EEF blog

So today's GDP estimate of 0.5% growth in the first quarter was, well, expected.

To certain degree, it won't set hearts and minds racing about the strength of the recovery. Nor will it send the markets to panic stations about a double dip.

Manufacturing remains the strong point of the recovery, with 1.1% growth in the first quarter. The service sector rebounded from the snow by growing by 0.9%.

But while we've avoided a return to recession, 0.5% growth won't settle nerves about the rest of 2011. As Joe Grice, Chief Economist at the Office for National Statistics says:

"Abstracting from the snow, we have an economy on a plateau."

Worryingly for the economy, that's plateau, as in stagnant growth...as in stagflation. The Monetary Policy Committee may feel justified in its stance on holding tight on interest rates, but it will worry about the underlying health of the economy: strong service sector growth in q1 is likely a rebound in activity from the snow. As FT Alphaville bearishly notes:

"Plateau isn't the word we would use of course. More stagnation, flat-lining, stalling in mid-air, that kind of thing. The ONS also called growth in Q1 2011 'essentially an arithmetic effect' which seems even more devastating."

What worries us here at EEF isn't necessarily what today's data says about where the economy is now, but what it says about the economy for the rest of the year. The UK will face some stiff economic challenges in the coming months:

• Fiscal austerity has begun (we've seen roughly the equivalent of 1.5% GDP cut back in the past 12 months) and will begin to weigh on the economy through the rest of this year.
• There appears to be no respite in rising oil and commodity prices.
• Supply chain disruptions from the Japanese earthquake will only begin to affect output in this quarter.
• The euro-zone crisis will only get worse unless Greece, Ireland and Portugal begin to restructure their debts (which will be painful enough).

The recovery could probably withstand a shock from any of these on their own. But the risk is that they combine to create a perfect storm that keeps the economy trapped on the plateau...or even worse, forces an economic retreat back down the hill.

Ahead of the EEF Economists' shadow MPC debate on twitter we will be stating the case for each of the four different stances held by the MPC. The posts on the other policy stances will be available here.

Adam Posen has a point. Standing out on a limb might be lonely, but, hey, a dove’s got to do what a dove’s got to do.

The economy is weak. GDP contracted in the last quarter of 2010. Forecasts for growth in 2011 and 2012 are weak. Unless next Wednesday’s GDP data release is surprising enough to knock the dove off his perch, those forecasts aren’t going to change much.

And that’s because the fundamental prospects for growth remain pretty dim. Government spending – we know – will be cut. Consumer spending is unlikely to be strong: consumer confidence remains at levels associated with recession¹ and 400,000 public sector job losses are forecast in the next five years². The private sector should offset this, creating new jobs³, but we cannot take that for granted either.

The hope is that business investment and net exports will shore up demand but, as yet, the data has proved conflicting at best.

Low growth could well lead to below-target inflation. Shaky demand could increase the margin of spare capacity in the economy. And, let’s not forget, it is high already: unemployment is likely to average 8.2% this year⁴, compared with the pre-recession level of 5.2% . It is precisely this spare capacity that could cause inflation to fall below target in the medium term.

And monetary policy operates in the medium term⁵. Current short-term above-target inflation aside, there is a real risk that dismally slow growth causes below-target inflation in the medium term. Thus, the case for a rate rise, which would impact inflation in the medium term, looks weak. But I am not only arguing against a rate rise.

There is a strong case for increasing the amount of QE, based on the medium term risks to growth. Inflation forecasts⁶ already show inflation falling below target in May 2012. If growth is lower, inflation will be lower.

The concern is not necessarily that we see deflation. The Bank of England’s website clearly states that “Inflation below the target of 2% is judged to be just as bad as inflation above the target.” So, given the substantial risk of low growth causing below-target inflation, we should expand QE.

QE would offer the boost the economy needs. As “extraordinary monetary policy” QE does more than reducing rates would: even if it were a viable policy option.

The process of QE – where the Bank purchases government gilts with newly created money – means that as well as the usual economic stimulus which would come from reducing interest rates there are two important additional impacts. Purchasing more government gilts causes the interest rates on gilts to fall. This means that:

1) the rate of interest the government pays on its debt falls, which would thereby reduce some of the pressure of deficit reduction; and
2) other alternative (riskier) investments become more attractive

Both of these would support growth. Although the Bank is not explicitly allowed to purchase government gilts to reduce the cost of government borrowing⁷, expanding QE would have this effect.

