Ever since the crash in 2008, the central banks in the advanced economies have had but one obsession — how to set monetary policy to ensure the maximum growth rate in aggregate demand. Interest rates at the zero lower bound, followed by a massive increase in their balance sheets, was the answer they conjured up.
Now, those central banks contemplating an exit from these policies, primarily the US Federal Reserve and the Bank of England, are turning their attention to the supply side of their economies. When, they are asking, will output reach the ceiling imposed by the supply potential of the economy?
The Bank of England has been in the lead here, with the Monetary Policy Committee recently conducting a special study of the supply side in the UK. Its conclusion was that gross domestic product is now only 0.5 per cent below potential, which implies that tighter monetary policy will soon be needed if GDP growth remains above potential for much longer.
In the US, the Fed has been much less specific than that, but the unemployment rate has now fallen very close to its estimate of the natural rate (5.0-5.2 per cent). Sven Jari Stehn of Goldman Sachs has used the Fed staffers’ supply side models to calculate that their implied estimate of the US output gap may be only 0.6 per cent, not far from the UK figure.
If the UK and US central banks were to act on these calculations, the implication would be that they no longer hold out much hope that they can ever regain the loss in potential output that has occurred in the past decade, relative to previous trends. That would be a massive admission, with an enormous implied sacrifice in future output levels if they are wrong. It would also be very worrying for financial assets, since it would draw the market’s attention to a downgrade in the Fed’s estimation of the long-run path for GDP. Read more
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When the Brazilian finance minister Guido Mantega complained that the Federal Reserve was waging a currency war against his country in September 2010, his comments led to a wave of sympathy and concern. The Fed’s aggressive monetary easing was causing a capital flight from the US into the apparently unstoppable emerging markets.
Uncompetitive exchange rates and domestic credit booms in the EMs were the result of US quantitative easing. American monetary policy makers showed little sympathy, arguing that the US had its own domestic inflation and unemployment mandates to worry about. If the dollar fell in the process, so be it.
That episode proved short lived. The Brazilian real is now a chronically weak currency. Yet the term “currency wars” has stuck. It is now alleged that almost all the major central banks are engaged in weakening their currencies, if not against each other then certainly relative to commodities, goods and services. Read more
The leading central banks in the developed economies have, of course, been the main actors underpinning the global bull market in risk assets since 2009. For long periods their stance has been unequivocally dovish as they have deliberately tried to strengthen an anaemic global economic recovery by boosting asset prices.
In the past week, we have had major statements of intent from Janet Yellen, the new US Federal Reserve chairwoman; from the European Central Bank; and from the Bank of England. After multiple hours of fuzzy guidance about forward guidance, the clarity of previous years about the global policy stance has become much more murky. Central banks are no longer as obviously friendly to risk assets as they once were – but they have not become outright enemies, and they are unlikely to do so while they are concerned that price and wage inflation will remain too low for a protracted period.
It is now quite difficult to generalise about what central bankers think. However, a few of the necessary pieces of the jigsaw puzzle slotted into place in the past week. Read more
Mark Carney’s announcements today about the UK housing market represent the first blast from a major country of a new policy weapon that is increasingly available to the global central banks, a weapon known as macro prudential regulation. Because this weapon is seen as an alternative to raising short rates, not as a prelude to raising them, the Carney intervention should logically under-pin the lower-for-longer path for short rates discussed in his evidence to the Treasury Select Committee earlier this week. Mr Carney has turned more hawkish today, but not more hawkish about interest rates or sterling.
The Carney announcement will represent an important restraint on the UK housing market, which was showing distinct signs of getting too ebullient in the south east of the country. By acting early, and using methods that are distinct from the short term interest rate, this action may well make the economic recovery in the UK more durable than otherwise, though it may slow down some parts of the consumer sector in the immediate future. Read more
For many years, one of the most enduring mantras of central banking was along the lines of “we never pre-commit to future actions, because all of the information we have about the state of the economy is already contained in the actions we have just announced”. Now that has been completely abandoned. With the ECB and the BoE changes announced today, the central banks are shouting from the rooftops that “we are all forward guiders now”.
In the old days, if the central banks wanted to ease or tighten policy, they just adjusted the size of the change in interest rates at any given meeting, and allowed their actions to speak for themselves. The forward path for short rates was generally very sensitive to any given change in the policy rate, so they did not have to worry too much about the impact of their policy on the yield curve. Read more
After more than 20 years, and 82 issues, Sir Mervyn King has delivered his last Inflation Report. The transparency and rationality of this innovation has been one of Britain’s most important gifts to the world in recent times, even if the UK has not actually been very good at controlling inflation itself since 2008. As its main architect and, in his own words, the UK’s “consistent monetary referee”, Sir Mervyn deserves great credit. I hope that, in retirement, he will receive it.
