Comment: Now we fret over too hot a recovery

Bill Jamieson

Bill Jamieson

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IN ECONOMIC policy, the world broadly divides into two camps: if you believe you can never have too much of a good thing, a career beckons at the Treasury.

If you don’t, it’s the Bank of England for you.

Recent “forward guidance” has muddled matters. But as a rough guide, the first group are fiscal expansionists and interest rate doves who lean towards the school of “lower for longer”. The second are fiscal conservatives and rate hawks, fearful that signs of economic buoyancy must soon need interest rate rises to head off higher inflation.

The doves are in the ascendant for now – but perhaps not for long. Over the summer we have no end of good things – a veritable “data carnival” according to HSBC. Last week brought news of recovering house prices, improving employment figures, buoyant retail sales and rising confidence.

But barely have we begun to feel relief that recovery at last is under way than the hawks have begun to rally: all this may be too much of a good thing is their cry. And from the sidelines others have chipped in: it’s yet another domestic spending boom – the wrong sort of recovery.

News that UK retail sales had surged 3 per cent in July compared with the same period last year (in Scotland the sales surge was even stronger at 4 per cent) set off alarm bells.

The FTSE 100 tumbled almost 105 points, or 1.6 per cent, on fears that a rate rise could now come a lot sooner than the recent “forward guidance” of Bank governor Mark Carney had led us to believe.

His guidance was that rates would not rise before unemployment drops to 7 per cent – a level expected to take three years to reach.

But no sooner had market watchers rushed home, having bought Mr Carney’s shiny new pop-up toaster with its “no burnt fingers” guarantee, than they were scouring the warranty fine print for those get-out clauses.

A rate rise could be on the cards much sooner than 2016 if this pace continues. And the guidance did indeed come with three “knock-out” clauses. Shares in rate-sensitive sectors such as house building and construction were particularly hard hit.

The minutes of the MPC meeting released last week revealed Martin Weale to be a lone but brave dissenter over the consequences of forward guidance. He hit on the potential conflict between adherence to the guidance for the sake of maintaining the Bank’s credibility, and adherence to the 2 per cent inflation target. He wanted the guidance to be less tolerant of inflation overshoots.

And already commentators are picking away at the 7 per cent unemployment target. As economist Stephen Lewis asks, can the Bank really expect markets will remain settled as the unemployment rate edges down to 7.3 per cent, 7.2 per cent and 7.1 per cent?

“Long before 7.0 per cent is reached the expectation of higher interest rates will come to dominate market sentiment unless the ‘forward guidance’ is amended,” he believes. Confusion will soon set in.

And there is a more fundamental point. At the heart of the Bank’s thinking is that the “output gap” between current levels of output and what the economy is capable of sustaining is larger than others have estimated. This is the basis for its belief that even strong demand growth can be matched by growth in supply.

There is common agreement that the economy is operating below full potential. But how big is the gap? Here there is considerable uncertainty. The larger the gap, the stronger the growth the UK can enjoy without price increases.

Such have been the changes in demand since the financial crisis struck back in 2007 that a significant chunk of the economy’s productive capacity and tools may now be obsolete. And over the past six years capital investment to replace and re-tool has been notoriously low. The point here is that output constraints could kick in well before unemployment falls to 7 per cent, triggering inflation pressures.

The Office for Budget Responsibility (OBR) reckons the gap could be quite small. The economy, it calculates, suffered a large permanent decline in “potential” output because of a combination of overheating prior to the recession and permanent supply-side damage as a result of the financial crisis. It has estimated the gap at 2.6 per cent, broadly in the middle of the range of independent forecasts, which range from 0.4 per cent to 4 per cent. The Bank itself does not release its estimates of the output gap.

But its inflation reports suggest a larger gap than the OBR figure. And that will be quite a gamble to take from next year on the pace of recovery not triggering inflationary pressure as demand hits supply constraints.

However, there are other factors that will have an important bearing on our economic performance for the rest of this year and beyond. Inflation is still running well ahead of wage growth, putting a cap on consumer spending. There are concerns over the pace of recovery in the United States, with the central bank still likely to begin tapering off quantitative easing support. And while last week brought news that the Eurozone had moved out of recession, there is considerable uncertainty, both over how evenly spread this recovery is and whether after the German elections next month, there will be further pressure on Spain, Portugal, Italy and Greece to push forward on bank deleveraging. This carries the unnerving prospect of another showdown between Germany and the “Club Med” economies.

For these reasons, and with the UK’s annual economic growth still running at half the rate that has been the norm in previous recovery periods, it is unlikely we will see “too much of a good thing” any time soon.

But with so much uncertainty over how big that output gap really is, it would be wrong to assume that “forward guidance” is truly robust and that interest rates really will stay “lower for longer”.

Twitter: @Bill_Jamieson

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