Governor has given the green light with continued low interest rates, but markets, inflation or a housing bubble bring caution
Larry Elliott, economics editor
The Guardian, Wednesday 7 August 2013 14.25 BST
Mark Carney, governor of the Bank of England at the quarterly inflation report.
Get out there and spend. Feel free to take the plunge and buy that house. Go ahead with plans for new investment mothballed since the recession.
That, in short, was the message from the Bank of England to consumers, property hunters and entrepreneurs on Wednesday. Why? Because unless something unexpected happens, official interest rates are staying where they have been since early 2009 until 2016 at the earliest.
Such a long period of cheap money would be unprecedented. The Bank of England has never had interest rates this low in its 319-year history and is on course to keep them pegged at 0.5% for longer than it took the allies to win the second world war, longer than the French Revolution between the storming of the Bastille and the topping of Robespierre, and longer than it took the Beatles to record everything from Love Me Do to Abbey Road.
Quite a period, and evidence of just how fragile Threadneedle Street thinks the economy remains following the deepest recession and the slowest recovery in recorded history.
The financial crisis has left deep scars on the UK. This was an economy, after all, which became chronically dependent on the casino activities of the City and an over-heated property market. Matters have been made worse by the debt crisis in the eurozone, which has hit exports, and by the government’s deficit reduction plan.
That has left the Bank of England with responsibility for keeping the economy going and, fearful that recent signs of green shoots could be nipped in the bud by unwarranted suspicion that it would soon tighten policy, the Bank provided guidance on how it intends to play things.
Monetary policy is now unashamedly pro-growth and deep into uncharted waters. It has raised the inflation target to 2.5% in all but name and is effectively operating the sort of twin mandate system used by the US Federal Reserve in which growth and price stability carry equal weight.
Having experimented with quantitative easing, the Bank is now trying forward guidance: sending messages out about how it intends to conduct policy in the future. Unemployment as measured by the internationally agreed labour force survey measure of joblessness, will have to come to 7% before the monetary policy committee will even consider raising interest rates or starting to sell back to the financial markets the £375bn of government bonds it has bought under the QE scheme.
Unemployment on the LFS measure is currently 7.8%, and according to the Bank’s forecasts will not hit 7% until 2016. Conveniently for George Osborne, that means well after the next general election. Carney was hand-picked by Osborne to replace Mervyn King and the chancellor must have been well pleased with his first big public outing.
The new governor made it clear that he considered the strong data in recent weeks no big deal: “There is understandable relief that the UK economy has begun growing again. But there should be little satisfaction.”
Even after raising its forecast for growth this year to 1.4% (from 1.2%) and to about 2.5% next year, the outlook is for weak post-recession expansion by historic standards.
The MPC wants to see this recovery fully embedded and believes that there is plenty of scope for expansion while keeping inflation to 2%. But the plan to keep monetary policy ultra-loose is not a hard-and-fast promise and there are three circumstances (or knockouts) in which the MPC would consider action before the 7% threshold is reached.
The first would be if inflation 18-24 months ahead was expected to be more than 0.5 percentage points above its 2% target.
This, though, is much less of a “knockout” than it looks. The Bank invariably says inflation will be back to 2% within two years, and did so even when it was running above 5%.
The second knockout – that action would be contemplated if medium-term inflation expectations slip their anchor – is also a bit fuzzy since it will depend on the subjective judgment of the MPC.
Finally, the MPC would rethink its policy stance if it thought an abundance of cheap credit was fuelling an asset-price boom that could not be controlled by the bodies charged with regulating the City – the financial policy committee and the Prudential Regulation Authority. Even so, it would probably want to see whether imposing specific capital requirements for lending to certain sectors of the economy (such as real estate) would work first.
So, in reality policy is not going to change anytime soon, despite the risks.
The Bank believes there is plenty of spare capacity in the economy following the slump but it doesn’t know exactly how much. If there is less than it thinks, faster growth will quickly feed through into higher inflation. Nor does it really know whether there is a stable relationship between inflation and unemployment in the UK, in the way there appears to be in the US.
Nor can it confidently predict how the financial markets will respond to the news that monetary policy will remain unchanged for another three years at a time when other central banks – the US Federal Reserve for example – will be tightening. Sterling looks vulnerable to a tumble on the foreign exchanges, thereby stoking imported inflation.
Finally, there is the risk that when policy is tightened it will need to be tightened aggressively. Britain’s predilection for booms and busts in the past 40 years means that a good, old-fashioned housing bubble, with its attendant balance of payments deficits, cannot be ruled out.
The Bank, though, considers this to be a risk worth running. It has plenty of experience of recessions caused by over-heating and knows how to deal with them. But the slump of 2007-09 was different. Normal policy tools weren’t effective in a downturn caused by global financial systems failure. That’s why exceptional measures were deemed necessary. And are still deemed necessary, whatever the side effects may prove to be.