Andrew Sentance: Getting back to business
Speech by Mr Andrew Sentance, Member of the Monetary Policy Committee of the Bank of
England, at the lunch hosted by the Bank of England and the Confederation of British
Industry (CBI), Belfast, 24 November 2010.
* * *
I would like to thank Tomasz Wieladek and Matt Corder 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.
It is a great pleasure to be back here in Northern Ireland for the fourth time in my capacity as
a member of the Monetary Policy Committee. As a former business economist, I greatly
value the opportunity to visit individual businesses and meet with business groups in different
parts of the UK, as I am doing on this two-day visit to Northern Ireland. And I would like to
thank Frances Hill and her colleagues at the Bank's Northern Ireland Agency for all the work
they do with the business community here and for organising this visit.
It is over twenty years since I first came to Belfast when I was working for the CBI in the late
1980s. It was so long ago that Nigel Smyth was not yet then the CBI Director here in
Northern Ireland! And it may even have been before Nigel joined the CBI as Deputy Director
to Alasdair MacLaughlin, over twenty years ago. Indeed, I would like to acknowledge in
particular today the very substantial contribution that Nigel has made to the business
community here in Northern Ireland over the past two decades, in the face of many
challenges and over a period of great change and opportunity.
The Northern Ireland economy has made great progress since those days in the late 1980s
and early 1990s when I came here with my CBI economist hat on. Through the 1990s and in
the 2000s prior to the financial crisis, Northern Ireland achieved an average rate of growth of
3% a year - significantly above the growth rate recorded in the UK as a whole.1
Unemployment fell by two-thirds, from over 12% of the labour force in the early 1990s to just
4% in the mid-2000s. As in the rest of the UK, the unemployment rate here in Northern
Ireland has risen in the recession. But it remains below the UK average - in contrast with the
1980s and 1990s when unemployment here was significantly above the national average.
There are clearly some particular challenges facing the economy here in Northern Ireland as
we move into the recovery phase of the cycle. Compared with the rest of the UK,
employment is more dependent on the public sector and the participation rate in the labour
force is lower. Ireland's fiscal and banking problems may well have a bigger impact on the
economy here than elsewhere in the UK. However, the political and economic progress
made over the last two decades, as well as some of Northern Ireland's traditional economic
strengths - a high-quality education system, a close-knit business community and a strong
manufacturing tradition - should provide grounds for encouragement about recovery
prospects, despite these challenges.
Here in Northern Ireland, and throughout the rest of the UK, it is the strength and vitality of
business which will determine how well the economy recovers from recession. After a period
in which the public sector has played an important role in helping to support demand in the
aftermath of the financial crisis, government spending now needs to be restrained to put
public finances on a sounder footing. Against that background, the key challenge now facing
the UK economy is to ensure that the private sector and the nation's business community
can be a powerful and sustained engine of job creation and growth as the public sector
rebalances.
I can think of no better place to discuss this challenge of "getting back to business" than at an
event jointly hosted by the CBI, the UK's leading business organisation - which I am still very
proud to have been associated with earlier in my career. In my speech today, I will highlight
three grounds for optimism that a healthy, business-led recovery can be sustained in the UK
while public spending is restrained and the deficit is brought down: the progress of the
recovery so far; the resilience of UK businesses through the recession; and the experience of
the previous recovery in the mid-1990s, when there was also a significant rebalancing of
public finances. However, for a healthy recovery to be sustained, it also needs to build on a
platform of low and stable inflation. And this, in my view, has implications for the way in
which the MPC should be responding to the current economic situation - an issue I will come
back to later in this speech.
Progress of the recovery so far
Since the second half of 2009, the UK economy has been recovering from recession. This
recovery has not been uniform across different sectors of the economy, with manufacturing
growing faster than services. There has also been some variability in growth rates from
quarter to quarter, with relatively weak growth through last autumn and winter, but much
stronger growth over the spring and summer of this year. GDP has risen by 2.8% over the
last year, a faster pace than the 2% or so seen in the first year of the previous two
recoveries.2 A recovery has also started at an earlier stage in the cycle than in the early
1990s, when the economy "bumped along the bottom" for a number of quarters before
growth became firmly established.
It is particularly encouraging that manufacturing output has been growing particularly
strongly, up by 5.3% on a year ago in the third quarter. This is the strongest year-on-year
manufacturing growth we have seen since the end of 1994, sixteen years ago. The latest
business surveys are generally positive about the continuation of the growth of
manufacturing output. And the CBI's latest quarterly Industrial Trends Survey, released last
month, shows the strongest investment intentions in manufacturing since 1997 and the most
significant employment growth since 1989. These are all encouraging signs for the
rebalancing of the UK economy - towards manufacturing and away from services - which
most economic analysts have suggested is likely to be needed over the course of this
recovery.