The economic message of today’s report is a familiar one. Inflation has been revised down so that it is shown to hit the 2 per cent target in two years’ time, and real GDP is forecast to recover gradually. Similar forecasts have proven too optimistic in the past, but this time there are clear indications that the Bank will be introducing new forms of policy easing in the next few months, which may underpin the economic recovery.
Following the astonishing arrival of Governor Kuroda in Japan, Mr Carney must be sorely tempted to follow suit in trying to jolt UK economic expectations towards a new equilibrium. He is likely to get plenty of encouragement in this from the chancellor, who emphasised in the Budget that “monetary activism” is a core part of his overall economic strategy.
In fact, Mr Osborne has asked the Bank to focus in the August Inflation Report on how the UK might adopt forward policy guidance, with thresholds, following the example of what the Fed did (successfully) last December. This is an unusually specific request from the Treasury, and even Sir Mervyn seemed sympathetic to this approach today.
In the context of high British inflation, there are serious impediments to repeating the fireworks unleashed by the BoJ, but some progress can be made, Fed-style. What exactly can we expect? Read more
The new Funding for Lending Scheme (FLS) announced today in the UK is a useful and sensible development. It directly attacks the important micro problem of inadequate lending to small and medium sized enterprises (SMEs). But it is unlikely to have large scale macro-economic effects.
The FLS was introduced last July to address the increase in the funding costs which British banks were incurring as a result of spill-overs from the eurozone crisis. This had increased lending rates on UK mortgages and corporate loans at a time when the monetary policy committee was trying very hard to ease overall monetary conditions in the UK. And the FLS was the chancellor’s main response last year to the charge that he was deaf to the needs of the real economy, and inflexible in his pursuit of austerity policies.
Almost a year later, the verdict on the FLS is that it has significantly reduced banks’ funding costs, with the benefits of that being mostly passed on to mortgage and company borrowers, but that it has had relatively little effect on overall bank lending to companies, especially to small and medium sized enterprises (SMEs).
Today’s extension to the FLS greatly increases the incentive for banks to skew their lending to SMEs by offering them larger overall access to subsidised funding if they do that. Every pound of SME lending in 2013 will contribute tenfold to the banks’ eligible total of subsidised FLS lending. In 2014, it will contribute fivefold.
Furthermore, today’s announcement extends the FLS by 12 months to the start of 2015, thus re-assuring banks that their access to cheap funding for new lending will not suddenly disappear early next year. The Chancellor also hopes that the new FLS will help to influence the IMF’s response to his overall economic approach when they visit the UK shortly. Read more
Predictably, the chancellor has rejected calls for a radical change in his economic strategy. Plan A has not morphed into Plan B. If anything, it has become Plan A-plus, with the underlying path for fiscal tightening left unchanged, and a little more flexibility for the Bank of England to pursue unconventional monetary stimulus.
UK real GDP is still stuck some 5 per cent below its pre-crisis level, the worst record among the major economies, apart from Italy. Some of this is certainly due to the problems which the Coalition inherited. However, about half of the shortfall in UK growth in recent years, compared to that in the US, is due to the tightening of 5 per cent of GDP in fiscal policy since 2009/10.
The dominant criticism of the government from mainstream economists is, of course, that the poor performance of UK GDP is due to a shortfall in aggregate demand, which in turn is primarily due to these fiscal measures. The Chancellor’s reply is that the UK could have faced a fiscal crisis without his budgets. The fact that public debt is now forecast to rise to 85 per cent of GDP in 2017/18 suggests that his concerns are not easy to dismiss as scare-mongering. Read more
The sterling exchange rate has now declined by about 7 per cent this year, thus eliminating all of the rise which occurred when the euro crisis was in full flood in 2011-12. Investors are asking three main questions about the drop in sterling. When will it end? Will it succeed in boosting UK economic growth? And could it, conceivably, lead to a full blown sterling crisis? Read more
The markets were impacted yesterday by two very different sets of monetary policy minutes from the Fed and the Bank of England. In the case of the Fed, the worry is that the central bank is back-tracking on its commitment to maintain open-ended QE until the labour market has improved “substantially”. Meanwhile, at the Bank of England, the concern is that monetary policy might be too easy in the context of a declining exchange rate, and an inflation outlook that will exceed the official target for at least the next two years.
Although coming at the monetary policy problem from entirely different angles, these concerns have one thing in common. It has become increasingly difficult for both the Fed and the BoE to communicate their policy regime clearly to the markets in an environment where their policy committees have become openly split about the right stance to pursue in the months ahead. Read more
Mervyn King. Getty Images
Mervyn King’s speech on UK economic policy on Tuesday has received relatively little attention, perhaps because he is in his last few months in the governor’s seat at the Bank of England. However, it is extremely interesting , both in its analysis of the UK’s current predicament and in its recommendations for future policy action.
It lays out a distinctive course of action, which is different from the Plan A adopted by the government and the Bank in 2010, and also different from the Keynesian alternative that Olivier Blanchard of the IMF seems to have recommended at Davos.
