For the first time in quite a while, the Monetary Policy Committee of the Bank of England has today made a knife-edge decision which genuinely might have gone either way. The outcome, which was to leave the total of quantitative easing unchanged at £325bn, tells us something about the inflation fighting credentials of the MPC, which have been widely questioned in the financial markets. And it also tells us something about the way in which other central banks, including the Fed, might react to similar, if less strained, economic circumstances in coming months.
The Bank of England has been on a mission in the past two years. That mission has been to participate, possibly a little too enthusiastically at times, in a plan to change the fiscal/monetary mix in the UK, and to support the Coalition’s plan to reduce the budget deficit on an accelerated timsescale. The MPC has therefore delivered the largest dose of monetary easing among the major economies, and has acquiesced to a prolonged period in which UK inflation has exceeded targets by very significant amounts. From my vantage point, while inflation and unemployment have both been far too high, there were few better policy options available at a time of enormous difficulty for both the Treasury and the Bank.
Today’s decision to pause (note, pause, not reverse) the monetary stimulus by leaving the amount of QE unchanged is not a signal that the UK policy mix has succeeded so well that no further work needs to be done. Rather it is a signal that the supply side of the UK economy has performed so poorly that a further boost to demand cannot be justified at the present time. For now, the Bank has been forced to accept the inevitability of much weaker growth in real GDP in order to bring inflation back under control.
How do we know that the supply curve has shifted in the wrong direction? Nothing in economics is ever certain, but recent signals from GDP growth and consumer price inflation are both pointing in that direction. As Chris Giles has frequently pointed out, the Bank’s projections for both GDP growth and inflation have consistently proven far too optimistic over the last 5 years. And the Bank has not been alone in this. The first graph shows the development of consensus forecasts for the growth in UK real GDP in 2012 over the period from the start of 2011 to the present. (The forecasts are compiled by Consensus Economics.)
A year ago, the consensus of forecasters expected real GDP growth in 2012 to come in at 2.2 per cent. Now they expect growth to be only 0.8 per cent. Part of the explanation for this shift is the annoying tendency for the official statisticians repeatedly to under-estimate the true path for GDP in their initial estimates (which means that the economy probably has not really fallen back into a technical recession in 2012 Q1). This likely underestimate by the ONS has led to a much bigger outburst of economic pessimism than is really justified. Nevertheless, there is no doubt that output in the economy has sharply under-performed expectations in the last year.
One obvious explanation for this could be that aggregate demand has been slowed by the fiscal tightening and the eurozone crisis, and QE has not been powerful enough to compensate for this. No doubt there is some truth in this point of view. However, if this were the whole explanation, the shortfall in demand should have resulted in inflation under-shooting expectations, which would have allowed the MPC to boost demand further. In fact, however, the reverse has occurred, as the second graph shows.
A year ago, CPI inflation in 2012 was forecast to be 2.0 per cent, whereas it is now predicted to be close to 3.0 per cent. Furthermore, although the MPC still expects the inflation rate to decline back below its 2 per cent target over the next two years, they are beginning to lose credibility when they make these claims. Clearly, they have decided that they can put their credibility at risk no longer, and will now probably wait until inflation subsides substantially before contemplating further support for the economy.
Where does that leave the UK’s economic experiment? That depends a lot on whether the adverse shift in the supply curve turns out to be temporary or permanent. There are reasons for thinking that it might be temporary. The economy may be taking time to adjust to last year’s oil and VAT shocks, and inflation is clearly being affected by a restoration in profit margins which were severely squeezed in 2008/09. If this interpretation is correct, then inflation will (finally!) obey the wishes of the MPC, and come back within the target. That could eventually leave scope for more monetary action to boost the economy.
However, if the UK’s supply side performance has permanently deteriorated so much that inflation will continue to exceed target even with real GDP stuck at present depressed levels, the outlook would be bleak indeed. Not only would this severely handicap the MPC, it would also make the fiscal position of the economy look even more difficult, leaving less room for budgetary flexibility if the economy should weaken further in the near term.
But this would imply that economy is now working with little or no spare capacity, despite the fact the GDP, properly estimated, is still about 2 per cent below the levels attained in the boom five years ago. This still seems much too pessimistic. The Office for Budget Responsibility believes that the output gap is currently around 2.5 per cent of GDP, and even that seems to make some very cautious assumptions about the supply potential of the economy. If the OBR is anywhere near right, then output is still some way below potential, and we should see this demonstrated in a lower inflation rate before too long.
The MPC is probably right to wait and see.