Sunday, November 15, 2009
Bank says let's party like it's 1994 again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Life is full of mysteries. This week's is how to square the Bank of England's upbeat forecast for the economy a few days ago with governor Mervyn King's relentlessly downbeat tone in presenting it.

Though the Bank is enough of a tease not to give us precise numbers, a reading of its charts suggest its new forecasts are for growth of a little over 2% next year, rising to 4% in 2011.

The Treasury is in the process of putting together a new compilation of independent forecasts but its last set suggested a consensus prediction of 1.2% growth in 2010, rising to 1.9% in 2011.

The Bank is twice as optimistic as the consensus, so why the gloomy governor? One possibility is that he was a bit under the weather, the evidence for which is that a pink-jacketed flunky brought in a warming cup of something to get him through Wednesday's press conference. The pink jacket, by the way, is a 300-year old tradition and nothing to do with Sir Elton John.

The second possibility is that although King presented the forecast, he does not believe it. The inflation report forecast is, however, the judgment of the monetary policy committee (MPC) and he said differences between members were small.

Anyway, let me try to offer a guide as to how the Bank got to such an optimistic forecast, whether it is credible and what it may mean for interest rates.

The Bank expects a return to growth because of the combination of record low interest rates, the fall in the pound and 200 billion of quantitative easing. That is an unprecedented monetary relaxation. Combine it with a return to global growth next year the International Monetary Fund expects more than 3% and you have all the ingredients for a UK upturn.

The Bank acknowledges that there are factors that will hold down growth during the recovery period. It expects credit conditions to remain tight, knows that tax increases and public-spending cuts will squeeze incomes and activity, and thinks households and companies will be engaged in a period of "balance sheet adjustment" putting their financial houses in order which will restrain spending.

Those headwinds are quite powerful, so how does the Bank come up with such an optimistic forecast? Part of the answer is that most economic models, including the Bank's, are not good at allowing for some of the factors, particularly credit growth, that could keep growth weak.

The way these models work is that if there is spare capacity in the economy after a recession, in the jargon an "output gap", it will tend to be closed quite quickly. There are no bottlenecks, such as problems with getting hold of new workers, to get in the way. So faster-than-normal growth during recoveries is to be expected.

That is the theory, and the way the models churn out the numbers. What about the practice? Is it remotely possible that an economy emerging from a nasty recession in which asset prices have fallen sharply, the banks are carrying lots of bad loans, taxes are going up and public spending is being squeezed can grow by 4%?

Well, yes. This is exactly what happened in 1994. The economy emerged from the last recession in 1992, grew by 2.2% in 1993 and then by 4.2% in 1994, in the nearest thing we have seen to an export-led recovery in modern times. Then, as now, sterling had fallen sharply.

You may say that this time it is different, but one thing we have learnt in the past two to three years is that things are often not as different as all that. Economic history has a habit of repeating itself, both good and bad.

One area where things have been a little different is the job market. I have commented before on the flexibility of the labour market and how this has limited the peak-to-trough fall in employment to less than 2%, compared with a 6% fall in gross domestic product. The latest Labour Force Survey figures show that employment rose, albeit by a modest 6,000, in the third quarter and unemployment fell, if only marginally, in August and September. After confident predictions for the past three months that unemployment would rise above 2.5m, it remains below it.

We probably have not seen the peak in unemployment. The Bank warns that there may be job losses in the pipeline because the redundancy process takes time. It could be that when temporary assistance runs out, like the willingness of Her Majesty's Revenue & Customs to defer some business tax payments, there will be another wave of job losses.

Even so, the figures are inconsistent with the idea that the economy remains mired in recession. Without wanting to sound like a broken record, I think we have been recovering for four to five months, if not longer, and that in the fullness of time the figures will show this to be the case.

Let us assume that the Bank is right and that in 2011 we can party like it is 1994 all over again. What would that mean for interest rates?

King's insistence that it was wrong to assume the Bank had finished loosening policy (by which he means there could be more quantitative easing, not rate cuts), means it is much too soon to think about a tightening of policy.

Some in the City were thinking about the first rate rise happening as early as February but that looks highly unlikely. A big decision like this will probably require the backing of a new inflation forecast, and my judgment would be that the earliest we can expect even a modest upward tweak in interest rates is August.

That is in spite of the fact that the Bank has warned of a sharp rise in inflation over the next few months as the helpful effects of a year ago drop out.

Rate hikes could gather pace in 2011, if the economy indeed achieves 4% growth, but the Bank's hands will be tied by the fiscal tightening tax rises and spending cuts then occurring.

These things change and can change quickly, but my sense is that the MPC recognises that nursing the economy and the banking system back to health will require a long period of very low rates.

The interest-rate assumption used in preparing the Bank's latest forecast was that rates rise to about 1.5% by the end of next year, 3.25% in two years' time and 4% by late 2012. I would be inclined to bet that they stay somewhat lower than that.

PS: Has Lord Mandelson's car scrappage scheme been the most successful incentive measure ever? Despite scepticism, the scheme offering 2,000 trade-ins for cars more than 10 years old (the government contributes 1,000) has worked well since being introduced in May.

Estimates by the Bank suggest Britain's scrappage scheme has resulted in a 52% rise in car registrations, above Germany, 40%, America, 32%, or France, 9%. The cost of the UK scheme, 400m, was similar, relative to the size of the economy, to the ones in France and America but only a seventh the size of Germany's.

Why has scrappage worked? Some in the car trade argued that buyers would have been better off driving their old banger into the nearest canal, then bargaining for a discount as a cash buyer.

At the risk of sounding trendy, this might be one of those "nudge" type policies favoured by behavioural economists such as Richard Thaler. Scrappage schemes nudge owners of old cars into buying new by making them aware they could do it and that plenty of others were doing so while taking bangers off their hands. Clever. There must be other applications of the principle.

From The Sunday Times, November 15 2009