Charles Bean: The economic outlook
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
to the Council of Mortgage Lenders, Mortgage Industry Conference & Exhibition, London,
3 November 2011.
* * *
Good morning and thank you for that kind introduction!
In the very early part of this year, with the recovery from the 2008-9 recession seemingly
becoming more solidly based and inflation running at double our 2% inflation target, the
Bank's Monetary Policy Committee, of which I am a member, was edging towards starting to
withdraw some of the considerable monetary stimulus we had injected during the downturn.
Indeed, as recently as our May meeting, a third of the Committee were voting to raise Bank
Rate from its emergency level of 0.5 per cent. Although I did not join them in voting to raise
Bank Rate, I did view the arguments for and against a tightening as being finely balanced.
Now, just a few months later, the Committee has unanimously voted to re-start its
programme of asset purchases financed by the issuance of additional central bank reserves,
also known as quantitative easing. In my address this morning, I thought I would say a few
words about why the Committee's view of the outlook has shifted so dramatically and what
we can expect additional purchases to achieve.
As I said, earlier this year the recovery seemed broadly on track. But, as time has passed, so
it has seemed less secure. That is not so obvious in the figures for quarterly GDP growth
(see left-hand panel of Chart 1), which have been buffeted by a variety of special factors,
such as: the bad weather late last year; the impact of the Tōhoku disaster on global supply
chains; and the extra bank holiday for the royal wedding. These last two, in particular,
provided a temporary boost to the third-quarter growth rate of 0.5 per cent released on
Tuesday. But business surveys and other indicators suggest that the underlying rate of
expansion has probably eased (see right-hand panel of Chart 1). Those same surveys point
to only very moderate growth at best in the final quarter of this year.
This slowing in growth is not confined to the United Kingdom. Growth has eased in the euro
area and the business surveys are consistent with contraction in the second half of this year
(see Chart 2). Though output growth has picked up in the United States according to the
latest official data, the business surveys suggest this may prove ephemeral (also see Chart
2). And there are signs that China and some other emerging economies have slowed too,
though in their case the slowing was partly policy-induced in order to alleviate inflationary
pressures.
I would highlight two primary drivers of this slowing. The first is the heightened tension in
financial and bank funding markets associated with the twin euro-area banking and
sovereign debt crises. Stretched fiscal positions have raised questions about the ability of
several euro-area governments to support their banking systems. And the weak position of
those same banking systems has also heightened doubts about the sovereigns' fiscal
sustainability (Chart 3). Though UK banks' exposure to peripheral country debt is relatively
modest, interlinkages with euro-area banks that are more heavily exposed have meant that
UK banks have also experienced heightened funding difficulties in recent weeks. Unless
those conditions improve, our banking contacts indicate that the availability of credit to the
real economy may soon begin to suffer. Moreover, the heightened tensions in financial
markets are likely to have raised uncertainty more generally and further depressed
household and business confidence. Our regional Agents are already starting to tell us that
some businesses are putting investment projects on hold as a result.
In the early hours of last Thursday morning, European leaders agreed to take further steps:
to address the fiscal sustainability of Greece and other periphery countries; to expand the
firepower of the European Financial Stability Facility; and to buttress the resilience of
European banks through recapitalisation. While the major UK banks will not be required to
raise capital, they would nevertheless be well advised to take advantage of any opportunity
that does arise to further strengthen their capital and liquidity buffers, thereby putting
themselves in a better position to withstand any further deterioration in conditions, without
needing to constrain lending. Last Thursday's agreement represents an important element of
a satisfactory resolution to the euro area crisis, but there are still many details to be worked
out. Moreover, the announcement by the Greek government that it plans to hold a
referendum on its package has injected additional uncertainty. And, even if the 27 October
agreement is eventually implemented, the peripheral economies of the euro area will still be
faced with substantial adjustment challenges, including the need to rebalance their
economies and improve their competitiveness. So the strains in the euro area seem likely to
continue for some while yet.
The second factor behind the unexpected slowing in growth is the substantial rise in energy
and other commodity prices during the latter part of 2010 and first part of this year,
associated with strong growth in the emerging economies as well as interruptions to the
supply of oil as a result of geopolitical developments in the Middle East and North Africa. UK
inflation over the past year has consequently been around 11⁄2 percentage points higher than
the central view in our November 2010 Inflation Report, with the twelve-month rate reaching
5.2% in September. That has added to the squeeze on real household incomes already
taking place as a result of earlier increases in energy and other import prices, together with
the increase in the standard rate of VAT to 20 per cent. In the eight quarters since the trough
of the recession in the middle of 2009, real household income has fallen 21⁄2 per cent, as only
modest wage growth has been more than offset by elevated inflation. And with higher utility
prices pushing consumer prices up another 11⁄4 per cent since June, it is probable that real
household disposable income will turn out to have fallen during the second half of this year
too. Against that background, it is not surprising that real consumer spending growth has
been weak.
