Paul Fisher: The economic outlook - some remarks on monetary policy
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, to the
Agency for Scotland, London, 23 May 2011.
* * *
I would like to thank Ronnie Driver for his help in preparing this speech.
For most of us, the current outlook for the UK economy is not a very attractive prospect. After
experiencing a precipitous fall in demand during 2008/09, the latest estimates suggest that
UK output in 2011 Q1 remained around 4% below its peak pre-crisis level. The Monetary
Inflation
Policy Committee's (MPC) central projection published in its May Report, is for
output to grow at around its historical trend rate (Chart 1), such that it would be mid-2012
before that previous peak level is regained (Chart 2). At the same time annual CPI inflation,
far from being subdued by the recession, has picked up to 41⁄2%. In the short-term it is likely
to go higher still before, we expect, falling back towards the 2% target (Chart 3). All this
poses a significant challenge for policy makers, not least because of the genuine hardships
slow growth and high inflation cause for businesses and households up and down the
country.
Chart 1 Chart 2
GDP projection based on market Projection of the level of GDP based
interest rate expectations and on market interest rate
£200 billion asset purchases expectations and £200 billion
asset purchases
Chart 3
CPI inflation projection based on market
interest rate expectations and £200 billion
asset purchases
The recent data has not been particularly encouraging. Official figures for 2010 Q4 and 2011
Q1 suggest that there was no underlying growth (allowing for the unusual impact of snow in
December). And the unemployment rate remains at just under 8%. The data may not be
totally reliable - they never are - but the message we get from our business contacts in all
parts of the United Kingdom is not inconsistent with this broad picture painted by the official
statistics. Meanwhile, CPI inflation is likely to go yet higher if (as the MPC expects) rises in
the price of energy get reflected in utility bills in due course.
The largely unanticipated path of CPI inflation over the past couple of years can be explained
by three factors: changes in the standard rate of VAT, unforeseen changes in wholesale oil
and gas prices and higher-than-expected import prices following the 25% depreciation of
sterling since mid-2007. Given our target of 2%, the recent path of CPI inflation is
uncomfortable to say the least. Nevertheless, the nature of the price shocks were such that,
in my view, there was little that monetary policy should or even could have done to offset
them. Rather, given that changes in Bank Rate (or asset purchases) take a long time to have
their full effect on the economy, monetary policy needs to be forward looking, focusing on the
medium-term outlook for inflation yet to come. Trying to respond to every short-term
movement in prices would probably be futile and would certainly involve a lot of unnecessary
volatility. The Remit we have from the Government allows for these circumstances:
"The framework is based on the recognition that the actual inflation rate will on occasions
depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the
inflation target in these circumstances may cause undesirable volatility in output".1
To meet our remit we should ideally try to look through one-off price level shocks, in either
direction, only responding if there are risks to the rate of inflation expected to prevail in the
medium term. That theory is all well and good: but the one thing we know about the future is
just how little we know for sure.
Since I joined the Committee in March 2009 - the very week we announced the "quantitative
easing" programme, buying gilts in large scale - I have voted with the majority at every
meeting. As a result, my individual views on policy have mostly been wrapped up with those
of others in the MPC Minutes and the Inflation Report. So today, I want to offer some more
personal thoughts on how I see the economic outlook developing; how I interpret the balance
of risks to output and inflation in the medium term; and why I have been voting for no change
in Bank Rate or the scale of asset purchases at recent meetings.
The outlook for growth
The financial crisis brought with it the deepest recession the UK has experienced since at least
the Great Depression of the 1930s. The MPC responded by cutting Bank Rate as low as it
could reasonably go and injecting £200bn of extra money into the economy (14% of annual
nominal GDP). Since the trough in output in the autumn of 2009, the UK economy has been on
a gradual, if bumpy, path of recovery. That was to be expected. Historically, and internationally,
we know that economic recovery after a major financial crisis is usually slow and seldom
smooth - the MPC (and I personally) have been aware of this and flagging it for some time.
Even though we have been predicting a rough ride, the output data at the end of last year
and the beginning of this still came as an unwelcome surprise. Analysis of past data
suggests that the most likely explanation is that we are currently going through a temporary
soft patch. We can't be sure since no two historical episodes are ever exactly the same. Until
underlying growth resumes, we can't be certain that it will, of its own accord. At the very
least, that makes me pause to consider when policy should start to be normalised or even
whether further loosening might be justified.
