MPC needs an exit plan
By Andrew Sentance, Senior Economic Adviser, PwC
The MPC has brought its programme of asset purchases to a halt again. This partly reflects better news on the UK economy over the last few months, as documented in our latest Economic Outlook report published today. But it may also indicate that the MPC is beginning to doubt the effectiveness of continuing to provide further monetary stimulus through Quantitative Easing (QE).
In 2009, cuts in interest rates and the first round of QE helped stabilise the UK economy in the immediate aftermath of the financial crisis, and provided the basis for a slow recovery. Growth has been disappointing – but this is not something that can be addressed by further loosening of monetary policy.
In my view, relatively slow growth is part of the “new normal” for the UK and other western economies and reflects the departure from the world of easy money, cheap imports and strong confidence which prevailed before the financial crisis. This world cannot be recreated simply by providing more and more demand stimulus. The major western economies, including the UK, face a prolonged process of economic adjustment and this is not an environment in which we should expect growth to return to the rates we were accustomed to before 2007.
So monetary policy is on hold for now. But at some point, however, the MPC needs to plan for an exit from the very stimulatory monetary policies that have been pursued in recent years. The current official Bank Rate of 0.5% is not only low by recent standards. It is the lowest in the history of the Bank of England and much lower than the 2% rate which prevailed in the Great Depression of the 1930s.
The MPC strategy so far has been to wait until the “time is ripe” for interest rates to rise – a combination of strong growth and an inflationary threat which justifies rising interest rates. But in the current “new normal” world it will be very difficult to judge the right economic conditions to start raising them. The growth and inflation performance of the UK economy has been very different since the financial crisis than before it. There is a risk that the time never appears to be right to raise interest rates and unwind the bond purchases made under QE.
This scenario raises a number of concerns. First, a rate of interest which compensates savers for inflation and provides a reasonable return in real terms is one of the mechanisms which ensures that investment funds are deployed efficiently to support the long-term growth of the economy. There is a risk that the long-term growth potential of the economy will be harmed by a very prolonged period of exceptionally low interest rates. Second, the longer we persist in a world of very low interest rates, the greater will be the shock to the private sector when interest rates do start to rise. Businesses and households are likely to be able to plan for and adjust to a gradual approach to raising interest rates over a number of years.
A third concern is the impact on the credibility of the Bank of England and perceptions of its independence. The Bank has so far been reluctant to raise interest rates, even though inflation has been almost continually above the 2% target since 2007/8. If this situation persists – as it could well do – the credibility of the Bank’s commitment to stable prices will increasingly be questioned. Similarly, if the £375bn of bond purchases made by the Bank through QE are not eventually unwound, it may appear that the Bank has printed money simply to finance the government’s deficit – a policy which has created inflation and threatened the financial stability of economies in the past.
In my view, a better strategy would be for the MPC to plan for a gradual rise in interest rates, accompanied by a gradual unwinding of its QE asset purchases over the next few years. It would be unrealistic and undesirable for interest rates to go back quickly to the rates seen before the financial crisis. But a gradual rise to around 2-3% over the next 2-3 years would help the economy to acclimatise to a more normal level of interest rates – allowing firms and households to plan accordingly. This would help avoid the risk of a very prolonged period of exceptionally low interest rates, which could be damaging to the economy over the long-term.
Interest rate rises may not be on the agenda yet. But if the economy continues to grow next year – as our main scenario projection suggests - it will make sense for the MPC to start planning for an exit from the emergency monetary policies which have been in place since early 2009.
This blog summarises a longer article in our November 2012 UK Economic Outlook report, which is available here, and also contains updated projections for the UK economy showing growth picking up from zero in 2012 to around 1.8% in 2013.
Andrew Sentance | Telephone: +44 (0) 20 7213 2068