Why, after throwing everything bar the kitchen sink at the economy over the past few years, has the economy started to grow only now? Even more importantly, will the recovery last? Having seen a few false dawns over recent years, has the recovery really taken hold this time? And what does all this mean for monetary policy?
Last month in an
address before the Confederation of British Industry (CBI) East of England Midwinter Lunch, Spencer Dale, Executive Director for Monetary Policy and Chief Economist at the Bank of England, touched on three questions about the economic recovery that we would all like to have answered: "why now, will it last, and what next for policy?"
Why Now?
In answer to the first question, Dale believes the time is right for recovery (in the UK in particular) because of an easing in credit conditions and a reduction in economic uncertainty. Of the two factors, Dale credits overall reduced economic uncertainty, rather than than the availability of credit, as the greater factor in the economic rebound this year. While admitting that "reduced uncertainty" is a rather nebulous factor, he reminds us how paralyzing fear and uncertainty can be to firms and can act as an effective brake on economic growth and should not be underestimated.
To some, appealing to “reduced uncertainty” as a driver of the economic recovery may sound rather vague and nebulous. A convenient ex post rationalisation perhaps for something we don’t really understand.
But it seems clear to me that uncertainty and fear greatly amplified the initial impact of the financial crisis. How else, for example, can we explain the speed with which a failure of a US investment bank in September 2008 led to output and orders up and down our country, and indeed around the world, “falling off a cliff” within a matter of months?3
More generally, speaking to companies over recent years, I’ve been left in no doubt that heightened uncertainty has served as a significant brake on their activity and plans for expansion.
Reduced tensions in the Euro-zone and a UK focus on shoring up credit markets have given consumers freer access to credit and eased the liquidity stresses on financial institutions. This has helped breathe life into housing transactions and mortgage approvals, and house prices have picked up. A healthy housing market is a good sign for the continuing health of the recovery.
A healthy housing market is good for our economy and will help to support the recovery. Most importantly, it will underpin further increases in house building, which has played an important role in driving the economic growth we’ve enjoyed this year and which, as a nation, we need to see. It will foster greater labour mobility by allowing people to move more easily to where new jobs are being created. It will help to support consumer confidence.
Though well aware of the mercurial nature of the UK housing market, Dale believes that the UK financial system is now better equipped to deal with the peaks and valleys of this important sector.
The good news, however, is that it’s far better equipped to respond to these types of risks than in the past. In particular, the new Financial Policy Committee (FPC) – the sister Committee to the MPC – has explicit responsibility for maintaining the resilience of the financial system. And, together with the other regulatory bodies, the FPC has the policy instruments which can address potential excesses in the housing market – and in other markets – which pose a threat to the stability of the financial system.
All in all, these are sound conditions for an economy on the rebound.
Will It Last?
According to Mr. Dale, these two signs of recovery, reduced uncertainty and freer credit, have begun to release some pent-up demand to fuel the nascent recovery. He believes that the recovery will last if reduced uncertainty moves beyond consumer confidence to producer confidence, driving a supply side recovery.
Movements in uncertainty can amplify the recovery just as they amplified the downturn.
This virtuous circle may be enhanced by the benefits reduced uncertainty can have for the supply-side of our economy. Increased investment will add to our productive capacity. A strengthening labour market may give employees confidence to move jobs, so better aligning available skills with vacancies. Companies may lift the shutters and start to take the types of risks and entrepreneurial activities necessary for our long-run prosperity.8 Such improvements in the supply performance of our economy would greatly enhance the durability of the recovery.
What Next for Policy?
Provided Mr. Dale is correct about the recovery, he sees the biggest challenge for central banks to be balancing monetary policy supporting the recovery against bringing inflation back on target.
But we have also needed to trade off the speed with which we bring inflation back to target against the support that monetary policy can provide to the recovery. The MPC’s forward guidance gives greater clarity about our view of the appropriate trade-off.
More important for us today, our guidance is rooted in the recognition that it’s a long way back to the economy being fully recovered. The damage and losses associated with the financial crisis and the years of frustration and disappointment that followed won’t be reversed simply by one or two quarters of strong growth. Our guidance makes clear that we intend to maintain the current exceptionally stimulative stance of monetary policy until we’ve seen a sustained period of strong growth and the margin of slack in the economy has narrowed significantly, as long as this does not pose risks to either price or financial stability.
To this end, Mr. Dale said that the Bank of England expects to keep interest rates low until the recovery has fully bloomed.
The MPC intends not to raise Bank Rate or reduce the stock of asset purchases at least until the unemployment rate reaches a threshold of 7%, subject to three knockouts designed to guard against risks to price and financial stability.
But abstracting from the details of these thresholds and knockouts, our message to you – the businessmen and women driving this recovery – is clear. You can plan for the future in the knowledge that the MPC intends to keep interest rates low until we have seen a prolonged period of strong growth, unemployment is significantly lower, real incomes are higher.
According to Mr. Dale, we should all expect interest rates to rise again someday. But we should not dread that day, because according to Dale, that will be a sign that we have turned the corner on the recovery.
The MPC is fully aware that extraordinary low interest rates are likely to be needed for some time yet. But when they cease to be, this will be a sign that we have finally turned the corner for home.