The recovery in 2010 was driven by a particularly strong contribution from business
investment and stock-building (Chart 4). The latter was always likely to offer a transitory
boost to overall growth as companies returned stock holdings towards their desired levels,
after de-stocking during the recession. And investment was always likely to make some
positive contribution - at least once delayed projects and routine maintenance were
re-started. But that boost is unlikely to persist without a pick-up in final demand to justify it.
And consumer spending, the most important component of UK demand, has been stagnant
for a year (Chart 5). The current behaviour of consumption is markedly different to that
during the 1980s and 1990s when consumption had broadly regained its pre-recession level
by this point in the cycle, rather than being around 4% below it
(Chart 6).
Chart 4 Chart 5
Contributions to 4-quarter Household consumption(a)
GDP growth(a)
Percentage points
6
4
2
0
-2
Consumption
Government spending
-4
Investment
Stockbuilding
-6
Net trade
GDP (per cent)
-8
2000 2002 2004 2006 2008 2010
(a) Investment includes valuables. Stocks
(a) Chained-volume measure. Includes non-profit
excluding the alignment adjustment.
institutions serving households.
(b) Pre-recession trend calculated by projecting
forward household consumption from 2008-Q2
using the average quarterly growth rate between
1998 Q2 and 2008 Q1.
Chart 6 Chart 7
Consumer spending during Contributions to growth in real post-tax
recessions and recoveries(a) labour income since 2007 Q4
Percentage point changes since
pre-recession peaks
8
1980s 1990s
6
Latest
4
2
0
-2
-4
-6
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quarters from pre-recession peak
(a) Household taxes include income tax and Council
Tax.
(b) Wages and salaries plus mixed income.
(c) General government benefits minus employees'
National Insurance contributions.
(d) Calculated as a residual.
(e) Nominal post-tax labour income divided by the
consumer expenditure deflator (including non-profit
institutions serving households).
Relative to its pre-crisis trend, a weak recovery in consumer spending was always expected.
Prior to the financial crisis, the UK economy had become badly unbalanced, relying on overly
robust domestic demand to offset weak net export demand. The depreciation of sterling
starting in mid-2007 was in part a reaction to that and it was always likely to generate slower
domestic demand growth and a stronger contribution from net trade. So, a switch away from
domestic consumption - both private and public - and towards net exports was a necessary,
if painful, development.
What is making it so painful is that one of the channels through which rebalancing is
occurring is a significant squeeze on households' real post-tax incomes. According to the
latest data, the level of households' real take-home pay in 2010 Q4 was the same as in
2007 Q4 (Chart 7). Put bluntly, real incomes have stagnated over the past three years. The
main driver of the squeeze was the elevated rate of consumer price inflation reflecting, in
part, the required increases in indirect taxation (VAT) needed to help rebalance the
government budget, and increases in import prices relative to domestic wages and prices.
But it also reflects the falls in labour productivity and the degree of slack in the labour market,
which have weighed down on nominal earnings growth. During the depths of the downturn in
2009, nominal wage inflation fell sharply (and in many cases pay cuts were introduced), as
companies sought to reduce costs and, together with their employees, reacted flexibly to the
risk of severe cut backs in employment. Even so, the unemployment rate rose by
3 percentage points, peaking at 8% in February 2010.
Normally, following a recession, one might expect household income to start recovering,
once unemployment stops rising and productivity growth recovers. But not this time.
Although the data released last week suggested that unemployment has continued to fall
back a little from its peak, it has not moved much. And nominal regular pay growth (which
strips out bonuses, but includes merit related increases in pay) has remained subdued over
the past year, averaging around 2%. Assuming that the potential growth rate of the economy
has not been damaged by the financial crisis (and there is no compelling evidence to suggest
that it has), then this level of wage growth would be too low to be consistent with the inflation
target in the medium term.
