Kick-starting growth

Inflation in the UK has dipped below the Bank of England’s target of 2 per cent in only 9 of the 78 months since 2007. In that time it has registered its 33 highest monthly values since 1993 and commentators have been quick to accuse the Bank of abandoning its target. Yet this focus on inflation has masked the real failure of recent monetary policy, which is the prolonged stagnation of the UK economy.

Most of the high inflation is explained by temporary blips in oil prices, food prices, and VAT, which have created a perfect storm for the Bank. Yet these blips have not fed through into domestic inflation, which has remained subdued. In fact British wages have been falling, which points to a bigger problem lurking behind the paper tiger of high consumer prices.

The real concern is that the UK economy is moribund: annual growth has averaged less than 1 per cent since 2009 and GDP is still 3.6 per cent below its 2008 peak. With unemployment 50 per cent above its 2007 level and wages falling, the Bank must do more to pick up the slack in the economy. As Milton Friedman said, the goal of monetary policy should be “a reasonably stable economy in the short run and a reasonably stable price level in the long run.” In the UK it has failed the first of those tests.

The Office for Budget Responsibility’s estimates of the shortfall to the UK’s economic potential imply a cost of over £7,500 per person from the recession so far. Every year that the UK remains below its economic potential costs each British worker £1,500 per person. To improve the situation George Osborne has asked for “active monetary policy” and appointed Mark Carney as the new Governor of the Bank of England.

Osborne is right to ask monetary policy to do more to remedy the persistent lack of growth and high unemployment. Continued inaction risks embedding low growth and causing long-run economic damage. The risk is that he has not provided the Governor with the tools to make a real difference. Closing the shortfall in growth, relative to potential, requires a commitment by the Bank of England that changes expectations about the future. As the USA’s recovery from the Great Depression in the 1930s and Japan’s budding upturn in 2013 show, a credible commitment from the central bank, with the Government’s backing, can revive an economy wallowing in the doldrums. Japan’s “Abenomics” has generated a 60 per cent rise in the stock market and GDP growth of 4.1 per cent since being announced in November 2012. Importantly, it has been achieved after two decades of stagnation.

HM Treasury reviewed the current policy regime alongside the 2013 Budget to pave the way for the Governor’s arrival. They cautiously stuck with the current inflation target but urged the Bank to make use of forward guidance. This would involve the Bank publicly committing itself to a particular course of action, as the Bank of Canada did in 2009 under Mark Carney’s leadership. The Bank’s commitment would allow people to act with more certainty about future economic conditions, which would boost confidence and generate growth.

Implemented effectively, forward guidance could help the UK by raising expectations of future growth, as they have in Japan. But “cheap talk” will not be enough: a firm, credible rule that changes the course of Bank policy is required. The lack of a credible commitment is one reason why QE has yet to turn the economy around. The Bank could thus use nominal output as an intermediate target to guide their decisions. A commitment to ensuring nominal output growth of 5 per cent each year would ease policy and spur growth in the short run but it would also be consistent with the 2 per cent inflation target, which ensures that it is credible in the long-run and does not jeopardise price stability.

However, despite these possibilities, it is possible that the Governor’s best efforts will prove insufficient, given the constraints of the current inflation target. He might be unable to persuade the Bank to implement effective forward guidance, or guidance might turn out to be insufficient to change expectations and turn the economy around. In either case the Chancellor should be prepared to stand behind the Bank and review the policy target again to explicitly include growth. As the former Monetary Policy Committee member, Adam Posen, has said “…policymakers should not settle for weak growth out of misplaced fear of inflation.”