Charles Bean: The economic outlook
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
to the Northern Ireland Chamber of Commerce, Belfast, 19 May 2011.
* * *
Good afternoon! It is a great pleasure to be back again in Belfast. I am particularly pleased to
be addressing you in this historic venue, whose grandeur bears witness to Belfast's long
history as a key hub for international trade. That is symbolised in the stained glass windows
on the ground floor, which show Neptune, the god of the sea, flanked by images representing
the industries synonymous with Victorian Belfast: Navigation; Spinning; Weaving; and
Engineering. The local economy has changed considerably since those days. And change
will be a theme that runs through my talk today.
It is now 18 months since the economy began to recover from the worst fall in output in the
post-war period. Since its trough in 2009 Q3, estimated GDP has risen 21⁄2%, leaving it some
4% below its peak prior to the financial crisis. But towards the end of last year the pace of
recovery appears to have slackened. Excluding the effects of the snow, which the ONS say
reduced output by about 1⁄2 percentage point in the fourth quarter, activity was reported to
have been broadly flat across the final quarter of last year and the first quarter of this one;
see Chart 1. There is some doubt about this, not least because the official series for
construction output has been highly volatile over the past year and looks surprisingly weak in
the light of the commentary of the trade associations. But even if we leave out the volatile
construction and extraction sectors by focussing just on manufacturing and services, we are
still left with a picture of flattish underlying activity through the end of last year and only
modest quarterly growth of just 1⁄2% at the beginning of 2011.
It may be that later editions of the data may clarify some of this uncertainty, but some1 other
indicators, such as measures of consumer and business confidence and the reports from our
Agents around the country, also point to a slackening in the underlying rate of expansion
around the turn of the year. The crucial question is whether this just represents a temporary
"soft patch" of the sort often seen during the early stages of economic recoveries, or whether
it is instead the harbinger of a prolonged period of slow growth. To answer this, we need to
look at the forces driving the various elements of demand.
For some while even before the financial crisis broke in August 2007, the MPC had drawn
attention to the need for the composition of demand in the economy to rebalance away from
private and public consumption towards investment and net exports. And associated with
such a re-balancing, one would expect to see some shift in the structure of production away
from sectors focussed on serving domestic needs towards those producing internationally
tradable goods and services. The re-balancing should be facilitated by the depreciation of
sterling - down around a quarter since the middle of 2007 - but is still at an early stage.
Household spending stagnated over 2010 and remains around 4% below its pre-recession
level (Chart 2). The sluggishness of consumer spending should hardly be a surprise. Real
post-tax labour incomes have been squeezed by a mix of low pay growth and elevated
inflation on the back of higher VAT, energy and import prices. In addition, heightened
uncertainty probably led some households to increase their savings or pare back their debts.
The most recent survey of retailers by the British Retail Consortium suggested that the fine
Easter weather and the royal nuptials may have brought a welcome fillip to the High Street,
but with the squeeze on real pay likely to continue through this year, it seems likely that
consumer spending will remain subdued through this year at least. Public spending will also
provide little impetus to overall activity, given the necessary fiscal consolidation that is now
under way. That, of course, is a particular issue here in Northern Ireland.
So, the prospect for overall growth depends heavily on business spending and external
demand. In contrast to the stagnant consumer, business spending on inventory accumulation
and fixed capital together contributed 21⁄2 percentage points to GDP growth last year. The
contribution from stockbuilding cannot be expected to persist and indeed has already waned
somewhat. As far as capital spending goes, on the one hand, there seems little rationale for
businesses to expand capacity while activity is weak and there is still a margin of spare
capacity. On the other hand, business investment is still about 20% lower than its pre-crisis
peak (Chart 3). Some of that shortfall reflects replacement investment postponed during the
recession, which is likely to be re-instated at some juncture. Moreover, even though overall
demand may remain depressed, the rebalancing in activity towards the internationally
tradable sectors of the economy will probably necessitate some expansion in capacity in
those sectors, while achieving cost savings and efficiency gains also often requires
investment. Finally, many large companies are presently cash-rich and can access the
capital markets. So a shortage of finance should not prevent them increasing their
investment spend, though some smaller businesses relying on bank credit may have more
trouble. But, overall, it seems reasonable to expect further recovery in business investment.
Given the past substantial depreciation of sterling and the associated improvement in the
competitive position of UK suppliers, the performance of net exports has so far been
somewhat disappointing. That is less to do with exports, which grew by more than 5% in
2010, reflecting both strong global growth and improved competitiveness. Rather the let
down has been on the import side, where there has been less substitution of domestically
supplied goods and services for imports than past experience would have led one to expect.
It is possible that increased specialisation means that demand is less responsive to price
than it used to be. Alternatively, heightened uncertainty and the absence of UK suppliers for
some sorts of goods and services may mean that it takes longer for import penetration to
respond to the enhanced profit opportunities. In any case, the MPC still expects net exports
to contribute substantially to the overall growth in demand over the next few years as the
necessary rebalancing gradually takes place. The most recent trade figures indicate that net
exports of goods boosted GDP by around 11⁄4 percentage points in the first quarter2, and
suggest that we may at last be starting to see a more significant contribution to growth.
