Bank of England’s “slack” approach leaves economy at risk
The Bank of England is increasingly optimistic about the UK growth outlook. Britain remains on course to expand by a very punchy 3.4pc this year, Governor Mark Carney revealed last Wednesday, presenting the latest quarterly Inflation Report. Our economy, then, is now growing at its fastest pace since 2007, prior to the financial crisis. The Bank’s Monetary Policy Committee further upgraded its 2015 growth forecast, from 2.7pc to 2.9pc.
Over the next 2 and a bit years (9 quarters), UK GDP is set to rise at an annual average of no less than 3.1pc. This latest Inflation Report is among the most bullish the MPC has published since it was established 17 years ago. Britain is now moving “from a recovery supported by household spending to an expansion sustained by business investment”, according to Carney. “The economy has started to head back towards normal”.
While the Bank thinks the economy is normalizing, there are few signs of monetary policy even beginning its retreat from the radical extremes any time soon. The MPC has, of course, kept rates nailed down at their record low of 0.5pc since March 2009. That was an emergency setting for an emergency situation – which, in the Bank’s own words, clearly no longer exists.
Rates, though, will remain ultra-low for “some time”, Carney insisted. Many observers felt the Bank’s guidance was even more dovish at the launch of this Inflation Report than its February equivalent, with the Governor crushing speculation of a hike before Christmas, even though the medium-growth outlook has improved.
For weeks, the pound has been rising in anticipation the Bank would acknowledge that signs of a stronger recovery meant the first rate increase would happen sooner than previously thought. Yet, sterling fell as Carney spoke, as he made clear the Bank is still prepared to wait until 2015 before starting to push rates up. Market expectations were subsequently re-priced, with the weight of money now predicting the first increase in March 2015.
The Bank squares this circle – stronger growth and more inflationary pressure, but rate rises some way off – by pointing to “spare capacity” in the economy. It’s a time honored trick because, dear readers, if there’s more “slack”, then increasing demand doesn’t translate into inflation as quickly as it otherwise would.
Carney stressed his belief that the UK retains “significant” spare capacity and for that reason, above all, it’s right to keep rates low. The trouble is that the most obvious and visible measure of spare capacity – the number of people out of work – is falling fast, in a trend that looks set to continue.
Unemployment was 6.8pc during the first quarter of 2014, down sharply from 7.2pc the quarter before. By the end of next year, on the Bank’s own numbers, joblessness will fall to 6.0pc. Just three months ago, the Bank’s end-2015 unemployment forecast was 6.4pc, and in the November 2013 Inflation Report it was no less than 7.0pc. So in the last six months, the unemployment outlook has changed very significantly, but the rate-changing outlook hasn’t.
These trends are welcome, of course. Unemployment is always wasteful and often cruel, a scourge of society. Yet rapidly falling unemployment, and expected further falls, mean rates need to rise. To try to dodge this reality is to abandon any genuine commitment to inflation-targeting.
Employment is also surging, and at a quickening pace, up 691,000 during the year to February and by another 240,000 over the last three months. Job vacancies, too, are soaring, no less than 23pc higher than a year ago and above 600,000 for the first time since 2008. All this points to rising wage pressures, and inflation, if the current momentum is sustained – which, on the Bank’s own growth estimates, it will be.
The MPC number crunchers counter that spare capacity “remains considerable”, at 1-1.5pc of GDP. But as well as unemployment, this number also includes “under-employment” – those apparently working fewer hours than they’d like to. This “hours gap”, the Bank argues, is currently higher than normal, with almost 10pc of the workforce indicating they would like to work more. Such observations rely on obscure survey data that is open to serious question. Will people really work longer, or are they just saying that? Surely it would depend on how much extra they’re paid.
Once a central bank is into the realms using highly subjective and ultimately unproven calculations of spare capacity to justify not raising rates, even though the economy is clearly at risk of over-heating, it strikes me that its credibility will soon wear thin. As out-going Deputy Governor Charlie Bean admitted, the “true margin” of slack in the economy “could either be significantly smaller than or significantly greater than” the MPC’s central estimate.
I’d add also that this credit crunch we’ve just lived through, by forcing numerous companies to sell and/or not replace capital goods, while eroding skills, has seriously curtailed UK productivity, eating into the economy’s ability to respond to rising demand, so cutting spare capacity to a greater extent than most economists are prepared to admit. I recall the admirably candid Bean making a similar argument, in fact, at the Inflation Report press conference in May 2009.
The Bank argues, also, that pay growth is benign – so limiting the inflationary danger of not raising rates. It’s true average weekly earnings growth (excluding bonuses) remains low, at just 1.3pc year-on-year. But this partly reflects the recent sharp fall in the number of high-paid jobs (in finance, for instance) compared to relatively low-paid jobs (particularly in the service sector). Adjusting for this “composite effect”, average earnings growth is actually 2pc, and rising. In construction and manufacturing, wages are up 2.1pc and 2.7pc respectively, as the skills shortage bites. In the booming retail sector, the figure is 3.1pc. The UK labour market is far less “slack” than the Bank would have us believe.
At one point during Carney’s press conference, I punched the air with glee (in my head, anyway). The Bank “will not build a single one of the 120,000 fewer houses that are being built each year relative to what the economy needs,” he said.
There were 115,000 UK housing completions in 2013, almost a record peace-time low, compared to the 240,000 new homes needed each year just to meet the rise in household numbers hard-wired into our demography. This disgraceful shortage, and the government’s now long-past-its-sell-by-date Help-to-Buy scheme, is the reason prices are up 9.1pc across the UK over the last year and 17.1pc higher in London. And where house price inflation goes, economy-wide inflation eventually follows.
While agreeing with Carney’s house-building analysis, I don’t agree the Bank can’t do more to rein in a market now in danger of spiraling out of control. Tighter mortgage checks are one thing, but nothing would address this “irrational exuberance” like an immediate notching-up of rates. The trouble is, that the European elections are looming and we’re now just a year from a general election in May 2015. And messing with the house-price driven feel-good factor before polling day is the third rail of central banking.
The idea of an independent central bank, with all its regalia and scientific hocus pocus, is to take the politics out of monetary policy, allowing the technocrats to raise rates “ahead of the curve” regardless of electoral considerations, so saving us from the dangers of a later crash. That idea now seems to have been discarded, not just in the UK but across the Western world. It’s a development we’ll live to regret.