Unit 4 Macro: King on the UK Economy

Here are some notes from watching and listening to the Bank of England Inflation Report press conference. As always there was much for students of macroeconomics especially those keen to pick up some of the key thoughts of policy makers as we strive to achieve a sustained recovery.

King said that recovery in the UK will eventually be driven by rising real incomes and a pick-up in capital investment but the biggest risk remains economic and financial instability in the Euro Zone where a number of countries continue to suffer from a structural lack of competitiveness, high government debt and financing difficulties.

Questioned on a possible Greek default, King remarked that both the BoE and the Govt have considered a range of possible outcomes and made contingency plans. Many large UK banks are exposed to the real economy of the fragile Euro Zone economy rather than to Euro Zone sovereign debt.

“We are steering a course through choppy waters but we are aware of the fact that people are facing painful times - the consequences of the adjustments made inevitable by the financial crisis and the need to rebalance the economy.”

“We all want to return to a world of steady growth, inflation close to target and normal interest rates will take time. There is a limit to what monetary policy can achieve when real economic adjustments need to be made.”

Weak money and credit growth

There has been a noticeable and significant fall in the growth of money and credit - this is inevitable in a “balance sheet” recession resulting from a financial crisis where lenders are engaged in de-leveraging (i.e. cutting their loan books and tightening the supply of new loans to personal and business customers)

One of the main objectives of asset purchases (QE) by the Bank of England is to inject more money into the economy. But will fresh credit get to small businesses in the economy? Credit conditions if anything are still tightening for small businesses. Net lending to small businesses has fallen quarter by quarter in 2011.

In 2012, big businesses can borrow money more cheaply than our biggest banks- they are much less affected by the de-leveraging occurring in the banking system. Banks are still trying to strengthen their capital position in order than they can borrow more cheaply from the capital markets. In the long-term this will help small businesses but provides a problem in the near-term. The national loan guarantee scheme is a way forward, how quickly can it be set up?

The Bank of England will not buy assets other than gilts in QE programme as that would be a public sector subsidy, which is matter for the Government not the central bank

Diminishing returns to QE programme?

Any monetary policy easing can exhibit a limit to how far it can go. Monetary policy at the moment is trying to nudge people to bring forward their spending e.g. from next year to this year. But confidence is low and an impaired banking system constrains the effectiveness of monetary policy

The position of savers

Ultra-low returns on savings deposits and the growing impact of QE on pension scheme deficits and annuities beg the question about whether it is worth saving at the moment? The evidence is that household saving in the UK has gone up despite negative real returns on deposits, this is a sign of wider economic weakness and desire to repay debt

A return to normalised interest rates of say 4 or 5% might on the surface provide some relief to millions of hard-pressed savers, but a quick return to normal rates would also cause asset prices to fall, a sharp appreciation in the exchange rate and an almost guaranteed recession in which everyone is worse off

King reflected that all groups in society are suffering from the consequences of the financial crisis - an example of the externalities of financial collapse. He believes that the UK has put in place conditions to make the necessary real economic adjustments

1. Credible fiscal plan to bring down the budget deficit
2. 25% fall in exchange rate without a rise in wage inflation allowing the real exchange rate to fall
3. Historically large easing of monetary policy including QE

He reminded those there not to underestimate the impact of the automatic stabilisers - an important part of fiscal policy - they are more potent in the UK than in other nations. And looking to medium-term adjustment and re-balancing of the economy, it is particularly valuable to bring in supply-side reforms to raise productivity - it will raise higher future incomes which will help address the debt overhang. Which supply-side reforms will best support the growth agenda?

The Bank of England says UK inflation will reach 2% target by end of 2012 before falling as low as 1.5% in 2013. UK policy interest rates look to be on hold for the foreseeable future. We haven’t seen a rate change since the spring of 2009. What probability that interest rates will remain at 0.5% or at least 1% or lower when we head into 2014?

See also BBC news: Bank of England says UK economy ‘to zigzag’ this year