Although elevated inflation has been the medium through which some of this squeeze in
living standards has been brought about, the squeeze reflects three deeper real economic
forces that monetary policy can do little to negate. The first force is the aforesaid rise in the
price of commodities, relative to the prices of global goods and services, associated with the
confluence of strong demand growth in the emerging economies and commodity producers'
inability or unwillingness to increase supply to match the extra demand.
The second force is the fall in the purchasing power of sterling. Before the financial crisis, the
UK was operating with an unsustainably low level of national savings and an associated
current account deficit. In addition, the crisis has probably led to a long-lasting hit to the
demand for financial services exports. Generating an expansion in net exports in order to
counterbalance the necessary increase in savings and to offset any reduction in the demand
for financial services exports then requires a real depreciation of the currency. This was
achieved by a fall of a quarter in the trade-weighted value of the nominal sterling exchange
rate between the start of the crisis and the end of 20081. Although the impact of this
depreciation on net exports initially seemed rather disappointing, recent revised data from
the ONS now suggest that the impact on net exports has been roughly in line with that seen
after previous large movements in the exchange rate (Chart 4).
The third force is the loss in output and income associated with the financial crisis. Output
presently lies almost 15 per cent below where it would have been if it had continued to grow
in line with its pre-crisis trend. Even if that shortfall does not prove to be permanent, the
experience after previous recessions following banking crises suggests that it is likely to be
highly persistent (see Chart 5, which shows the UK experience since the start of the
recession, together with the range of analogous historical experiences). Initially, households
and businesses were protected from the full impact of this downward shift in prospective
incomes by the previous Government's decision to let the budget deficit temporarily take the
strain. But the necessary subsequent fiscal consolidation has led inevitably to a higher tax
burden and lower public spending growth.
As already noted, inflation reached 5.2 per cent in September. But much of that reflects the
combined impact of higher VAT and prices for energy and other imports. A range of
estimates of the impact of these factors is provided by the blue swathe in Chart 6. The
remainder is attributable to domestically-generated inflation, estimates of which are provided
by the green swathe in the same Chart. This appears to have been running well below the
2 per cent target, reflecting in large part the unusually low rate of pay growth, which is in turn
symptomatic of the slack in the economy.
As we go into next year, so last January's increase in VAT will drop out of the calculation,
knocking around one percentage point off inflation. And commodity prices have started to fall
back as the pace of global expansion has eased (Chart 7). So the contribution of energy and
other commodity prices to inflation should fall back sharply as we go through the year. Of
course, we cannot assume that the evolution of domestically-generated inflation is
independent of these factors. Indeed, some countervailing pickup in the contribution of
domestically-generated inflation is quite possible if businesses look to provide their
employees with some recompense for the past squeeze in living standards. Moreover, one
cannot rule out further adverse external price shocks. But a sharp fall in inflation is the most
likely outcome and that in turn should mean that the squeeze on real household incomes will
ease, providing some support for consumer spending.
Even so, real income growth will still only be moderate and high levels of indebtedness may
weigh on the spending of some households. Moreover, the uncertainties associated with the
euro area are likely to persist, retarding growth there. Not only will that weigh on our exports,
but funding conditions may also remain difficult, while British businesses are likely to remain
cautious about investing and hiring.
At its October meeting, the Monetary Policy Committee agreed that the outlook for UK output
growth was markedly weaker than it had believed earlier in the year. Without action, and
despite the present excessive level of inflation, the extra margin of slack meant that inflation
would consequently be more likely to undershoot, rather than overshoot, the 2% target in the
medium term. So it was against that background that we decided to re-start our asset
purchases, buying another £75 billion of gilts.
As you will no doubt know, quantitative easing aims to depress a range of longer-term yields
and raise asset prices, so boosting demand. Our analysis suggests that our first £200 billion
of asset purchases reduced the yields on gilts and corporate bonds by around a percentage
point2. Studies for the United States, using a similar methodology, find comparable effects
from the Federal Reserve's large-scale asset purchases, which is comforting. The asset
purchases also have the effect of boosting banks' holdings of the most liquid asset, central
bank reserves, which may be of particular value at the current juncture. While one cannot be
confident about the impact of our earlier purchases on the real economy, our analysis points
to a peak effect on output of 11⁄2-2 per cent and of 3⁄4-11⁄2 percentage points on inflation. At
this juncture at least, we have no reason to believe that, suitably pro-rated, the current phase
of purchases will be greatly different in their effect on either asset markets or on the real
economy.