But the second effect is crucial. One of the key factors holding back business investment is a lack of Access to Finance. EEF’s surveys show that there has been little improvement on this since the recession ended. As the return on government gilts falls investors will look to other assets, which could include buying shares, or providing loans to businesses.

Additionally, if more shares are bought this boosts their price, and has a wealth effect. People who own more shares feel better off, and may then spend more money elsewhere.

So QE could reduce pressure on the government, boost business investment and boost consumer spending. It is also likely that exporters would benefit from any additional weakening of sterling that expanding asset purchases caused.

Crucially, and this is the clinching point for me, some of the benefits of QE would remain even if interest rates went up in the near future. 

I recently wrote that the reason the Monetary Policy Committee did not need to worry too much about inflation is that there was little evidence of a price/wage spiral developing⁸. I still hold this view, but I also see this as a key upside risk. Current inflation may be caused by temporary and external factors, but if wage rises start to quicken then high inflation could become permanent and domestically generated. In this situation interest rates would need to rise.

But monetary policy has to be made on the balance of risks. Currently there is little evidence that a price/wage spiral will develop. Evidence already shows that growth is struggling.

QE should be expanded now. QE should be expanded to boost access to finance. QE should be expanded to better enable businesses to invest and drive a strong economic recovery.

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¹The GfK-NOP consumer confidence index currently stands at -28
²Figures taken from the OBR
³The OBR forecasts 1.3million new private sector jobs in the next five years, meaning net job creation of 900,000.
Figures taken from the OBR
⁴ONS figure for February 2008
⁵The Bank of England’s website states that it takes 24 months for monetary policy to feed through
⁶Which admittedly factor in rate rises along the way, but also reflect the expected fall in inflation as temporary factors such as VAT subside.
⁷This is forbidden by the Maastricht treaty
⁸Additionally, the Bank of England Agents’ April report states that pay rises are around average pre-recession levels and even then reflect improved profitability and recognition of past wage restraint.

The minutes from the Monetary Policy Committee’s latest meeting were released yesterday, and showed that once again there was a four way split over monetary policy. On the 5th May the MPC announces its next decision. Just a couple of months ago market expectations were that this was when the MPC would finally raise rates.

In the interim, data releases have painted a picture of a weakening recovery. But inflation has remained well above target. The European Central Bank has raised rates, despite weak growth in the periphery.

So the question is, where next for monetary policy?

On the 4th May EEF’s Economists will be using twitter to debate where the MPC should go next. To follow the debate use the hashtag #EEFMPC from 11am.

In the meantime, we will be discussing each of the different policy positions via the blog.

So last week we had Sir John Vickers and his Independent Commission on Banking (ICB) put out their interim report on how to clean up the UK banking sector post financial-crisis.

Rightly most of the media attention both before and since its release has been on the proposals to secure the structural health of the system.

But proposals to improve competition were also part of the ICB’s remit and the report does include ideas.
These are:

to force Lloyds, which currently has 30% of current accounts, to sell-off more branches than the 600 it already has to (additional number not specified);

Make switching bank accounts easier and more reliable;

Make sure the proposed Financial Conduct Authority has an explicit duty to promote competition.

And of course the elimination of the implied subsidy for the big banks of being ‘too big to fail’ would enhance competition too, even though its motivated by making the system safer. The competition angle is of particular interest to us because the lack of competition in banking is something our members have noted.

Banks looking to break into the UK market or grow their share are often the ones that give growing manufacturers a break on a loan at the cut-off for the incumbents.

The more competitive and dynamic the banking sector the more it will support this growth-enhancing activity. So how do these proposals stack up?

The test of the Lloyds divestment will be how many potential entrants there are snapping at the heels of the big UK bank incumbents.

We know NBNK Investments was already eyeing Lloyds and admittedly much smaller Northern Rock assets up for a tilt at the UK retail banking market. Presumably an extension to the divestment encourages this even further.

And the Treasury Select Committee has this month noted interest from others already in financial services or indeed small scale banking including Metro Bank, Tesco, and Virgin Money.

But as the Committee also points out major effects on competition are likely to be slow in coming. These players are generally focusing on consumer banking with branch networks in the low 100s rather than 1000+.

So further interest would be good too, say from already established banks overseas that have ambitions to aggressively grow a share in the UK market. It might need to be a big boy to buy up 100s of branches from the divestment anyway.

It would be good to see new entrants push on SME banking rather than just the consumer side.

