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
The debate about whether the ECB should engage in open-ended purchases of eurozone sovereign debt rages on, and the financial markets continue to follow every twist and turn with rapt attention. This debate has legal, economic and political aspects, none of which have been confronted before in exactly this form. The custom and practice of central banking, and of the relationships between central banks and fiscal policy, is being rewritten under the glare of a global spotlight, and in the harshest of circumstances. Read more
An overseas friend asked me last week: “How is the guinea pig doing?” He meant the UK economy, which has embarked on an extreme version of the tight fiscal/easy monetary mix which all other developed economies are trying in varying doses. The answer I gave him was that Plan A was severely fraying around the edges, but that it just about remained intact.
That has become clearer with the decision by the Bank of England to re-launch QE in much larger size than anyone expected. While this is consistent with Plan A, there do seem to be differences between the Treasury and the Bank over the nature of the quantitative easing which the Bank is pursuing. These revolve around the question of whether unconventional QE should now be on the agenda. Read more
Mervyn King. Image by Getty.
A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.
There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:
1. Conventional liquidity injections
This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008. Read more
The Bank of England’s latest Inflation Report was certainly a downbeat document. Mervyn King, Bank governor, said there are “difficult times ahead”, because the economy is still undergoing a slow adjustment to the impact of the financial crisis. By reducing its GDP growth forecasts while simultaneously increasing its inflation projections, the Bank has signalled that it believes the UK is now facing a series of supply side problems – and those are always the most difficult for any central bank to handle. Read more
This week in global macro, the emerging markets reminded us that they are, well, emerging markets. The Egyptian crisis may have moved towards resolution, but there are risks of contagion elsewhere in the region. India continues to be the worst performing stock market of the year, and China is slowing under the weight of tightening monetary policy.
Developed equity markets continue to out-perform, although headline inflation is rising, notably in the UK. Although many people are claiming that the Bank of England is losing credibility, that is not yet showing in the gilt market. In the US, there were some signs of greater hawkishness from certain members of the FOMC, but none where it really counts – which is in the minds of Ben Bernanke and his senior lieutenants. The US equity market ended the week at its highest level since June 2008. Read more
From now on, GDP figures in the UK will be watched with more than usual interest, because Britain is embarking upon the most significant fiscal tightening among the G7 nations. Can the economy withstand it?
Today’s GDP statistics for the third quarter, which show that the economy is growing at an annualised rate of 3.2 per cent, were much stronger than expected, and suggest that the economy is in better shape than many economists had predicted as the government is launching its fiscal retrenchment. However, the composition of the data is somewhat less encouraging than the picture painted by the headline figures. Read more
The shift in market prices since the Fed meeting on Tuesday has been very minor in the great scheme of things, but it has obviously got some people worried that it is the start of a much bigger move in the coming weeks. Read more
The Fed decision announced last night seems to have disappointed markets, yet it will surely come to be seen as a clear win for the doves. Prior to yesterday, the default option at the Fed was to allow the size of its balance sheet to decline whenever its holdings of mortgage debt matured. Although this would not have led to much shrinkage of the balance sheet in the near future, it signalled that the Fed was looking for opportunities to reverse its policy of unconventional easing. That bias has now been removed, though not yet reversed. Read more