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Issue 35/ 5 May 2011

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Today’s Issue Includes:

1) Key issues for UK Monetary Policy by Andrew Sentance, External member of the Monetary Policy Committee, Bank of England.

Editor’s Note: This is my summary of a speech given by probably the most ‘hawkish’ member of the MPC at the end of last month, prior to his last meeting of the MPC this Thursday.

Over the past two decades the global trading system has expanded to include China and India, but this intense period of globalisation is not without its downsides. We have seen how a highly integrated economic and financial system can also generate instabilities and transmit economic shocks around the world.

In response to these shock waves the MPC cut the official Bank Rate to 0.5% - the lowest level in over 300 years, followed by direct injections of money through the programme of Quantitative Easing.

These policies succeeded in arresting the sharp downturn in demand in late 2008 and early 2009 and a recovery has been underway since the second half of 2009. The indicators from manufacturing industry continue to show strong growth on the back of buoyant export markets and activity is also expanding in the services sector, albeit at a relatively modest pace. Employment growth is picking up again, driven by private sector job creation and in the past twelve months, nearly 400,000 jobs have been created across the economy as a whole.

UK employment is about one per cent down on its peak level in early 2008, compared to a reduction of 5-6% at the equivalent stage of the previous two economic cycles in the early 1980s and early 1990s.

The problem of inflation

For me, it is not the growth or employment performance which has been disappointing, but the persistence of relatively high inflation. Over the 55 months I have spent so far as a member of the MPC, inflation has been above target more than five times as often as it has been below.

The official commentary of the MPC on this inflation over-run has been to emphasise one-off factors pushing up inflation, such as oil and commodity prices and the recent rise in VAT. But when compared to other European economies, the UK’s inflation experience looks noticeably higher through the recession and into the recovery. Our consumer price inflation has been around 1.5-2.5% above our peer group in the European economies,

In my time on the MPC I have earned myself a reputation as a ‘hawk’ because of my stance on interest rates. I voted in a minority on a number of occasions to raise interest rates in response to the relatively strong growth and rising inflation we were experiencing before the financial crisis.

In the debates we have had within the MPC over the past year, there appear to be four key areas where these differences of judgement arise.

Issue 1: The powerful influence of the global economy

The UK is very open to international trade, with imports and exports combined accounting for over 60% of GDP. When I joined the Committee in 2006, it struck me that most of the shocks and disturbances that the MPC had had to deal with had emanated from the global economy.

The global financial crisis from 2007 to 2009 was the most extreme of these international shocks affecting the UK economy. The policy response featuring deep cuts in interest rates and direct injections of money, in my view, was entirely right. However, the trends in the global economy have now turned around. The chart below shows global growth in both the advanced and emerging and developing economies – dominated by Asia – has recovered to rates very similar to before the recession. This relatively strong growth is set to continue through 2011 and 2012.

Figure 1: Strong emerging market growth to continue
Annual percentage growth rates of real GDP

figure 1

*: 2011 and 2012 growth rates are IMF forecasts.
Source: IMF World Economic Outlook

Against this background, it seems to me likely that the upward pressure we are seeing from global inflationary pressures is likely to continue for some time. Rises in energy and commodity prices are clearly part of this pattern, and may continue.

We should not be surprised to see these inflationary pressures transferred to more general increases in the prices of manufactured goods imported into the UK. In China and other Asian economies which are key producers of manufactured goods, domestic inflation and the pressure of demand from global markets is putting upward pressure on wages and the cost of production. This means we cannot simply regard them as one-off shocks which will fade away. And just as the MPC has adjusted to changes in global growth and inflation in the past, we need to be prepared to do so now.

Issue 2: The role of sterling in UK monetary policy

One obvious way in which a tightening in UK monetary policy might affect our exposure to imported inflationary pressures is through its impact on the value of the pound. And this is the second key area in which I see my view diverging from the majority of MPC members. In my view, the external value of the pound is a key channel of UK monetary policy and I would have expected that the policy I have been advocating - of gradually raising interest rates – to exert some upward pressure on the value of sterling on foreign exchanges.

This would have provided some offset to the global inflationary pressures we have been experiencing over the past year. The chart below shows that sterling has remained relatively weak, particularly against the euro, which is the most important currency for UK trade, accounting for around half of our total exports and close to half of our total imports.

Figure 2: Sterling depreciation since 2007
Rebased to 100 in January 2005

figure 2

*: Effective exchange rate
Source: Thompson Datastream and Bank for International Settlements

The weakness of sterling is one of the key reasons why UK inflation has been much higher than our peer group of European economies. The differential between inflation in the euro area and the UK is closely associated with the relative strength and weakness of the sterling/euro exchange rate.