The switching thing needs some serious thought on the SME side, particularly with the interlocking interests banks will have in multiple products i.e. it’s not as simple as changing over a current account. It’s more daunting for SMEs to switch if it means renegotiating terms of loans and working capital facilities and the cost and stress that entails.

The vigilance of the Financial Conduct Authority sounds worthy – but no real detail yet about how it would enforce or promote this.

Forecasters have become more divided about the prospects for an interest rate rise in May after statistics showed that inflation fell back a little in March, although CPI is still well above target.

It cannot yet be claimed that the inflation problem has been tamed. CPI has been above target for sixteen months now and further energy prices rises are likely to keep it high. But this is not the only problem the UK faces. With large numbers out of work, households are facing a squeeze in both directions. The debilitating combination of sustained high inflation and high unemployment could severely hinder growth in the UK economy.

This risk should not be overstated. The ‘misery index’ – a measure which combines the unemployment and inflation rates – is some way below levels reached in the 70s, the 80s, or even the early 90s. Though it may rise a little over the coming year, forecasts suggest it will fall back as the impact of the VAT rise subsides.

But this is not assured. The worry with inflation is that it – in itself – can cause more inflation. Workers see higher prices, and demand higher wages, this puts up costs for firms who then put up their prices: the so-called price/wage spiral. Avoiding this spiral is one of the reasons credible monetary policy is so important. If people believe that the inflation target will be met, they are unlikely to be too swayed by short-term increases in inflation.

As our pay survey shows, average settlements have not yet been too heavily influenced by inflation. They have risen from the lows seen in the recession, but remain well below the level of CPI inflation. This may not be because people believe in the Bank of England’s inflation-fighting ability, however.

A weaker labour market means weaker pay demands. Unemployment is high, and government cuts mean that more jobs losses are on their way. The weakness of the labour market means that the MPC has so far been right not to raise rates. A lack of consumer confidence had led to muted household spending, which is a major component of growth.

The best policy response over the next few months is not certain. An inflation target that loses its credibility loses its efficacy too. And inflation has remained stubbornly above target. But the MPC’s credibility on its assessment of the broader economy is also important. By raising rates too soon it could choke off the very growth it has so far tried to support. It is little wonder that the MPC have so far held the course.

One of the clearest messages we have received following the financial crisis is that the relationship between banks and businesses has deteriorated.

We do recognise that effort is needed from both sides on this relationship and that sometimes the onus is more clearly on the customer to initiate improvement.

However there are some helpful steps the banks and/or government could take, which we suggested in September last year in response to the government access to finance green paper:

1. Restore direct bank-business communications via the Small Business Finance Forum;
2. Greater transparency and publication by banks of the factors behind certain lending policies and conditions  e.g. personal guarantees;
3. Greater transparency from banks on ancillary costs (lawyers fees, due diligence on accounts etc) associated with lending;
4. Increasing the frequency/volume of publishing results on which institutions are generating complaints to the Financial Services Ombudsman (FSO);
5. Government obligation for banks to publicly pledge to adhere to the Lending Code coupled with reporting performance against this code.

Quickly following the green paper, the major UK banks (Barclays, HSBC, Lloyds, Santander, Standard Chartered, RBS) under their ‘Business Finance Taskforce’ announced a series of commitments.

Delivering on these commitments has gone some way to addressing our recommendations. The banks have established a Business Finance Roundtable.

And at the end of last week the banks launched a new Lending Code for micro-businesses and lending principles for larger SMEs. Today they have further announced a monitoring and appeals process for the processes banks will use for declined loan requests and wrapped everything under the tag of a campaign for Better Business Finance.

These steps will help to improve the customer service experienced by businesses.

But better customer service also means greater transparency on when and why conditions are attached to loans, transparency on additional costs around loans, and on covenants borrowers can expect to face.

Both the banks and the government must be vigilant in ensuring that the announced steps really do improve relationships with customers.

If there isn’t genuine improvement, the banks and the government need to be ready to take further steps. One option to consider would be including transparency on terms and conditions in the Code and principles.

For example, banks could pledge greater transparency on when certain conditions are likely to be attached to loans or what sort of covenants borrowers can expect to face given broad borrower characteristics.

EEF has also previously recommended genuinely independent monitoring of adherence to the Code and principles. This would give businesses more confidence that they would lift service standards – and probably increase the visibility of them as well.

The action taken so far is good but we must keep watching to make sure it makes a difference to firms.