Several commentators have suggested that the effectiveness of quantitative easing could be
enhanced by spending the newly created money on something other than government debt.
Conceptually, one can always think of this as raising extra government debt to finance
whatever is bought, combined with conventional quantitative easing that offsets the extra
debt issued. In addition to highlighting the potential interest of the Treasury in the first leg of
the intervention, splitting it up in this way can also help to clarify analytical issues.
For instance, one idea that has been floated involves sending households a voucher, which
could then be spent in the shops and redeemed for cash by the retailer. This may sound like
a good idea, as it seems to get the money quickly into action in stimulating demand. Now,
such a policy in effect combines an increase in borrowing to finance a temporary increase in
income tax allowances with some conventional quantitative easing in which gilts are
exchanged for claims on the Bank of England3. But economic theory, as well as considerable
empirical evidence, suggests that such a temporary increase in disposable income would be
likely to be very largely saved4. Only households that wish to borrow, but presently cannot,
would be likely to increase their spending materially. And making the voucher time-limited
would do little to help, as households could always use the voucher instead of the cash they
would have spent. In sum, this hardly seems the most effective way to add additional
stimulus.
Let me conclude by offering you a comment on what all this might mean for the housing
market and the demand for mortgages. As my colleague, David Miles, argued in a speech to
the Home Builders Federation earlier this year5, we are presently in a transition from a
precrisis world with compressed risk premia and in some cases imprudently generous
loan-tovalue and loan-to-income ratios, to a more sustainable equilibrium with lower ratios. That
implies a period during which first-time buyers and those hoping to move up the housing
ladder save the necessary extra equity, low transactions and a fall in the share of
owneroccupiers. That is pretty much what we have seen and the transition has been made harder
by the squeeze in real incomes. The prospective moderation in the squeeze on real
household incomes should help those saving for a deposit to get onto, or move up, the
housing ladder. So, as well as supporting consumer spending, it should also help support
mortgage demand. That would, no doubt, be a most welcome development to you, as well as
to the households themselves.
On that note, let me finish by hoping that the rest of your conference today proves most
stimulating and valuable. Thank you!
The Economic Outlook
CML Mortgage Industry Conference
London
Charlie Bean, Deputy Governor Monetary Policy
03 November 2011
Chart 1: UK activity
Real GDP
PMI surveys
1.2 Index, 50 = no change
Percentage
CIPS services ouput
65
increase on a
CIPS manufacturing output
quarter earlier
0.9
60
0.6
0.3
55
0
50
-0.3
-0.6
45
2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3
Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
Chart 2: International activity
Composite PMI surveys
Real GDP
Percentage change
1.2
US
Index, 50 = no change
on a quarter earlier 65
Euro area US
1
Euro area
60
0.8
55
0.6
50
0.4
45
0.2
0 40
2009 Q3 2010 Q1 2010 Q3 2011 Q1 2011 Q3
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Chart 3: Euro-area sovereign and banking risks
10-year government bond spreads CDS-based bank default risk
Basis points
Percentage points
12
800
Austria, Belgium, France,
Portugal Ireland
Germany and Netherlands
Italy Spain
10
Greece, Ireland, Italy,
Portugal and Spain
600
France UK
8 UK
US
6
400
4
200
2
0
0
Jan 10 Jul 10 Jan 11 Jul 11
Jan 10 Jul 10 Jan 11 Jul 11
Chart 4: Change in net exports after big sterling moves
Percentage point contribution to GDP
3.0
1996 Q1 (22%) (inverted)
1992 Q2 (-14%)
2.0
2007 Q2 (-25%)
1.0
0.0
-1.0
-6 -4 -2 0 2 4 6 8 10 12 14 16
Quarters before/after start of exchange rate movement
Chart 5: Output losses after banking crises
Percent of pre-crisis trend; mean
difference from year t = - 1
20
10th-90th percentile Interquartile range
Estimated mean path UK
10
0
-10
-20
-30
-40
-1 0 1 2 3 4 5 6 7
Distance in years from the first year of crisis
* UK observation for year 3 based on Q1-Q3 data for 2011
Chart 6: UK inflation
Per cent
7
Estimates of VAT, energy and
6
import price contribution
5
CPI
inflation 4
3
2
1
0
- -1
CPI estimates excluding
VAT, energy and import
- -2
price contribution
- -3
Chart 7: Commodity prices
180
Index: Jan 2010 = 100
Oil
Metals
160
Agricultural
140
120
100
80
Jan 10 Jul 10 Jan 11 Jul 11
The Economic Outlook
CML Mortgage Industry Conference
London
Charlie Bean, Deputy Governor Monetary Policy
03 November 2011