This is because the benchmark prices of traded goods in the European market will be set in terms of euros. So when the pound falls against the euro, producers will tend to raise their prices in sterling terms to maintain euro revenues, creating a positive UK-euro area inflation differential. UK inflation could run 1 to 2 percentage points above the euro area inflation for a considerable while unless there is some noticeable appreciation in the value of the pound.

The counter argument is that the recent substantial depreciation of the pound is needed to support a rebalancing of the UK economy and sustain the growth of UK manufacturing. But the extent of the depreciation since 2007 has been much greater than in previous rebalancing episodes. But, there is very little difference in the current level of output relative to its pre-recession level in the UK, Sweden and the euro area, though the depreciation in the pound may have helped shield manufacturers from a bigger decline in output during the recession.

Since many UK manufacturers are niche producers linked into highly integrated global supply chains, their products are not highly price sensitive, since they reflect innovative capabilities and technical know-how and high skill levels. In the short-term therefore there is limited scope for an expansion of UK manufacturing output without major investment in skills and capacity.

Sterling’s depreciation since 2007 has added significantly to inflationary pressures in the UK economy and the resulting squeeze on disposable incomes is clearly a factor holding back the growth of consumer spending in the short-term, offsetting the boost to growth we might see from improved trade performance. In my view we have allowed the pound to depreciate more than is necessary or desirable to support the growth of manufacturing and exports.

Issue 3: The “output gap” and inflation

The third issue where I have found myself at odds with the majority view on the MPC is on the influence of the “output gap” and spare capacity on the rate of inflation in the UK. The OECD’s estimates of the UK output gap have changed over the 1990s and in the 2000s prior to the recession, to indicate that there was much less spare capacity in the economy than originally thought. Their current estimate is that the UK was operating much further above capacity before the recession that thought at the time.

Changes in demand conditions clearly do affect inflationary pressure. In a climate of stronger demand, firms will expect price increases to stick more readily than in weak demand conditions, but this pressure of demand is not well captured by simple “output gap” type measures.

Expected price increases are currently running at relatively high levels in both manufacturing and services. The service sector is heavily oriented towards the domestic market, so if the margin of domestic spare capacity is pushing down on inflation, we should see this reflected in service sector inflation. However, such inflation has been remarkably resilient, with a 3-4% level rate of inflation being fairly consistent in the decade prior to the recession.

So, if services prices continue to rise at a 3-4% rate, and goods prices continue to be pushed up by external factors and the weakness of the pound, it is very difficult to see how the MPC will be able to return inflation to the 2% target, even over a number of years.

Issue 4: Inflation expectations and credibility

The global economy affects inflation in the UK through the cost of imports, the impact of world demand on the UK economy and through the way in which international businesses perceive the pricing climate changing on global markets. All these factors can affect UK inflation – but monetary policy has three powerful counter-influences: the influence of monetary conditions on the exchange rate and the level of domestic demand, and the ability of the monetary authorities to anchor price expectations through their commitment to the inflation target.

We now face circumstances in which inflation has been persistently high relative to the target, and is set to remain so for some time. There are clearly upside risks to the expectations of low and stable inflation in this environment. Individuals and firms can no longer look back with so much confidence on a track record of inflation close to the 2% target. And so a large burden of weight is being placed on the view that the Bank of England will return inflation to target before too long, despite not having delivered on promises to achieve just that over the past couple of years.

In my view, this policy would be much more credible and we would have a much better chance of anchoring inflation expectations if the MPC was willing to act to steer the economy in the direction of a low inflation trajectory. By adopting a very relaxed monetary policy the MPC has sent the signal to the private sector that it has been prepared to accommodate price increases as the economy adjusts from recession to recovery. But the longer this process of accommodation goes on, the greater the risk that it becomes ingrained in expectations of relatively high future inflation.

As I prepare to leave the Committee, I do worry that the MPC’s credibility and commitment to the inflation target may already have been eroded by not adjusting policy settings soon enough – as the challenge for monetary policy has shifted from preventing deflation to curbing inflation and from halting recession to managing the recovery.

Editor’s note: There are 12 very interesting charts in the full speech, as well as further argument, which can be accessed by clicking here.


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2) The future of macroeconomic policy: Nine tentative conclusions by Olivier Blanchard, Chief Economist, IMF.

The global economic crisis has taught us to question our most cherished beliefs about the way we conduct macroeconomic policy. In this column, IMF chief economist Olivier Blanchard lays out his thoughts, arguing that we are far from a new Washington Consensus. Exploration is the order of the day.

