A surprise improvement in the rate of growth followed the UK Government’s austerity measures – so which way will the Bank of England turn this week?
Meetings of the Bank of England’s Monetary Policy Committee (MPC) can be dull affairs. Members discuss developments in the financial markets, the state of the international economy, money supply, demand, output and costs. The talk is of asset purchases, equity prices, exchange rates and the dollar index. But its purpose is clear; to control inflation (its target for the consumer price index is 2 per cent). And the mechanism by which it seeks to achieve this is simple; the Bank Rate, the rate of interest which a central bank charges on loans and advances to commercial banks and other financial intermediaries.
A creation of the 1997 Labour Government, the MPC is, according to Mervyn King, the Governor of the Bank of England, an important social institution that represents a collective agreement “about how to constrain our actions”. At a lecture in St Bryce Kirk, Kirkcaldy, in 2006, on the eve of the issue of a £20 note portraying Adam Smith, King observed that there was no enduring way of enforcing that commitment; constitutions can be rewritten, revolutions can occur, he said. “But we can try to find ways of making it more or less credible that we will, collectively, act in a way that is conducive to our long-run prosperity.” This Thursday, the MPC meets for its regular monthly meeting and it might be livelier than usual. For the past two years, its policy has been consistent; keep the Bank Rate low and feed money into the economy, so-called quantitative easing. Although the money tap was turned off last February, the interest rate has been kept low as part of a strategy of encouraging investment and spending back to the UK economy. At last month’s meeting, King invited the nine-member committee to vote on the proposition that the Bank Rate should be maintained at 0.5 per cent and that the Bank of England should maintain the stock of asset purchases financed by issuing central bank reserves – the quantitative easing – at £200bn.
Seven of the committee agreed, but two took diametrically opposed views. Adam Posen, an American economist and expert on Japan’s economic woes, said the interest rate should remain at 0.5 per cent and that the asset purchase scheme should be increased by £50bn. There was a strong case, said Posen, for ramping up quantitative easing to avoid a prolonged Japan-style downturn. But Andrew Sentence, a parttime Professor of Sustainable Business at the University of Warwick, said that asset purchases should remain capped at £200bn and that the interest rate should be increased to 0.75 per cent.
In a speech after the meeting, Sentence argued: “In the years ahead, we will see much tighter restraint of public spending as the large deficit which built up over the recession is reined in. That process of deficit reduction is necessary to ensure longer-term confidence in the future stability of the economy – in financial markets and more generally. In this environment, it is the private sector which will be the engine of growth for the UK economy – just as it was in the 1990s recovery and the previous recoveries we have experienced here in the UK. Confidence that inflation is being kept under control is a key factor in sustaining that private sector engine of growth.
“My view remains that we should be starting now to make a gradual adjustment of monetary policy. The improvement we have seen in the economy over the last year and the above-target inflation we have experienced point to the need to begin the process of withdrawing the very substantial level of monetary stimulus which was put in place to counter the big financial shocks we experienced in late 2008 and early 2009.
“Such a policy should not be a threat to the recovery. In my view, it is the key to sustaining the recovery. It is the right response to an economy which is growing but experiencing persistent above-target inflation. It would reduce the risk of a future shock to confidence if current above-target inflation does become more deeply embedded and interest rates then need to rise more sharply to combat it. And it would provide more confidence to the public and the business community that the MPC takes its remit seriously and is determined to ensure that this recovery is built on the solid foundation of price stability.” A close reading of the minutes of the MPC’s meeting reveals that although the committee agreed to the interest rate and quantitative easing remaining unchanged, the sentiment appeared to be siding with Posen. “Most members felt that the balance of risks had not altered sufficiently to warrant a change in the policy stance at this meeting.
On the one hand, they continued to believe that the economy contained a considerable margin of spare capacity and, therefore, that demand could expand significantly before widespread capacity constraints put upward pressure on inflation.” The members did worry about inflation: “On the other hand, there were concerns about the risks to inflation expectations from the persistent and prospective above-target inflation outturns. The risks to inflation in either direction remained great, and these members stood ready to alter the policy stance in either direction as the balance of risks became more decisively tilted in one direction or the other.” But the possibility of further quantitative easing existed: “Some of those members felt the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months. But, for them, the evidence was not sufficiently compelling to imply that such a course of action was necessary at present.” At the time, economists said the Government’s impending Comprehensive Spending Review was likely to push the MPC toward further quantitative easing at some point. But what will the committee think now? Last Tuesday, the Office for National Statistics released figures showing that Britain’s economy grew more quickly than expected during the third quarter. The news eased concerns that it could tip back into recession and has, for the time being, buttressed the Government’s policy of reducing the country’s huge deficit through the deepest public-spending cuts since the Second World War. The same day, the ratings agency Standard & Poor’s raised its outlook on the UK economy and upheld the UK’s triple A credit status (see Beyond the headlines, page 64).