Looking ahead, it is most likely that there will remain a reasonable margin of slack in the
labour market, which should help contain any pressure on nominal wages and hence price
inflation. But this is unlikely to persist indefinitely. Historical analysis of the UK labour market
shows that the longer individuals are unemployed, the lower their chances of getting a job
become. Hence, persistently high actual unemployment tends to be followed by an increase
in the level of structural unemployment. Theory and empirical evidence predict that the
structurally unemployed exert less downwards pressure on wage inflation. Major shifts in the
pattern of employment - as we are likely to see from the shifts in growth from services to
manufacturing, and from the public to private sector - tend to reinforce that effect. If
structural unemployment rises sufficiently, then the downwards pressure on inflation from
spare capacity will eventually start to dissipate.
For now, contacts of the Bank's Agents confirm that the margin of slack in the labour market
should continue to restrain wage growth in the coming months. In my view, that should
continue for the next few years, even if structural unemployment begins to rise: the latter is a
relatively slow process. Given the inflation outturns so far in 2011 and the prospects for
nearterm inflation outlined in the May Inflation Report, the squeeze on household real incomes is
likely to be intensifying in the short term. Overall, it could be quite some time before we start
to see rising real take-home pay.
The marked decline in household confidence since the start of the crisis might also have
played a role in the weakness of consumer spending during 2010. For a given level of
income, households may decide to spend less (and hence save more) if they are uncertain
about the outlook for the economy and, especially, about the security of their job. Although
survey measures suggest that households' unemployment expectations have fallen slightly,
the fiscal consolidation now underway might encourage greater precautionary savings
among some households - indeed, the MPC has been, to some extent, incorporating such
an effect in its projections for over a year.
The worry now is that consumer confidence has fallen back a second time: a forward looking
measure derived from the GfK survey is close to its trough of mid-2008 (Chart 8). And the
balance that assesses households' views about "whether it is a good time to make a major
purchase" has also fallen back substantially since the start of the year - although that is
likely, to some extent, to reflect the impact of the rise in VAT.
Chart 8
Measures of consumer confidence
Optimism over the next year(a)
Good time to make a major purchase? Balance
40
30
20
10
0
-10
-20
-30
-40
-50
1985 1990 1995 2000 2005 2010
Source: Research carried out by GfK NOP on behalf
of the European Commission.
(a) Average of the questions on households' current
financial situation, and the general economic
situation, over the next 12 months.
Other factors, such as the ongoing restrictions on the availability of credit and households'
concerns about their levels of debt, may also contribute to the likely weakness of household
spending going forward, by encouraging households to save more and spend less, for a
given level of income.
Overall, given the continuing squeeze in household real incomes and the renewed fall in
consumer confidence, I wouldn't be surprised if there was only slow growth in consumer
spending over the next year or so. The risks around that are probably skewed to the
downside. Even if we do get the anticipated boost to net exports, overall growth in output is
unlikely to be much above its historical average rate. That is a lot slower than would be
needed to regain the level of output implied by a continuation of the pre-recession trend.
The outlook for inflation
For many quarters, the judgment about the outlook for inflation two to three years ahead has
been shaped by two opposing factors - the balance of demand and supply in the economy,
and the extent to which the resulting degree of spare capacity bears down on prices; and the
extent to which price shocks cause higher inflation expectations to become embedded,
prompting higher nominal wage and price increases.
On the economy's potential supply, the evidence is highly conflicting (there are few aspects
of the economy where the data are clear!) On the one hand, labour productivity remains
around 8% below the level it would have reached had it followed its pre-crisis trend
(Chart 9), implying a significant margin of spare capacity in the economy. But on the other
hand, the main business surveys suggest that there is little spare capacity within businesses
(Chart 10). Moreover, the expansion in output since the trough has been met by an increase
in employment, rather than by productivity growth. Coming to a judgment about the degree of
spare capacity in the economy is therefore difficult - but at the same time crucial. Given the
scale of the numbers involved, small differences in the judgment about the relative roles of
cyclical and structural explanations for the recent path of productivity can have enormous
implications for one's views of the risks to inflation.
Chart 9 Chart 10
Whole economy labour Survey measures of capacity
productivity per hour(a) utilisation by sector
Indices: 2006 = 100
110
Path implied by a continuation of 108
pre-recession trend
106
104
102
100
98
Whole economy
96
productivity per hour
94
92
90
2005 2006 2007 2008 2009 2010
(a) The pre-recession trend is calculated by
projecting forward labour productivity from 2008Q2
Sources: Bank of England, BCC, CBI, CBI/PwC and
using the average quarterly growth rate between
ONS.
