The Bank of England and Treasury face a hard task in reining in inflation while not damaging economic growth
Since the “great recession” began in early 2008, there have been two chancellors of the exchequer and 14 members of the Bank of England’s monetary policy committee. Between them they have borrowed in excess of £500bn, pumped £325bn into the economy through quantitative easing, and pegged the bank rate at an all-time low of 0.5%.
As we discovered last week, the upshot of this stimulus is an economy in double-dip recession, with output 4% below its 2008 peak and a staggering 14% shy of where it would have been had growth continued at its long-term annual trend of 2.5% over the past four years. Truly, never was so much done by so few for so little.
The International Monetary Fund wants the Bank of England to shave borrowing costs even closer to zero and to crank up the electronic printing presses again. If that doesn’t work and the economy continues to tank, the IMF would support easier fiscal policy through temporary tax cuts and public works.
This is not a happy state of affairs. By this stage in previous economic recoveries, even in the 1930s, the economy was growing briskly. Yet today policy seems curiously ineffective. To make matters worse, sluggish growth has been accompanied by levels of inflation that are high for an economy that has been flatlining for 18 months.
The “stickiness” of inflation has prompted a vigorous debate among economists about just how much of the output lost over the last four years will ever be made up. If gross domestic product is now 14% below where it would have been had it continued merrily on its long-term trend, then is it not possible to have several years of rapid growth, of say 5% per annum, to get us back to where we would have been?
It’s not quite as simple as that, for two reasons. First, the economy might have been operating at above full capacity when the recession began. Second, it is possible that the recession has caused permanent damage to the economy that has affected its growth potential.
On the most pessimistic assumptions, the output gap – the difference between where the economy is now and where it could be if the spare capacity were utilised – is not 14%, but about 2%.
Estimates of the output gap matter because they affect the way the Bank and the Treasury set policy. A small gap would mean that even a relatively modest pick-up in growth would quickly see the economy run up against supply constraints, which would be reflected in rising inflationary pressure.
The monetary policy committee (MPC) would need to be cautious about providing further stimulus and ought to be alert to the possibility that it might need to start tightening policy. The Treasury would have to assume that most of the UK’s 8% budget deficit would be eliminated only by higher taxes and lower spending levels. It will therefore look askance at suggestions that it should let up on austerity.
The problem is that no one really knows how much spare capacity there is, so calibrating the size of the output gap is educated guesswork. That much was clear from a speech (http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech576.pdf) made last week by David Miles (the one member of the MPC currently voting in favour of more quantitative easing) in which he admitted that it was difficult to assess the amount of spare capacity.
Miles said higher than expected inflation had forced him to conclude there was less slack in the economy than he previously thought, but he still said it was right for the Bank to adopt an ultra-expansionary stance.
Why? Well, Miles also believes that inflation is relatively unresponsive to action from the Bank. It would, he says, require quite aggressive tightening to get inflation back to its 2% target quickly and, conversely, it would take a lot of easing to push inflation higher.
Like the eight other members of the MPC, Miles is uncomfortable with inflation having been above target for so long. “But that doesn’t mean that bringing inflation back to target very rapidly is the best thing to do. In a situation where weak demand is likely to be having a negative impact upon productive capacity, the cost of having a tighter monetary policy to bring inflation back to target fast will be some lasting damage to incomes.”
The message from Miles’s speech is that he will continue voting for more quantitative easing. Judging by what’s happening in the eurozone and the weakness of domestic activity, it seems a fair bet that other MPC members will come round to his view; the minutes of the May MPC meeting show several were close to backing more stimulus. But any moves are likely to be relatively modest and will rely on inflation continuing to be well behaved.
This softly, softly approach is fine provided the amount of spare capacity in the economy is small. If the output gap is actually a lot bigger than the supply-side pessimists are assuming, there is a danger that over-restrictive policies could produce a vicious spiral, where weak demand leads to weaker confidence and a reduction in supply.
That is the argument made by Bill Martin and Bob Rowthorn, from the Centre for Business Research at Cambridge University, in their updated research on whether the UK is supply-constrained. They are sceptical of the idea that Britain has lost so much growth potential in such a short time.
“The scale of the imagined capacity shortfall is remarkable,” they say. “The loss would put it on the same footing as a major natural disaster.”
Drilling down into the economy, the study (http://www.cbr.cam.ac.uk/)finds no evidence that the recession has been particularly brutal on the hi-tech, high-productivity sectors. It also says it is implausible that lower business investment could have caused such widespread capacity damage in such a short time.
As for the alleged impact of the recession on skills, Martin and Rowthorn note that on-the-job training has actually recovered since the depths of the slump. The impact of tight credit conditions on innovation among small and medium sized companies is overstated, since they account for only 3.5% of business R&D spending.
One counter to the pair’s critique is that the recession exposed the long-hidden dark underbelly of the economy. Another might be that there is plenty of spare capacity, but in sectors such as retailing, which do not need it, rather than in manufacturing.
The message is a sobering one that should be carefully considered by the Bank and Treasury. It is that Britain has yet to suffer the sort of large impairment to its potential growth feared by the pessimists, but could easily suffer it if it goes on facing demand deficiency.