Bank of England November 2009 Inflation Report - Treasury Contents

Written evidence submitted by Professor Sheila Dow, University of Stirling

  1.  The critical aspect of the Report is the prediction as to when and how rapidly the economy will get out of the current recession. This is critical for the resumption of financial stability in that continuing defaults and uncertainty about future prospects would further weaken bank balance sheets and the financial position of firms and households. It could also be argued that demand conditions are critical for the achievement of the inflation target (neither deflation nor excessive inflation), but given the continuing fragility of the economy and the financial structure, it is hard to see inflation targeting as the central issue. Indeed there is scope for judgement as to whether above-target inflation in the longer term, for example, is a price worth paying for avoiding further extensions to the economic and financial crises. Given that the MPC is charged with achieving the inflation target, it is difficult for them to be explicit about such a judgement. But the public discourse about the economy and the role of the Bank has now gone beyond the formal framework. For both the MPC and the government the question is whether it is too early to be thinking about an exit strategy from the current monetary and fiscal policy stance.

  2.  The GDP projection is for a sharp improvement, returning to positive growth in the new year, rising to close to 5% in early 2011. Nevertheless the level of output is only projected to return to its early 2008 peak by 2011. One source of demand expected to drive this improvement is exports (depending on the fall in sterling, but also resumed growth and/or unwinding of savings elsewhere, such as these might be). And indeed focusing on exports is identified as an important element in rebalancing the UK economy (page 44). Domestic demand is expected to remain weak due to the efforts of households and banks to rebalance their financial structures, and consequent hesitancy among firms to resume investment spending. It may therefore be that the predicted sharp rebound is overoptimistic (and the uncertainties surrounding the forecast are emphasised in the Report). Thus any talk of exit strategies arguably is premature.

  3.  A major source of increased demand continues to be the substantial fiscal stimulus, which has undoubtedly prevented a much worse recession. On the other hand it is noted (page 43) that fiscal consolidation will dampen improvements in domestic spending, and anticipation of such widely-discussed consolidation may bring this effect forward. This sounds an important note of warning on fiscal policy. There is in fact no basis (other than convention) for a set maximum to the public sector deficit which would require active consolidation before resumed growth becomes well established. Further the effort to reduce spending and/or increase taxes could choke off such growth before it became established, with the perverse effect of causing the public sector finances to deteriorate further. Growth in itself would improve the fiscal position by means of the automatic stabilisers (rising revenues and falling recession-related expenditures), so consideration of fiscal restraint is not only premature but may prove to be less necessary than is commonly thought.

  4.  The third source of growth is the one of greatest concern to the MPC, namely the policy of quantitative easing. The intention was that this policy would encourage spending through three channels: raising asset prices and thus wealth (and thereby lowering yields and the cost of financing investment); fostering more optimistic expectations; and increasing bank lending. Asset prices have been increasing, notably share prices, and housing to a lesser extent, and bond yields have been falling. Also there is some sign of returned optimism among businesses, reflected in smaller reductions in planned investment (Table 2.B, page 21). But business intentions are still for significant falls in investment, expected to worsen what is already a drastic actual drop in investment (Chart 2.6, page 21). It is difficult to quantify the effect of the quantitative easing policy on expectations, but its significance should not be discounted; monetary policy is now often as much about signalling as about price setting. But the hoped-for increase in bank lending has not happened, and there is continuing uncertainty as to whether bank lending could still be a force for economic growth (pages 40-41). This is not altogether surprising since banks' balance sheets are still fragile, since the banks are sensitive to taking on more default risk in an uncertain economic environment, and since credit is being extinguished as households aim to reduce their own vulnerability by paying back loans. Indeed it is suggested (page 17) that, even if companies' demand for credit were to increase, this demand might not be met by the banks. The Bank had accepted from the start that the policy might not increase lending as such, but would at least return the mark-up of interbank rates on Bank Rate to pre-crisis levels, and this has indeed occurred (Chart 1.13, page 15). The effect of the policy so far has therefore been on financial markets without clear signs of effects on spending plans. Nevertheless the MPC expect the latest additional tranche of asset purchases to speed up the recovery.

  5.  The MPC has signalled that the quantitative easing policy is winding down, and in some quarters concern is being expressed about the consequences of the policy for excessive bank lending in the future. Given the capacity of the banks to expand lending, as indicated by their reserves position, it is feared that a confident resumption of growth would become inflationary if accompanied by a large increase in bank credit. But this bank multiplier approach to credit creation has not been relevant to UK banking for a long time. Effectively the Bank of England has either supplied the banks with the reserves they need, or withdrawn liquidity, in order to keep wholesale interest rates at the desired level relative to Bank Rate. But, given Bank Rate, the banks effectively decide how much liquidity they need. If the MPC judged credit creation to be excessive, the Bank could attempt to tighten financial conditions by withdrawing liquidity in the normal way, ie attempt to enforce a higher interest rate. The main difference now is the large scale of asset purchases.

  6.  Rather than being concerned about growth in bank lending in general, some have expressed concern about the purpose of borrowing, and the danger that credit is being created, and could in future be created, more to fuel an equity and housing bubble rather than firms' investment and households' expenditure. This would require a different kind of response. In order to steer bank lending towards recovery-oriented expenditure, a range of measures might be considered ranging from fiscal incentives to regulatory restrictions.

  7.  Meanwhile the MPC are concerned with designing macroprudential controls more generally in order to prevent a recurrence of the banking crisis. The Governor has laid out his ideas for addressing the problem of large banks being too important to fail (and thus taking on excessive risks), and yet too expensive to bail out. He advocates the separation of traditional banking (what he calls utility banking) from other financial activities, and thus restricting the coverage of the lender-of-last-resort facility. This proposal is consistent with the logic of retail banking, whereby banks can support balance sheets with widely diverging maturities between assets and liabilities because their liabilities are money. The central bank supports this system with the lender-of-last-resort facility in exchange for regulation which restricts the activities of the banks, and thus maintains confidence in bank liabilities. Effectively a deal is done between the state and the retail banks. This is necessary because, without a working monetary system, the economic (and social) system simply could not function.

  8.  Retail banks which were smaller would be less costly to bail out, making a guaranteed lender-of-last-resort facility more palatable to the authorities. But the discussion of regulatory changes (as in a recent speech by Paul Tucker) still refers to future bank failures and how to resolve them. It is implied that there would be less systemic effect from allowing smaller banks to fail. Indeed banks would be required to set out "living wills" in order to plan for a more orderly winding-down than we have experienced during the crisis. But this acceptance of the possibility of small bank failure ignores the systemic effect of the failure of any bank in the form of puncturing confidence in banking in general. This concern would imply that the emphasis in considering a return to traditional banking be on returning to a satisfactory deal whereby the Bank undertakes to guarantee to supply the lender-of-last-resort facility in exchange for banks acceding to restrictive regulation designed to limit moral hazard. Just as the ideal would be for the general population not to think about inflation at all, so it would be ideal if we could return to not thinking about bank failure at all.

17 November 2009

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