These rates of growth - across the UK economy as a whole and in manufacturing - would
not be possible unless the demand climate had changed very significantly over the course of
the last 12-18 months. The global economy has bounced back strongly, with the IMF now
projecting world growth of 4.8% this year and 4.2% next year. Asia and a number of other
emerging market economies are providing a powerful engine of growth to the world economy
at present. Though the news is more mixed from the US and Europe, their economies are
still on a recovery track. Indeed, the current gloomy mood about the US economy does not
seem to be borne out by the most recent economic data - with the value of retail sales up by
7.3% on a year ago in October and manufacturing output up by 6.1% over the same period.
Within Europe, a strong performance from the "core" European economies is outweighing the
drag from the fiscal and banking problems of some countries on the periphery. The German
economy has been particularly resilient, with GDP up nearly 4% on a year ago in the third
quarter and unemployment down to its lowest level since 1992.
This strong performance in overseas markets, coupled with a competitive exchange rate, has
lifted the volumes of UK non-oil goods exports by close to 15% over the past year and is
supporting the rebound we are seeing in the manufacturing industry. Chart 1 shows that
overseas markets account for nearly a quarter of the demand for the output of UK
businesses, with domestic demand from the private sector - consumer spending and
investment - accounting for a further two-thirds. Exports and domestic private sector
spending therefore make up over 90% of the demand for the output of the business sector in
the UK with public sector procurement and capital spending accounting for less than 10% of
the total. So while the global economy continues to perform strongly and as long as private
sector demand is still growing at a reasonable rate, UK plc should be well-placed to cope
with the squeeze on public spending flowing from the October Spending Review (OSR).
Alongside the recovery in overseas markets, domestic demand in the UK economy has also
bounced back following the sharp declines seen in late 2008 and early 2009. In cash terms,
domestic spending in the UK economy by consumers, government and business grew by
6.8% in the year to the second quarter of 2010. As I pointed out in a speech last month, this
is relatively strong demand growth by comparison with the decade prior to the financial crisis,
when the growth of domestic demand in money terms averaged 5.8%.3
These data do not suggest that lack of demand is the main problem currently facing the
private sector in the UK. We may see some slowdown in demand early next year as the
fiscal measures announced in the Budget and the spending review take effect and
consumers adjust to a higher rate of VAT. But this variability in the growth rate should not be
confused with a genuine double dip which is still a remote possibility in my view. That would
only be a problem if the world recovery faltered seriously. While Asia and emerging markets
continue to power ahead, and the US and the European Union are also recovering steadily,
we should not expect to see a significant interruption to growth across the world economy.
Business resilience through the recession
The turnaround that we have seen in the UK economy over the last year mainly reflects a
change in demand conditions. But economic growth cannot be generated simply by
stimulating demand if the supply side of the economy is not in good shape and able to
respond. In the UK, we saw this most clearly in the 1970s and early 1980s, when British
business was encumbered by problems of poor industrial relations, low productivity and
inflexible labour markets - the symptoms of what became known as "The British Disease".
Since that time, we have seen quite a bit of evidence that the supply side of the UK economy
has indeed become more flexible and supportive of growth. Surveys of the business climate
in the UK, which aim to take into account the impact of regulation and other factors as
barriers to doing business, show that we are well placed internationally, as the latest "Doing
Business" survey from the World Bank shows (see Chart 2).4
The performance of the economy through the recession and in the early phases of the
recovery has provided further encouraging evidence of the resilience and strength of British
business. There are three particularly positive features which should make us relatively
optimistic about the supply-side performance of the UK economy in this recovery.
The first is the resilience of employment through the recession and evidence of a pick-up in
jobs at a relatively early stage of the recovery. Though the GDP figures currently suggest
that the downturn in output in the UK in the 2008/9 recession was relatively severe, the latest
labour market data suggest this has been a much milder recession than earlier episodes in
terms of employment.5 At this stage of the economic cycle in the early 1980s and early
1990s, employment was about 5% down on its peak. As Chart 3 shows, the latest data from
the Labour Force Survey suggest that UK employment is currently just over 1% down on its
peak level, and over the last six months, employment has risen by 350,000.6 As a result, the
unemployment rate has stabilised at below 8% of the workforce - and has recently edged
down slightly - whereas it had risen to over 10% at this stage of the cycle in the early 80s
and 90s.7 Given the personal difficulties and waste of resources created by high
unemployment, the fact that employment has held up well in the recession - and is now
rebounding - is very encouraging.