The global economic crisis forces us to question our most cherished beliefs about the way we conduct macroeconomic policy. With this in mind, I have just organised, together with David Romer, Joe Stiglitz, and Michael Spence, a conference at the IMF on "Rethinking macroeconomic policy”.

Before the conference, I put forward some ideas to help guide the conversation (if you go to the conference site, you can view the proceedings as well as read the various contributions). At the end of the conference I organised my concluding remarks around nine points. Here they are:

1. We’ve entered a brave new world, a very different world in terms of macroeconomic policymaking.

2. In the age-old discussion of the relative roles of markets and the state, the pendulum has swung – at least a bit – toward the state.

3. There are many distortions relevant for macroeconomics, many more than we thought was the case earlier. We had largely ignored them, thinking they were the province of the microeconomist. As we integrate finance into macroeconomics, we’re discovering that distortions within finance are macro-relevant. Agency theory – about incentives and behaviour of entities or “agents” – is needed to explain how financial institutions work or do not work and how decisions are taken. Regulation and agency theory applied to regulators themselves is important. Behavioural economics and its cousin, behavioural finance, are central as well.

4. Macroeconomic policy has many targets and many instruments (that is, the tools we use or variables to implement policy). Many examples were discussed at the conference. Here are two:

  • Monetary policy has to go beyond inflation stability, adding output and financial stability to the list of targets and adding macro-prudential measures to the list of instruments.
  • Fiscal policy is more than just “G minus T” and an associated “multiplier” (the proportion or factor by which changes in government spending or taxes affect other parts of the economy). There are potentially dozens of instruments, each with their own dynamic effects that depend on the state of the economy and other policies. Bob Solow made the point that reducing discussions about fiscal policy to what is the right multiplier does not do service to the issue.
  • 5. We may have many policy instruments, but we are not sure how to use them. In many cases, we are uncertain about what they are, how they should be used, and whether or not they will work. Again, many examples came up during the conference:

  • We don’t quite know what liquidity is, so a liquidity ratio is one more step into the unknown.
  • It was clear that some people believe capital controls work and some don’t.
  • Paul Romer made the point that, if you adopt a set of financial regulations and keep them unchanged, the markets will find a way around, and ten years later, you’ll have a financial crisis.
  • Michael Spence talked about the relative roles of self-regulation and regulation. Both are needed, but how we combine them is unclear.
  • 6. While these instruments are potentially useful, their use raises a number of political economy issues.

  • Some instruments are politically hard to use. Take cross-border flows. Putting in place a multilateral regulatory structure will be very difficult. Even at the domestic level, some macro-prudential tools work by targeting specific sectors, sets of individuals, or firms, and may lead to strong political backlash by those groups.
  • Instruments can be misused. It was clear from the discussion that a number of people think that, while there may be an economic case for capital controls, governments could use them instead of choosing the right macroeconomic policies. Dani Rodrik argued for using industrial policy to increase the production of tradable goods without getting a current-account surplus. But in practice we know the limits of industrial policy, and they haven’t gone away.
  • 7. Where do we go from here? In terms of research, the future is exciting. There are many topics on which we should work – namely macro issues with, as Joe Stiglitz suggests, the right micro foundations.

    8. Things are harder on the policy front. Given we don’t quite know how to use the new tools and they can be misused, how should policymakers proceed? While we have a good sense of where we want to get to, a step-by-step approach is probably the way to go.

  • Take inflation targeting. We can’t, from one day to the next, just give it up and have, say, a system with five targets and seven instruments. We don’t know how to do it and it would be unwise. We can, however, introduce gradually some macro-prudential tools, testing the water to see how they work.
  • Increasing the role of Special Drawing Rights (SDRs) in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in private SDR bonds to exploring the possibility for the IMF to issue SDR bonds to the private sector and then, if feasible, issuing them to mobilise funds in times of systemic crisis.
  • Pragmatism is of the essence. This was a general theme that came up, for example, in Andrew Sheng’s discussion of the adaptive Chinese growth model. We have to try things carefully and see how they work.
  • 9. We have to keep our hopes in check. There are going to be new crises that we have not anticipated. And, despite our best efforts, we could have old-type crises again. That was a theme in Adair Turner’s discussion of credit cycles. Can we, using agency theory and the right regulations, get rid of credit cycles? Or is it basic human nature that, no matter what we do, they will come back in some form?

    I was asked whether the conference was “Washington Consensus 2“. It was not intended to be, and it was not. The conference was the beginning of a conversation, the beginning of an exploration, and we look forward to your contributions.

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