Chart 4 shows the MPC's current assessment of the outlook for four-quarter GDP growth, as
published last week in the Bank's latest Inflation Report and assuming that Bank Rate follows
the gently rising path implied by market interest rates. The single most likely path lies within
the deepest green band. The near-term path is somewhat choppy, reflecting the impact of
factors such as the extra bank holiday associated with the royal wedding. But the underlying
picture is one of growth gradually picking up to around its historical average rate, reflecting
continued recovery in investment and a higher contribution from net exports and, on the back
of that, some modest strengthening in consumer spending as we go through next year.
One should not, though, put too much weight on any single path, as the coloured fan in Chart
4, which covers nine out of ten of the possibilities as we see them, is pretty wide. That serves
to emphasise the high degree of uncertainty at the current juncture. Those uncertainties
include not only the spending of households and businesses here in the United Kingdom, but
also the evolution of demand abroad. In particular, while the euro area overall has exhibited
decent growth in recent quarters, the countries of the periphery are struggling with a mixture
of fiscal, banking and competitiveness problems. There is a risk that this could lead to
renewed banking sector turbulence and a hit to confidence more generally, with adverse
consequences for us.
Even though our central projection has growth returning to around its historical average rate,
that would still leave the level of activity well below a continuation of its pre-crisis trajectory
(Chart 5). That makes it unlike normal downturns, in which the economy usually experiences
a period of above-average output growth during the recovery period, thus making up much of
the lost ground.
The tendency for economies to suffer substantial persistent losses relative to a continuation
of their pre-crisis trajectory is a common feature of downturns after banking crises. That is
illustrated in Chart 6, which shows the spread of outcomes for the shortfall of output relative
to a continuation of its pre-crisis trajectory across 88 past banking crises in different
countries3; the blue swathe covers the central 50% of cases, while the grey swathes take in
the central 80% of cases. There is a considerable diversity of experience, but the average
outcome - given by the purple line in the middle of the swathe - shows a persistent output
shortfall of about 10%, even seven years after start of the crisis. In other words, the typical
banking crisis results in a substantial persistent depression in activity relative to what might
otherwise have taken place. The red line shows the central path for the level of output,
relative to a continuation of its pre-crisis trend, from our most recent projections (the dash
denotes the forecast period up to and including 2013). As you can see, that path lies quite
close to the average experience from this sample of past banking crises.
There are a number of reasons why output losses after banking crises have tended to be
much more persistent than after normal economic downturns. First, banks and
highlyindebted households and businesses need to get their balance sheets back in order, typically
resulting in a period of low credit growth and high savings.
Second, the injection of public funds into stricken banking systems, coupled with a loss of tax
revenues in the downturn, results in a deteriorating fiscal position, which subsequently needs
correction. Third, such crises often also result in some long-lasting impairment of the
economy's supply capacity.
We can see the first two mechanisms at work in the UK economy. But it is not so easy to see
what is happening to the economy's supply capacity and therefore also to the available
margin of spare capacity, which is an important determinant of domestic inflationary
pressures. Certainly there is some spare capacity in the labour market, where the
unemployment rate is around 3 percentage points above its pre-crisis level. But the margin of
spare capacity within firms is less clear.
In recessions, employers normally hang on to essential or hard-to-replace employees. As a
consequence, the growth in output per hour worked typically slows, while unused capacity is
simultaneously created. Productivity then accelerates sharply in the recovery phase, as that
labour is brought back into use and the margin of unused capacity diminishes. But while
productivity growth slowed sharply in both services and manufacturing during the downturn,
only the latter has subsequently picked up (Chart 7). Moreover, since the trough,
employment and total hours worked have risen by around 11⁄2%, not much less than the 21⁄2%
rise in output. This suggests underlying productivity growth, and with it the rate of growth of
the economy's supply capacity, may have fallen back during the recession. And that is
corroborated by business surveys, which suggest that manufacturers are, on average, back
to pre-crisis utilisation rates, while the margin of spare capacity has also closed significantly
in services firms (see Chart 8).
It is, though, unclear why underlying productivity growth should have been quite so weak. To
be sure, the collapse in business investment has resulted in a somewhat lower rate of growth
of the capital stock, but estimates suggest that can only account for a modest slowing in
underlying productivity growth. And while some businesses will certainly have been forced to
reduce the scale of their operations or close because of lack of access to credit, corporate
bankruptcies have remained at relatively low levels. Overall, there are few objective
indicators to suggest a major hit to capacity growth from the crisis and subsequent recession.
It is possible that the true fall in output during the recession has been overstated in the
official statistics4, but the extent of the mismeasurement would have to be very large to
reconcile all the facts. It is all somewhat puzzling!
