EEF blog

On Tuesday Paul Tucker from the MPC gave a speech about monetary policy in a rebalancing economy. A few remarks stand out

Rebalancing of the UK economy needs to happen…

… “the balance of aggregate demand needs, over the medium term, to shift away from household and public consumption towards net trade and investment”

But tight credit is causing problems …

“Rebalancing is already impeded by tight credit conditions…”

… and the instability in the Eurozone could make this worse

“With instability from the euro area crisis threatening the UK, our banks cannot avoid being exposed to outsized risks. That is reflected in elevated funding costs, which they pass on to customers to a greater or less extent”

“The gradual improvements in credit conditions seen until the summer, and documented in the Bank’s quarterly Credit Conditions Survey have been arrested for now”

Tucker argues that continuing constraints in accessing finance will “impede the rebalancing of the economy’s productive capacity” as credit can be a key part of firms' ability to invest, grow and enter new markets. This is particularly true for SMEs

Tucker states that loose monetary policy can help ease the costs for firms, but it is not the whole answer.

Ahead of the Autumn Statement on Tuesday we are calling on the government to do more to aid Access to Finance:

The government has already announced that it will look into credit easing, which is a welcome recognition of the problems on the supply side. However, the form that credit easing will take remains uncertain, including whether the proposals will have any impact in the near term.

This is why we are calling for the government to make the most of existing vehicles:

• One example would be the pre-existing £2.5bn Business Growth Fund. Government should use its existing relationship with the banks to encourage them to extend the scheme to cover debt as well as equity. Many smaller-business owners are reluctant to give up equity in their companies; a debt product could widen the pool of applicants to the fund. This reluctance on the part of SMEs could explain the low take-up of funding reported in today's FT.
• Another example would be extending Enterprise Investment Scheme eligibility to debt in line with the Business Angel Scheme, thereby increasing access to non-bank debt.

To improve the longer-term shape of finance and ensure banks are working for businesses, we are also looking for a positive response from the government on the Independent Commission on Banking’s recommendations on competition.

For more information on our key priorities for growth, see our submission to the Chancellor ahead of the autumn statement.

This is a summary of the MPC minutes - you can find the full version here. 

Financial markets

• Increased stress in financial markets associated with euro governments and banks is reflected in volatility in asset prices and a reduction in liquidity across a range of markets.

• Stresses on short-term funding markets are driving up costs for European banks, including UK banks. Domestic lending in the UK could be affected if higher costs persist.

International economy

• European activity indicators have weakened, particularly in the periphery, but indicators even for France and Germany suggest flat output.

• U.S. indicators mixed with encouraging signs of investment in quarter 3 like to be short-lived as business and consumer confidence are weak. The passage of Obama’s $450 billion stimulus bill through Congress looks uncertain.

• Some gradual slowing in activity in China. The rebound in activity in Japan following the earthquake and tsunami also looks to be short-lived with weak prospects beyond 2011q3.

Money, credit, demand, and output

• The latest revisions to national statistics have revised up the contribution of net trade to growth from the onset of the financial crisis through the recession and into the recovery. This is now more in line with what was expected given the depreciation in sterling.

• Business surveys suggest weak growth in 2011q3 in both services and manufacturing sectors.

• Mixed evidence on the weakening of external demand for UK exports with CIPS/Markit PMI suggesting falling demand but other surveys suggesting this is holding up, particularly to markets outside Europe.

• Credit conditions have remained tighter since the financial crisis but no sign yet that recent financial market turbulence has tightened conditions still further.

Supply, costs, and prices

• MPC expected inflation to rise above 5% in the short term [as it has, to 5.2%] before falling back sharply in 2012 as VAT and oil price rises fall out of the series.

• Inflation expectations as measured by surveys of households remain unchanged while implied expectations through financial markets have fallen somewhat – though such implied expectations are volatile in times of financial stress.

• Excluding the impact of bonuses in some sectors, recent data suggests wage growth remains modest.

• The degree of slack in the labour market is a key factor in determining how much additional downward pressure there will be on  inflation.

Immediate policy decision

• The main upside risks to inflation in the medium term are expectations of higher inflation becoming embedded in wage and price-setting behaviour, lower spare capacity in the economy than thought, and another rise in commodity prices.

• No recent data suggest any strengthening in the upside risks.

• The main downside risk to inflation in the medium term is weak demand being unable to absorb the spare capacity in the economy.

• Ongoing problems in the eurozone area and the strains these are putting on financial markets have increased recently and the outlook for the UK economy had weakened.

• The MPC voted unanimously for Bank Rate to be maintained at 0.5% and also unanimously to finance a further £75 billion of asset purchases (QE).

To be fair my earlier post didn't cover everything the Chancellor said.

He also mentioned the possibility of the government using its balance sheet (made credible by him) to act a guarantor behind SME lending, thereby encouraging banks to lend more. There are already schemes in place with a similar theme - the Enterprise Finance Guarantee and the Export Enterprise Finance Guarantee.

These schemes are being used but demand for them is hardly overwhelming.When the scheme was first introduced it was to support facilities of up to £1.3 billion from Jan 2009 to March 2010. BIS figures show in the end the scheme was used to support loan offers of less than £950 million of which around £780 million was actually drawn. Over the next year to March 2011, with facilities of up to £700 million able to be supported, loans of £490 were offered with £460 million actually drawn.It's a little unclear what more the government may do further here.

Will they extend the scope of the EFG to cover larger businesses or larger loans? Will they increase the guarantee from 75%? Will they lower the fee charged for using it? If they did any or all of these things there would be a cost. And if the Chancellor considers this a macroeconomically meaningful intervention it would have to be done on a very large scale - so it might be a considerable cost. And being on the hook for what could be a very large potential liability would presumably be something that people who judge the credit-worthiness of the UK might look at quite closely.