1996Q1 and 2008Q1.
(a) Includes measures of services capacity
utilisation from the Bank's Agents, BCC and CBI.
The CBI measure weights together financial
services, business/consumer services and
distributive trades surveys using shares in nominal
value added. The BCC data are non seasonally
adjusted.
(b) Includes measures of manufacturing capacity
utilisation from the Bank's Agents and CBI, and a
measure of non-services capacity utilisation from
BCC. The BCC data are non seasonally adjusted.
Personally, I believe that there is a significant margin of slack in the economy - you need
only look to the labour market for evidence of that. But it is also likely that there is less slack
in the economy than implied by the deviation of productivity from its pre-crisis trend. Looking
ahead, the degree to which the margin of slack is eroded will depend on the outlook for
demand. If demand recovers strongly, that would close up the degree of slack in the
economy. But if demand stays weak, then potential supply will gradually respond
downwards, also closing the margin of slack (although that process would probably be
slower than if it was faster demand growth doing the work).
The risks from inflation expectations are also difficult to assess, principally because we do
not have good data on the true expectations of businesses and wage bargainers, only what
they record in surveys. Personally, I look for signs of de-anchoring inflation expectations in
two places. The first is in nominal wage growth, which as I have discussed earlier, remains
subdued. The second is in financial prices, where we can extract information on inflation
expectations by looking at the differences between the yields on conventional and
indexlinked gilts or by looking at inflation swap markets. These data - like any other - need to be
interpreted and analysed with caution. Financial markets are prone to bouts of volatility. The
instruments are linked to RPI and not CPI inflation. The short maturity end of both the gilt and
the swap markets are relatively illiquid, and the long-end of the markets can be moved
around by structural demand (e.g. from pension funds looking to maturity-match their
longterm liabilities). What this means is that it is difficult to separate moves driven by changes in
market liquidity, investor mandates or preferred habitat from moves driven by changes in
underlying inflation expectations. For me, the inflation swaps market, which has grown and
deepened in recent years, gives a more reliable read on underlying market participants'
views of inflation expectations than the gilt market data. Those swaps suggest that there has
been little change in medium-term inflation expectations for some time (Chart 11).
Chart 11
Medium term inflation
expectations derived from
inflation swaps(a)
Percent
5
4
3
2
1
2005 2006 2007 2008 2009 2010 2011
Sources: Bloomberg and Bank calculations.
(a) Based on the 5-year, 5-year forward.
Policy
In these remarks, I have tried to explain how I personally read the main forces acting on the
outlook for GDP growth and CPI inflation over the next few years. The final step is to explain
my policy vote based on those views.
At the moment, I see the risks to CPI inflation in the medium term as broadly balanced,
around the 2% target. In particular, I expect that the upside risk from any deterioration in the
level of potential supply is broadly offset by the downside risks to consumer spending. While
there are certainly upside risks to the outlook from higher inflation expectations, those are not
of immediate concern. I see little evidence that inflation expectations might generate the start
of a wage-price spiral for example.
There are, however, immediate downside risks to the growth outlook. Although my central
expectation is that the recent weakness will just be a soft patch, I do worry about a more
prolonged weakness in demand, and in particular, consumer spending. That could knock the
recovery off course for a sustained period, shifting the balance of risks around medium-term
inflation to the downside. With that risk in mind, putting up Bank Rate could be exactly the
wrong thing to do at this precise moment. If it further damaged consumer confidence then it
could be the marginal factor that makes a soft patch turn into something worse.
Of course, at some point, Bank Rate will have to rise: interest rates will need to normalise if,
once the spare capacity in the economy has been eliminated, monetary policy is to be
consistent with the 2% target. And because of the lengthy lags involved, Bank Rate will need
to start the long journey back to more normal settings well before the degree of spare
capacity is eliminated.
But for now, I believe there remains time to allow the economy to recover before the eventual
tightening begins. I am not trying to give any hints today as to exactly when that will be. I
honestly don't know. I can only continue to assess the data and the outlook as it changes,
month by month. As always, I stand ready to change my views should the economic outlook
change sufficiently to warrant it.