The King plan, tinged with both pessimism and realism, argues for a long-term fix, rather than a short-term dash for salvation. But while the fix will take a long time to work, it does have some important implications for the banks, and the exchange rate, in the near term. Read more
Canadian Central Bank governor Mark Carney has been appointed as Sir Mervyn King's successor. Getty
Congratulations and best wishes to Mark Carney. When he becomes governor of the Bank of England next June, he will assume one of the three or four most important roles in global finance.
In fact, it will be a role much broader than that of his immediate predecessors at the Bank, who have not been directly responsible either for microprudential supervision of financial entities, or for the macro-prudential supervision of the financial system as a whole. Under the new regulatory structure designed by Chancellor George Osborne, the new governor will now assume responsibility for both of these tasks, as well as for monetary policy. Read more
As the IMF meetings close in Tokyo this weekend, it is obvious that governments are struggling to find the correct balance between controlling public debt, which now exceeds 110 per cent of GDP for the advanced economies, and boosting the rate of economic growth. The former objective requires more budgetary tightening, while the latter requires the opposite. Is there any way around this?
One radical option now being discussed is to cancel (or, in polite language, “restructure”) part of the government debt that has been acquired by the central banks as a consequence of quantitative easing (QE). After all, the government and the central bank are both firmly within the public sector, so a consolidated public sector balance sheet would net this debt out entirely. Read more
The growth rate of the global economy is experiencing its weakest patch since the “upswing” in the cycle began in 2009. Of course, it has never been much of an “upswing”, given the depth of the recession which followed the financial crisis at the end of 2008. Still, the big picture seemed to suggest that global GDP was slowly on the mend, if not at a pace which could reduce global unemployment very rapidly. Now, even that modest recovery seems to be at risk.
Yesterday, we saw another leg of the policy response to this renewed slowdown. Monetary easing from the ECB, the Bank of China and the Bank of England followed earlier action by the Federal Reserve. As noted in this earlier blog, the central banks are back in play.
Markets have not been oblivious to this renewed round of easing: since the end of May, global equities have risen by 8 per cent and commodity prices have recently rebounded from their lows in spectacular fashion. Although ”shock and awe” from the central banks seems to have been replaced by a sense of rather tiresome routine, the impact of QE on market psychology has not entirely lost its traction.
That will only last, however, if the current global slowdown proves to be just another mid-year lull in a generally recovering world economy. So what are we to make of recent data? Read more
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. Read more
The UK GDP figures for 2012 Q1 are due to be published on Wednesday, and are likely to be followed by the usual out-pouring of angst about whether the economy is in a “technical” recession. This will clearly have important political connotations, but does not mean very much in a deeper economic context. The initial estimates for quarterly GDP are notoriously unreliable, and are no longer taken as the best estimate of UK economic activity even by the Bank of England.
No-one should read too much into the Q1 data, since the GDP outcome for the quarter is likely to be either slightly positive or slightly negative, depending on what happens in the construction sector. This volatile sector seems to have recorded a large drop in output in Q1, and since it represents 7.5 per cent of the economy, it is capable of being the swing factor which decides whether the Office for National Statistics prints a positive or negative GDP number for Q1. In the latter case, the media would probably scream “recession”, on the grounds that the economy would have experienced two back-to-back quarters of negative GDP growth.
In fact, most economists think that the figure will scrape into positive territory, but in any event no Chancellor deserves to be hanged on such flimsy grounds. Read more
In recent years, UK Budget Day has become the occasion for an outbreak of hand-wringing from the economics profession. Downward revisions to GDP forecasts, and upward revisions to budget deficit projections, have become the norm. Those who have criticised the chancellor for tightening fiscal policy far too quickly have increasingly felt vindicated. Calls for a Plan B, involving less fiscal stringency in the immediate future, have become deafening.
Today may be rather different. For the first time in quite a while, there is no good reason for the Office for Budget Responsibility to downgrade its previous views on the economy. The underlying improvement in the budget deficit (adjusted for the absorption of the Royal Mail pension fund into the government accounts) will stay much the same as the OBR expected in November. If you believed it then, there is no new reason to doubt it now. That should allow the chancellor to focus on micro-economic issues, such as the tax treatment of higher earners, which will generate enormous political heat, but which will not alter the path for the economy very much in either direction.
The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.
Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.
Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right? Read more
Amid all the focus on the UK’s decision to use its veto, it is important not to miss the main economic outcome of the summit, which is that the agreement heralds a new era in European policymaking. The German approach to fiscal policy will now be writ large across the eurozone. This raises three key questions:
- How different will this prove to be in practice from the old status quo?
- Is it a good idea from an economic point of view?
- Does it allow the European Central Bank in future to play the same role in the eurozone as the Federal Reserve and the Bank of England have been playing in the US and the UK?
My initial take on the deal is that it will be sufficient to dampen the acute phase of the crisis, but that the absence of a clear long-term strategy for growth means that there could still be a long period of chronic problems ahead. Read more