The conversation between Adam Posen and Andrew Sentence at this week’s MPC meeting promises to be interesting.
But are the signs of recovery illusory and where does Scotland stand as the Scottish Government prepares to publish its Budget later this month? According to Roger Bootle, economic adviser to Deloitte, the recovery will remain “sluggish.” Bootle, a specialist adviser to the House of Commons Treasury Committee and Visiting Professor at Manchester Business School, said that the private sector was in a relatively good position to withstand the fiscal squeeze. “Profitability has held up well during the recession and business insolvencies have been low,” he said.
“The corporate sector’s balance sheet is less stretched than those of the household and public sectors. The recent rise in business investment is certainly encouraging. And measures of investment intentions point to further increases to come.” As the public sector retreats, a wealth of opportunities for the private sector should emerge, he added.
“But there are all sorts of other ways in which companies will be affected by the fiscal squeeze. Most obviously, those private sector companies which supply goods and services directly to the public sector are set to suffer from the retrenchment in the Government’s procurement spending.
“Any other effects which hit the general level of demand in the economy will also hit companies. In particular, the major squeeze on households’ disposable income from tax rises, the public sector pay freeze and job cuts will clearly hit the revenues of those firms connected to the consumer and retail sectors.
What’s more, those companies geared towards overseas markets may suffer from the similar effects of fiscal squeezes abroad.
“It seems unlikely that the corporate sector will be able to offset the weakness in the rest of the economy, especially when a weak global recovery is set to prevent exports from taking full advantage of their increased competitiveness. The economic recovery is set to remain sluggish at best. After GDP growth of around 1.5 per cent this year, I now expect growth to slow to just 1 per cent next year. What’s more, the risk of a full blown double dip has certainly not disappeared.” Bootle’s view compounds Scotland’s gloom in the wake of Chancellor George Osbourne’s spending announcement. The Scottish Budget cut of £1.3bn in 2011-12 is 4.2 per cent, almost double Osborne’s overall cut of 2.2 per cent. Finance Secretary John Swinney has to contend not only with Osbourne’s cuts but also the cut for 2010-11 that the Scottish Government delayed implementing.
The SNP has ruled out the kind of savings being made in England and actually faces increased spending commitments, such as free prescriptions, from next April.
John McLaren, a senior researcher at the Centre for Public Policy for Regions, believes that the Scottish Government has little room for manoeuvre. Commitments to spending in health, education and on large infrastructure projects, the retention of Scottish Water in the public sector and a pledge to continue the council tax freeze are major factors. With rising pressures on social services, cuts in the non-schools local government budget would be difficult and a promise to maintain police numbers limits scope in justice. The enterprise budget is relatively small and to cut that would be counterintuitive.
McLaren argues that there should be a public sector pay freeze, including in the NHS. The Government could also raise revenues, if not via council tax then through business rates or even the temporary implementation of its unused income tax-varying power. It should retreat from the universal provision of free or subsidised services to more targeted ones. He also advocates doing a deal with the Treasury to allow for the cuts to be implemented more gradually over the next four years.
“The Scottish Parliament is facing a genuine crisis. It needs to agree a new budget for 2011-12 quickly, in order to allow those in the public, the private and the third sectors who have to implement major changes in the next three to six months to do so in a planned manner. Thus far there has been little or no co-operation in striving to reach any sort of consensus. The blame game continues.
“But in a Parliament that is voted in by a proportional representation system, no one party is ever likely to be able to have its own way. At some point, compromises need to be made. If the political parties in Scotland remain stubbornly resistant to genuine negotiation simply because they think it will aid them at the ballot box next May, the Parliament’s reputation will suffer. But even more importantly, Scotland will suffer as such a zombie Parliament commits us to enter a new financial year being run on the basis of a month-by-month crisis budget.”