The government could buy packages of SME loans - securities that offered a stream of payments based on a portfolio of individual loans made by banks. Banks would then have cash that they might be inclined to lend out to SMEs who are currently struggling to get a loan. There is some element of uncertainty about that though - because the banks may have reasons - such as shoring up their own capital - for not doing this.

For this to happen there would have to be a suitably qualified securitising agent - perhaps a market participant but in the current conditions maybe a government entity would be required to perform this role. It will be important that the securitising is done robustly and that credit worthiness of the package of loans is accurately assessed.

But assuming the government can rapidly assemble the entity and it can do a quick and thorough job - someone still has to buy these assets.

If that someone is NOT going to be the Bank of England, then does that mean it's up to the government? If the government's buying a whole lot of assets, will it have to borrow a whole lot more ££ to do so? What does that mean for its fiscal plans?

So a lot more questions than answers still on credit easing.

Inflation figures released today showed that CPI had crept up a little, to 4.5%, though this was broadly in line with expectations. But this is unlikely to move the monetary policy committee, whose members last month voted unanimously against a rate rise. But the committee’s arch-dove goes further.

Adam Posen thinks things are bad.

And he doesn’t just think they’re bad enough to merit more QE.

“Just because we have [QE] … does not mean we should stop there if the situation is sufficiently serious. Unfortunately, the underlying economic situation in the UK and throughout the G7 is that serious.”

Posen says it is “time for the Bank of England and HM Government to explore ways [to] make up some of the credit and investment gap” that is holding back growth.

What he suggests is:

That the government set up two new public institutions “one would be a public bank or authority for lending to small business” the other would be a Freddie Mac/Fannie Mae style entity to “bundle and securitize loans made to SMEs… to create a more liquid and deep market for illiquid securities which can then be sold off to banks”.

The Bank of England could, Posen suggests, support the creation of these institutions by providing the initial capital.

It’s certainly a bold suggestion or – as FT Alphaville put it – “an intriguing British take on the liquidity trap to say the least”.

A couple of months ago I asked if high effective interest rates were part of the reason that the Base Rate remains so low.

Today the Bank of England released their data on effective interest rates – the actual cost of borrowing money faced by businesses and households.

It shows that the difference between the Base Rate and the rates paid by business and households has increased notably following the recession – the “credit crunch” phenomenon that choked the economy to begin with.

Figure one: effective interest rates are higher since the recession
Average difference between the Bank of England base rate and the actual interest rate paid pre- and post- April 2008.

What is striking is that this difference has not dropped back much since recovery began. This is especially true for secured lending to households, but applies to business lending too. 

Figure two: effective interest rates remain high relative to the Base Rate
Difference between the Bank of England base rate and the interest rate paid by business for outstanding loans

So the low Base Rate is not fully reflected in the interest rate paid by businesses and households. This is the hangover from the credit crunch. And it has implications for monetary policy. For one thing, it implies that – all other things equal – a lower Base Rate could be consistent with lower inflation than was the case pre-recession.

David Smith's column from the The Sunday Times (£) asks whether economists and policymakers are barking up the wrong tree.

"Some would say there was too much credit pouring in before the crisis, and that is true. But there is plainly too little now.

The Bank used to think M4 growth of 9% a year was consistent with economic growth of 2.5%-3% and hitting the inflation target. That may have changed as a result of a shift in the velocity of money but not that much. 1.5% M4 growth is inconsistent with sustained recovery and chronically weak credit growth will hold back growth.

Responding by boosting government spending or cutting taxes is at best oblique, at worst irrelevant, like trying to fix a leak in the roof by replacing the windows. What the economy needs is s sustained private sector-led recovery, and what that needs is an adequate supply of credit.

David's point is that if we're going to have a 'Plan B', then supply and demand side fiscal measures may be 'barking up the wrong tree' because we've got a credit problem.

And more to the point, he says QE hasn't worked because the MPC has chosen the wrong type of QE - buying government bonds rathr than lending to the private sector.

So, while the International Monetary Fund suggested last week more QE (and temporary tax cuts) might be needed if growth grinds to a halt, that would be a bad idea. It does not solve the problem of dangerously weak credit growth.

The only person who has said much publicly on this is Adam Posen, the monetary policy committee’s Japan expert. Though I do not agree with him in his regular vote for more QE, which would be a futile gesture, he was early on to 'the likely failure of lenders to support recovery'. He, like others, would have preferred it if QE had not been conducted overwhelmingly by the purchase of government bonds. Policy has failed to get credit flowing."

And because a picture is worth a thousand words, David demonstrates this policy failure in the chart below, which shows the meagre growth in M4 money (the broadest measure of the amount of notes, coins and deposits floating around in the economy) since the crisis set in.

It does make you wonder.

On Wednesday, I flagged up a Morgan Stanley (via the always brilliant FT Alphaville) call that UK house prices could fall by 10%.

Well, here's the details behind that Morgan Stanley forecast. The key points?

"The supply recovery looks likely to be relatively weak, but we think that demand will be dampened by continued weak real household disposable income growth and likely rising mortgage rates. 

...

Mortgage spreads...[and]...real interest rates are also likely to be volatile. In the medium term, we think that inflation pressures will be relatively strong on average, prompting further rate rises from the bank as it tries to get inflation back to target. 

However, with the real economy continuing to go through a period of transition towards being a more export- and investment-led economy and the banking sector likely undergoing significant changes too, growth and financial conditions may fluctuate more than in the pre-crisis years and increase the volatility of any interest rate path."

Good thing I just bought a house, huh? *gulp*

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.

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.