Mervyn King and the MPC boys must have a soft hedge around the back of the Bank of England. Otherwise it must be pretty uncomfortable sitting on the fence for 17 months in a row. That’s just been confirmed by today’s announcement that the MPC will leave the official Bank Rate unchanged yet again.
It’s a call we agree with but will still no doubt cause some considerable commentary. That’s because beneath this apparent continuity the swirl of economic signals is becoming ever more complex, making monetary policy setting a tricky business.
Let’s look first at the case for loosening policy even further (which would mean more QE).
The motivation for this might be a belief that growth prospects are weakening, that inflation pressures, like VAT, are temporary, and that the bigger medium term risk is actually deflation. Deflation is bad because it encourages consumers and businesses to hold off spending and investing because their money will be worth more in the future – not what you want if demand is falling.
We know the MPC discussed this in July. What about this month?
The main problem for further easing is concern on inflation expectations. Expectations play a big role in determining actual inflation because of the way they impact on pricing behaviour in the economy e.g. wage demands – I expect inflation to be higher, so I want a higher wage increase than otherwise from my employer.
To keep to its 2% CPI annual increase target, the MPC needs expectations to be anchored. Consistently over-shooting this target undermines this anchoring.
Inflation has now been above target since December. The rise in VAT in January will probably keep inflation above target until the end of 2011 – two years of above-target inflation. That will really test how well anchored expectations are. Will people simply think to themselves “you know what, prices just seem to go up faster these days” and change their behaviour accordingly?
Recent strong manufacturing output growth and upside surprises for the economy generally, while good news, probably further limit the appetite for loosening. Demand could eventually outstrip the (somewhat uncertain) spare capacity of the economy and flow into higher prices. This too would push inflation up.
All this seems to argue against loosening – so what about tightening? (or 'normalising' as the hawks like to say).
We know this too was discussed in July. In fact one MPC member – Andrew Sentance – actually voted to hike Bank Rate and he’s likely to have called again for the song to be changed.
Why? Perhaps based on confidence the recovery is underway coupled with a fear that spare capacity is low and inflation is proving too persistent.
The problem with this view is that it may be too short term. Given long and uncertain lags in inflation and its response to monetary policy, policymakers have to focus on the medium term – roughly 18-24 months ahead.
If anything, since July, medium term prospects for the UK have slightly dimmed. Business and consumer sentiment surveys show domestic confidence waning.
As in July, we know there’s a considerable fiscal consolidation coming down the road. The Coalition will announce the detail of its Spending Review on 20 October.
The source of any upside to growth therefore would appear to have to come from the recovery’s so far disappointing net trade. But is that likely?
Well, recent reports suggest growth in the U.S. and China is moderating. Uncertainty over jobs, fiscal contraction, and a weak housing market are weighing on American consumers. In China growth also appears to be slowing from the first half of the year as the government looks to normalise fiscal and monetary policy (though still likely to top 8% for the year!).
Over in Europe our biggest export market has had a little more mixed news. Continuing weakness in the periphery has been offset somewhat by a stronger-than-expected German performance. But the Europeans, like us, face a looming fiscal consolidation – which for some looks really tough, with lingering sovereign debt fears.
I think the sum of all that makes you hesitate before pushing ahead with any tightening. Higher interest rates could further choke off both investment and consumption just as demand is beginning to slide – a threat to the recovery.
Where does that leave us? Back on the fence of course.