively conservative estimates of UK
mediumterm growth potential going forward.
Inflation and current monetary policy
At the beginning of this speech, I said that a healthy economy is normally a growing
economy. And that raises the issue of how UK monetary policy should best play its part in
sustaining the recovery by contributing to the underlying health of our economy.
Monetary policy can help sustain and support the emerging economic recovery in two main
ways. The first is through the impact of the current settings of policy on the growth of
demand. It clearly does not make sense to tighten monetary policy dramatically in the current
climate in a way which totally undermines the growth of the economy. However, if interest
rates were moved up gradually from current levels, in a well-communicated strategy that was
understood by the public, the business community and financial markets, the cost of
borrowing would still be low in real terms and I do not believe that the recovery would be
seriously damaged. Indeed, for the many UK households which rely on the income from
savings and investments, this could provide a powerful boost to confidence by signalling the
beginning of a return to more normal economic conditions.
The other very important way in which monetary policy can support recovery is by
maintaining confidence in price stability over the medium term. The mandate for the
Monetary Policy Committee makes clear that the best contribution that the MPC can make to
sustained economic growth is by maintaining price stability - which is specified in terms of a
2% target for CPI inflation under our current remit.
There are good reasons why low and stable inflation remains the focus of our monetary
policy. The effects of high inflation are damaging in their own right - eroding the value of
savings, hitting pensioners on fixed incomes and creating an uncertain and volatile business
climate. After inflation got out of control in the UK in the mid-1970s, we experienced two
decades of economic volatility and high unemployment, including three major recessions.
Fortunately, there is little risk today of a return to that era of double digit inflation rates. Since
the 1990s, the UK's monetary policy framework and the actions of the MPC operating within
that framework has built confidence that low and stable inflation will be maintained. But it is
important that this confidence is not eroded by a perception that the MPC has taken its eye
off the ball and is becoming more tolerant of higher inflation.
I believe this medium term confidence in a world of stable prices is an important anchor for
the private sector when there has been so much instability in recent years. If we continue to
experience above-target inflation, while the MPC sets policy to head off the opposite risk - of
deflation, confidence in the inflation target and the credibility of the MPC risk being eroded.
And the longer the period of above-target inflation goes on without any policy response, the
greater this risk becomes.
Unfortunately, the risk of such a loss of confidence and credibility appears to be increasing.
As Chart 11 shows, we have seen two major spikes in CPI inflation within the last two years.
And it is possible that another one is in prospect when higher VAT comes into effect early
next year, particularly if this is accompanied by a continuation of the recent surge in energy
and commodity prices. These repeated episodes risk eroding confidence that UK
policymakers remain committed to low and stable inflation, with a knock-on effect on inflation
expectations in financial markets, among the business community and the public which could
be self-fulfilling.
In the depth of the recession in the first half of last year, we could be fairly relaxed about
upward pressures on inflation. At that time, the MPC was worried about the opposite trend -
a lurch into deflation with prices and wages on a downward spiral. But these deflationary
fears have not been realised. Instead, inflation has run above the target and wage freezes
introduced to help businesses weather the storm of the recession are coming to an end. The
current period of above-target inflation risks being prolonged by monetary policy which is too
lax - creating a climate in which higher inflation is not just the product of one-off shocks but
becomes more deeply ingrained.
The economy is now recovering at home and abroad. The world economy is growing above
its pre-crisis trend, and domestic spending in money terms is also following the same pattern,
as Chart 12 shows. Inflation has been above target, not below it - and is expected to remain
so for some time. Because of these changes in economic conditions, I have voted for a rise
in interest rates at recent MPC meetings - as a start to a gradual movement away from the
exceptional level of monetary stimulus put in place to combat very difficult economic
conditions last year. And I continue to believe that this the right policy for the situation the UK
economy currently faces.
In the years ahead, we will see much tighter restraint of public spending as the large deficit
which built up over the recession is reined in. That process of deficit reduction is necessary
to ensure longer term confidence in the future stability of the economy in financial markets
and more generally. In this environment, it is the private sector which will be the engine of
growth for the UK economy - just as it was in the 1990s recovery and the previous
recoveries we have experienced here in the UK. Confidence that inflation is being kept under
control is a key factor in sustaining that private sector engine of growth.
My view remains that we should be starting now to make a gradual adjustment of monetary
policy. The improvement we have seen in the economy over the last year and the
abovetarget inflation we have experienced point to the need to begin the process of withdrawing
the very substantial level of monetary stimulus which was put in place to counter the big
financial shocks we experienced in late 2008 and early 2009.
Such a policy should not be a threat to the recovery. In my view it is the key to sustaining the
recovery. It is the right response to an economy which is growing but experiencing persistent
above-target inflation. It would reduce the risk of a future shock to confidence if current
above-target inflation does become more deeply embedded and interest rates then need to
rise more sharply to combat it. And it would provide more confidence to the public and the
business community that the MPC takes its remit seriously and is determined to ensure that
this recovery is built on the solid foundation of price stability.