Though we do not have fully up-to-date estimates, the most recent figures do not suggest
that recent jobs growth has been in the public sector.8 Instead, it is the private sector
- which employs over three-quarters of the workforce in the UK - which has been increasing
employment over the first half of this year. It might be unrealistic to expect the recent rate of
job growth to continue - and business surveys do suggest that employment growth is easing.
But recent employment trends provide positive indications of the flexibility of the UK labour
market and the confidence of business about future economic prospects.
Why have we seen a much better employment outcome in this economic cycle than following
previous recessions? One reason is the rapid policy response here in the UK and worldwide,
which communicated to businesses that policy-makers were actively seeking to reverse the
downturn in demand - using monetary policy, fiscal policy and direct interventions in the
financial sector. This contrasts with earlier recessions in the UK in which the downturn was
preceded by a surge in inflation and economic policy could not be relaxed so readily because
of the need to bear down on inflation.
Another factor supporting employment has been the flexibility in wages and working hours
which helped companies weather the stresses and strains of recession. Many companies
imposed or negotiated pay freezes, and in the downturn employees were willing to accept
reduced working hours or a pay sacrifice in order to help preserve their jobs. This points to a
high degree of flexibility about pay and conditions of employment in the short-term. But the
likely "quid pro quo" of this approach is that, when company fortunes improve, employees will
expect to share in the benefits of the upswing to compensate for sacrifices made in the
downturn. For this reason, I would expect private sector wage growth to pick up now that the
economy is recovering, returning quite quickly to the rates we saw before the recession.
Employment has also been sustained by the long-term confidence of management in the
viability and future success of their businesses. In past recessions, when this longer-term
confidence was much weaker, employment has fallen more sharply. For example, in the
early 1980s, UK manufacturing companies entered the recession facing many problems of
low productivity, poor industrial relations and an unstable macroeconomic environment, with
high cost and price inflation. It was therefore not surprising that the early-80s recession was
the last straw which saw many UK manufacturers closing down operations and international
businesses shifting their production bases elsewhere. In the recent downturn, the bulk of UK
businesses have felt more confident about their longer term prospects and have sought to
retain their resources of skilled labour and experienced workers so they would be well placed
to benefit from the upswing when it came. That attitude and approach is in my view a positive
signal for our future prosperity and business success.
A second positive aspect of UK business performance through this recession has been the
ability of companies to maintain their financial strength through the downturn. As Chart 4
shows, the retained profits of private companies in the UK fell only slightly during the
downturn and have already begun to recover. In the first half of 2010, the financial balance of
the private sector (excluding financial companies) was back above its average level over the
last two decades, as reduced interest payments offset a squeeze on profits. Companies have
also sustained profits by exploiting flexibility in their cost base - including measures to
contain labour costs. They also conserved cash during the recession by aggressive
destocking and holding back on investment.
This more healthy financial position puts the corporate sector in a better position than it has
been coming out of previous recessions to increase investment as they see demand
recovering. The most recent reports from the Bank of England Agents around the country are
relatively positive about the investment outlook and this is consistent with investment
intentions indicated by other business surveys.9 These indications of rising business
investment also suggest that constraints in the banking sector - which are making it more
difficult for many small and medium sized companies to obtain finance - are not acting as a
serious obstacle to a recovery in business investment.
The third positive development for the supply-side of the UK economy following the
recession is the low level of company failures. Company failure rates are normally pushed up
by a recession and in the early 1990s the liquidation rate peaked at close to 3% of the
number of UK companies. However, as Chart 5 shows, the failure rate of businesses has
remained below 1% in this recession and has recently turned down as the economy has
begun to recover. Even adjusting for changes in the legal framework for insolvencies in the
mid-2000s, the rate of company liquidation is lower than in the last recession and the
increase during the recession has been much lower than expected when the recession first
hit.
With the pressures on the banks following the financial crisis, we might have expected the
opposite result. If the banks had quickly sought to realise value from bad loans made in the
global credit boom, we might have seen more business failures. One reason that this has not
happened is because of government interventions in the banking sector which have
encouraged UK banks to sustain lending to companies from which they might otherwise have
withdrawn support. Another mitigating factor against business failures in the recent downturn
has been the willingness of the government to allow greater flexibility for companies in
making tax payments to ease cash flow constraints. And a further supporting influence has
been the relative strength of company cash flows I commented on earlier.