Even if the margin of spare capacity in businesses is no longer all that great, the elevated
level of unemployment should have put downward pressure on inflation. And, indeed, wage
growth has been, and remains, subdued (Chart 9). But other factors have conspired to push
inflation well above the MPC's 2% target.
First, the substantial depreciation of sterling, though helpful to the necessary re-balancing of
the UK economy, also simultaneously raised import prices. We initially underestimated how
strong this impact would be, but we now think that the rise in import prices as a result of
depreciation has added somewhere between 41⁄4% and 61⁄2% to the level of consumer prices.
Second, commodity prices - especially oil prices (Chart 10) - have been on something of a
roller-coaster, rising sharply on the back of strong growth in the emerging economies up to
mid-2008, then falling back sharply as global activity collapsed at the end of 2008. They have
subsequently rebounded, reflecting both the recovery, especially in the emerging economies,
and temporary adverse supply factors (bad weather affecting agricultural commodities;
unrest in the Middle East and North Africa affecting oil). Finally, the increase in the standard
rate of VAT has also boosted inflation.
The blue swathe in Chart 11 shows our estimate of the combined contribution of these three
factors, for a range of plausible assumptions, together with the actual inflation rate (the red
line). The green swathe is the implied contribution from all other influences on inflation. It is
worth noting that the current elevated inflation rate of 4.5% can be largely accounted for by
the effects of energy and import prices and VAT: energy prices and VAT are probably each
contributing around one percentage point to current inflation, and non-energy import prices
around double that.
The twelve-month inflation rate is likely to remain elevated through the remainder of this
year, and indeed may rise further in the second half of the year, as utility prices are likely to
rise sharply to reflect higher oil and wholesale gas prices. But inflation should fall back as we
go into 2012 and factors such as the rise in VAT drop out of the calculation. But the pace and
extent to which inflation will drop back will depend on a number of factors. First, there may be
further significant movements in commodity prices and in import prices more generally.
Second, there may be some resistance to the past erosion in living standards, resulting in a
period of faster pay growth. Third, although pay growth has been subdued, the low rate of
growth of productivity has nevertheless resulted in a squeeze in profit margins and there may
be some attempt to restore these as the economy strengthens. Finally, if the period of
elevated inflation leads business and households to expect higher inflation in the future, then
it may also lead them to set higher pay and prices.
Chart 12 shows our current assessment of the inflation outlook, also assuming that Bank
Rate rises in line with market yields, and with the most likely path lying inside the deepest red
band. This shows inflation moving towards the target through next year, though, as I have
already indicated, there is considerable uncertainty about the speed at which that will
happen. But we judge the chances of inflation being above or below the target by the end of
the forecast period to be roughly equal.
In concluding, there are two general points that I want to make regarding the current
conjuncture. The first is that the next few years are likely to continue to be rather difficult,
especially for households and consumer-facing businesses. The economy is still adjusting to
three substantial shocks, all of which conspire to reduce UK living standards. There is the
loss in output associated with the banking crisis, the consequences of which households
have hitherto been partially sheltered from by the expansion in the budget deficit. There is
the rise in commodity prices relative to the global price of finished goods and services, which
means that we have to pay more for the raw materials that we need. And there is the
substantial depreciation of sterling, which is a counterpart to the necessary re-balancing of
the economy, but which also implies that we have to pay more for our imported goods and
services.
The second, and related, point is that while monetary policy cannot ultimately insulate us
from the associated hit to our living standards, it can affect the adjustment path. In particular,
the MPC's chosen approach has been to accept a temporary period of above-target inflation,
rather than seeking to hold inflation as close to the 2% target as possible at all times.
Achieving the latter would have required a markedly higher level of Bank Rate and with it
most probably a somewhat higher level for sterling. That would have moderated some of the
external inflationary impulses facing us, but would also have depressed activity and pay even
more and retarded the requisite re-balancing of the economy. The Committee's approach
has, I believe, been consistent with its mandate from the Chancellor of the Exchequer, which
recognises "that the actual inflation rate will on occasions depart from its target as a result of
shocks and disturbances" and that "attempts to keep inflation at the inflation target in these
circumstances may cause undesirable volatility in output."
It is almost 100 years to the day since the ill-fated Titanic was launched from Queen's Island,
just across the channel. It may be tempting to see a parallel between the hubris and
excessive risk-taking that resulted in its tragic encounter with an iceberg on its maiden
voyage, and the hubris and excessive risk-taking that led up to the Great North Atlantic
Financial Crisis of 2008. But a more optimistic parallel is provided by rebirth of the old
Harland and Wolff shipyard as the Titanic Quarter, the biggest regeneration project in
Northern Ireland's history and the largest waterfront redevelopment in Europe. That serves
as a reminder of the ever changing nature of the fabric of the economy, as old industries
make way for new. And it also serves as a suitable metaphor for the UK economy more
generally, as it begins to re-balance in the wake of the deepest downturn in the post-war
period.
Thank you!
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