Sunday, September 27, 2015
Bank frets that is has run out of ammunition
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

The economic news is generally good, particularly in Britain. Growth has decent momentum, zero inflation is bringing strong gains in real wages, business investment is rising, and consumer and business confidence are high. There are even signs of a productivity revival.

Not only that but this week official figures will show that the recovery was stronger than initially thought, as is often the case. The Office for National Statistics (ONS) will revise growth in 2011 up from 1.6% to 2%, 2012 up from 0.7% to 1.2% and 2013 from 1.7% to 2.2%. The 3% growth number for 2014 will probably stay the same.

These revisions will be a reminder that conclusions drawn about the state of the economy on early ONS data are often misleading. Britain was never “flatlining” during the last parliament. Average growth over 2011-14 was more than 2% a year. Quarterly growth on the new figures was stronger on a number of occasions than in the second quarter of 2010, when the coalition took over and before most deficit-reduction measures were introduced.

I’ll return briefly to those revisions in a moment. The point about the generally good news about Britain’s economy is that it stands in sharp contrast to the fears stalking the world’s stock markets. The Greek crisis gave way to worries about China, which continue. There are now concerns that the Volkswagen scandal could drag down Germany. In a world of worry, it never rains but it pours.

My view is that most of this is overdone. Greece was about as messy as it could have been, given the Syriza government’s hamfisted brinkmanship. But the crisis is now on the backburner. Reaction to China’s necessary slowdown has been overdone.

Willem Buiter, the former Bank of England monetary policy committee member who is now global chief economist at Citigroup, recently generated headlines by warning that China could drag the world into a new recession. Yet Citigroup’s new forecasts for global growth, published a couple of days ago, show a relatively small downgrade compared with what it expected in the spring: growth over the next four years will average 3.2% rather than 3.5% a year. It also expects China to grow by between 6% and 7% a year. Britain, by the way, is predicted to grow by an average of 2.8% a year.

The circle is squared by Citigroup’s belief that Chinese growth is significantly overstated by official figures, so 6% to 7% growth is actually 4%. Adjust for that and global growth next year could be only 2.5%, the firm says, with a 40% chance that it drops to 2%; the usual definition of a world recession (at least until the much bigger one we experienced in 2008-9). We shall see.

As for Germany, while it is tempting to see the VW scandal as the Federal Republic’s Northern Rock moment, or its Libor, or even its version of the financial crisis, that looks like a gross exaggeration. Holger Schmeiding, chief economist at Berenberg Bank, points out that the car industry only accounts for 2.7% of German gross domestic product. “Even a heavy drop in diesel car production and exports would probably not subtract more than 0.2% from German GDP,” he says.

The worries and warnings are not confined to stock market investors. Central bankers, and those who hang on their every word and deed, are also fretting. When the Federal Reserve passed up on the opportunity to raise interest rates 10 days ago, saying “recent global economic and financial developments may restrain economic activity somewhat”, it underlined the difficulty central banks have had in escaping from the so-called zero bound.

More than six years on from the trough of the 2008-9 global recession, no major advanced-economy central bank has raised interest rates and kept them up. Some of the smaller ones, like the Swedish Riksbank were forced to reverse dramatically post-crisis rate hikes. Its main interest rate is negative, -0.35%.

The Fed’s non-hike has pushed out market expectations of the first rate hike in Britain until well into next year, a shift more or less endorsed by Ben Broadbent, the Bank’s deputy governor for monetary policy, who said in an interview with Reuters that the reaction of the markets was “entirely predictable”.

The trouble with interest rates is that there is never a good time to raise them. In the very many years I have been covering these things the number of times when a rate hike has not been met with at least some howls of protest and dire warnings of the damage it would do. The fact that rates have been near-zero for so long means there is now a powerful air of permanence about it.

This, in turn, means that when the downturn does come, central banks will have much less ammunition to fight it than usual. As Andy Haldane, the Bank’s chief economist, pointed out in a recent speech, the average loosening cycle – the amount rates have been cut – has been five percentage points since 1970 and nearly three points even in the period of generally lower rates since the mid-1990s. If you start at 0.5%, achieving anything like that is impossible without moving to what I would regard as unfeasibly negative interest rates.

Similarly, if the Bank goes into the next downturn with £375bn of assets purchased under quantitative easing still sitting on the its books, there is at least some constraint on its ability to do more. "Helicopter" money - the Bank creating money to hand ouit to households - would be a dangerous step on a slippery slope.

There is, as I say, never a good or popular time to raise rates. Had the Bank known for certain that the economy was stronger than it thought, maybe it would have happened some time ago. Had Mark Carney stuck to his summer 2013 forward guidance, and rates had begun to rise when the unemployment rate fell to 7%, we would be now be a few notches above 0.5%. I suspect, however, that the governor was more interested in giving people and businesses reassurance that rates would not go up for some considerable time (in 2013 the Bank did not expect 7% unemployment until 2016) than pinning the decision on a specific number.

There is a lesson here from fiscal policy. Though it would have been easier to postpone tough fiscal decisions until later, and though the latest figures were a touch disappointing, George Osborne’s actions in reducing the budget deficit mean that there is a decent chance that it will have been eliminated by the time of the next downturn. That, in turn, will allow for the possibility of a temporary fiscal stimulus – tax cuts and spending increases – as happened in 2008-9.

Unless the Bank and other central banks give themselves more room to cut interest rates and if necessary embark on a new round of quantitative easing – by reversing some or all of what they did in response to the crisis – fiscal policy will be on its own. Central banks would be spectators, out of ammunition when the battle begins. No wonder they are fretting.