The flip side of the fact that more companies have survived the recent recession is that there
has been a fall-off in measured productivity. Instead of slack being created in the labour
market through company failures and job losses, there is the possibility that more spare
capacity has been retained within companies which have survived the recession -
particularly in the services sector, which accounts for the bulk of business activity in the UK.
However, the extent of this margin of spare capacity and the way it will impact on the
performance of the economy going forward is a big uncertainty at present, as I will discuss
later.
The 1990s recovery
A third reason for optimism about the private sector and business activity to drive the UK
economy forward in the current recovery is the experience of the previous recovery from the
early 1990s recession. Through the mid-90s, the UK economy grew healthily - with annual
GDP growth averaging close to 3.5% while the public sector deficit was being brought down
in a broadly similar way to the reduction planned by the current government. Though the
latest Budget and OSR 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 over the next five years in the coalition government 2010 Budget.10
It is also important to recognise the profile for total public spending conceals significant
variations between different areas of spending. But the overall total is not being cut back as
dramatically as some of the media headlines suggest. The broadest measure of public
spending - Total Managed Expenditure - is still set to rise in cash terms at 1.5% per annum
over the four years to 2014/15, not far below the targeted inflation rate of 2%. The profile for
real spending in future years is not dissimilar to the mid-1990s when there was also a virtual
standstill in the real growth of spending. In the 1990s, the public spending squeeze was also
accompanied by a significant reduction in employment in the public sector, not dissimilar to
the figures currently projected by the Office of Budget Responsibility. Despite this,
unemployment fell in the 1990s from over 10% of the labour force to around 5% later in the
decade because the private sector generated many more jobs than were lost in the public
sector.
The private sector and a business recovery supported the growth of the UK economy
following the early 1990s recession. And economic conditions we currently face are not that
dissimilar from the world of the mid-1990s. If anything, the external stimulus to growth is
stronger - the global economy has bounced back more strongly from the recent downturn
and the sterling exchange has depreciated more sharply and at an earlier stage of the cycle
than in the early 1990s. There is a worry that domestic demand could be held back by the
legacy of the financial crisis and public sector deficit reduction. But that does not appear to
be reflected in the most recent data for domestic demand and from the evidence on business
investment intentions. And while we should expect a relatively muted recovery in consumer
spending, the impact of high household debt levels should not be overstated. This was a
major concern in the early 1990s too, when repossessions and mortgage arrears were higher
than we have seen through this recession.11
Inflation and UK monetary policy
In my view, the business sector of the UK economy has shown a great deal of resilience
through the recent financial crisis and global recession. Growth has bounced back more
strongly than we might have expected in the depths of the crisis, and policy measures have
played an important part in supporting this recovery. But we have also experienced relatively
high inflation. That is contrary to the normal view of what should happen to inflation after
recessions - when excess capacity generated in the recession is expected to depress
increases in prices and costs. It is also not consistent with the forecasts made throughout
last year by the MPC which suggested that inflation would we below 2% by now (see
Chart 6) and would continue below target through 2011. Instead, the Governor has had to
write four letters this year to explain why inflation is over 3%, and he may well have to write
another four next year as well, as the latest Inflation Report forecast suggests that inflation is
set to rise further in the early part of next year and not be back close to the 2% target until
2012.
Part of the reason for this period of above-target inflation is that we are currently facing a
period of upward price shocks from a range of different sources - the exchange rate, VAT
rises and upward pressure on commodity prices. We could afford to accommodate these
upside pressures on inflation last year when there were worries that a broader deflationary
trend could emerge and the recession was threatening to deepen further. But the serious
downside risks to the economic outlook we saw then have since receded. The UK economy
has actually bounced back more strongly than in previous recoveries, supported by both
domestic and overseas demand.
These upside pressures on inflation from import prices and VAT have been one reason that
inflation has not fallen back in the way we expected in the aftermath of recession. The other
significant factor is that spare capacity has not exerted as much downside pressure on cost
and price increases as expected. That is partly because the margin of spare capacity
appears to be less than we have seen in previous economic cycles. In the labour market, this
is the flip-side of the resilience of employment and a lower level of unemployment relative to
the early stages of previous recoveries.
But survey evidence also suggests that there is limited spare capacity within firms to take up
the slack as demand recovers.12 For example, the most reliable measure of capacity
utilisation in manufacturing - the CBI Industrial Trends Survey - shows capacity utilisation at
around its average level, which is quite surprising at this stage of the recovery. There is more
survey evidence of spare capacity in the services sector. But this does not seem to be
exerting much downward pressure on inflation. The CPI measure of services price inflation
has picked up from 2.4% at the end of last year to average around 3.8% in recent months.
This is considerably in excess of the 2% target and also slightly above the average rate of
services price inflation we experienced during the decade prior to the financial crisis, as
Chart 7 shows. This does not appear consistent with the view that spare capacity in the UK
services sector is serving to hold down inflation.
With the economy recovering at home and abroad, inflation above target and set to rise
further, I believe there are three powerful arguments for a gradual rise in interest rates which
have been evident for several months. First, the main elements of demand for UK
businesses - overseas markets and domestic private sector spending - have been
recovering for over a year now and look set to continue to grow. The outlook for growth
suggests the UK economy should be able to withstand a gradual rise in interest rates, even
taking into account the impact of fiscal consolidation. Indeed, it is worth noting that in 1994,
when the early 90s fiscal consolidation began, the UK economy grew by over 4%, which is
still the strongest rate of GDP growth we have seen in any calendar year since the late
1980s. The strength of growth surprised forecasters, who had greatly underestimated the
momentum of growth which would be generated by a rebound in private sector demand, a
strong world economy and a competitive exchange rate.13 There is a risk that we are making
the same mistake again because of the preoccupation with downside risks following the
financial crisis.
The second key argument is that higher interest rates should help to exert a brake on
abovetarget inflation and keep inflation expectations anchored around the 2% target. There are
significant upside risks to the forecast recently published in the Bank's Inflation Report which
could sustain the period of above-target inflation into 2012 and 2013. Continued strong
global growth could generate further upside pressure from rising energy and commodity
prices. Wage growth could also pick up more quickly as the recovery proceeds, as pay
settlements recoup some of the ground lost in the recession and employees seek
compensation for relatively high inflation. And the longer this period of relatively strong
growth in consumer prices continues, the greater is the risk of a more fundamental upside
shift in future expectations of inflation.
Raising Bank Rate sooner rather than later would provide more protection against these
upside risks, by restraining the ability of firms to pass through higher costs into domestic
prices and helping to limit import price inflation through the effect on the value of the pound.
With inflation significantly above target and set to go higher, such a policy would reinforce the
credibility of the MPC's commitment to stable prices - helping to keep inflation expectations
in line with the 2% target. It should also help build confidence that the Bank of England is "on
the case" in terms of its remit, taking appropriate policy action to return inflation to target
rather than appearing to just hope for the best.
The third important argument is the extremely low level of interest rates we are starting from.
Taken together with the monetary stimulus from Quantitative Easing, there is still likely to be
a considerable support for growth from monetary policy even if interest rates are raised
somewhat from their current level. Indeed, it is most unusual for the UK to experience a
period as long as eighteen months or more with no change in the official interest rate, as we
have done since March 2009. The period over which Bank Rate has been held constant at
0.5% is now the longest period without a change in the official interest rate since 1951 (prior
to which the Bank's official interest rate had been held at 2% since the 1930s). I do not
believe that the current economic conditions justify a continuation of this policy. The longer
we keep interest rates at an exceptionally low level, the greater is the risk that Bank Rate
would need to rise sharply in the future - creating a serious setback to business and
consumer confidence. We should seek to avoid such a sudden lurch in policy. A gradual
transition to higher interest rates appears much more likely to provide a stable and
predictable approach to policy-making which enables the business community to plan
sensibly for the future.
As the private sector of the economy "gets back to business" and we get accustomed to a
resumption in growth following the financial crisis, so monetary policy also needs to "get back
to business". It is quite right for the MPC to support the economy in recession when there are
significant deflationary risks. But, as the economy recovers, a key task for the MPC is to
maintain monetary discipline and confidence in a world of low and stable inflation. As the
Governor wrote in his letter to the Chancellor last week, echoing the MPC remit: "price
stability is a precondition for high and stable levels of growth and employment". Confidence
in a world of stable prices in the UK has been hard-won in recent years and we need to
safeguard it carefully.
I worry that monetary discipline and confidence in the inflation target risks being eroded by
keeping emergency settings for monetary policy in place for too long, when the growth and
inflation outlook points in a different direction. That is why I have argued for a gradual
withdrawal of monetary stimulus and why I will continue to do so, in the absence of material
and significant changes in the economic outlook relative to the picture I have described
today.