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Beating the UK downturn

Beating the UK downturn

Innovative fiscal policy needed to back Bank of England easing

by Charles Goodhart in London

Mon 22 Aug 2016

The UK authorities are right, after the referendum decision to leave the European Union, to take action to counter the immediate downturn. The Bank of England monetary easing announced on 4 August will buy time until fiscal measures can be enacted.

Since the long-term fiscal outlook is poor, the government must find ways of temporarily expanding the budget deficit with a return that will more than meet the very low extra interest rate costs. An immediate near-term concern is that the effect of a weaker sterling in boosting activity through higher exports is likely to be considerably less than anticipated.

Public sector housing is a key area for action. I believe there are others, though this will require innovative thinking. Look, for example, at what Prime Minister Shinzo Abe has been doing in Japan. His government has been road-testing a number of fiscal measures directly boosting consumption. Some of these could translate to the UK environment. These steps do not necessarily need to include a reduction in VAT – a number of others would be as good or maybe better.

More needs to be done in infrastructure, though this is unlikely to prevent the economy from slowing over the next one to two years. Relying on infrastructure alone is impractical because projects require much time to become operational. Large initiatives such as a third runway at London’s Heathrow airport or High Speed 2, the planned high-speed railway linking London, Birmingham, the East Midlands, Leeds, Sheffield and Manchester, are subject to considerable delays because of labyrinthine planning requirements.

The move to cut base rates by 25 basis points to 0.25%, reintroduce quantitative easing and announce a term funding scheme is not the monetary policy ‘bazooka’ it has been portrayed as in some quarters – more a popgun. The Bank of England did not overreact – how far the economy is going to slow remains uncertain, but the direction of travel is relatively clear.

By comparison, official rates were cut by 450 basis points following the collapse of Lehman Brothers in 2008. The Bank’s first round of QE, launched in March 2009, was highly effective and led to a 100 basis point fall in long-term interest rates. With 10-year government bond rates now standing at around 60 basis points, it would be surprising to see them fall by more than another five to 10 points. Monetary policy appears to be running out of steam and the Bank to be running out of ammunition.

The term funding scheme is unlikely to be taken up in a sizable manner because most banks will see reduced demand for borrowing in coming months. However, the scheme’s introduction at least implies that the Bank recognises that the transmission mechanism of monetary policy works through the banking system – and that if this is flat on its back because of a lack of profitability, it will not do much to spark recovery.

Is the market right that interest rates will not be increased until 2020? I think that is exaggerated. Monetary policy will have to be tightened again in the not-too-distant future. The worldwide decline in long-term interest rates and the ratcheting up of bond prices amount to the biggest bubble I have seen in my lifetime, and that frightens me.

The Bank is assuming that a weakening labour market will curb real wages, offsetting the inflationary impact of a lower pound. It may be right. But there is a danger that nominal wages will grow rapidly and that inflationary pressures could be greater and longer-lasting than it expects. All this means that we shouldn’t rely too much on monetary measures to counter the referendum repercussions. Fiscal policy is what counts.

Charles Goodhart is Professor Emeritus at the London School of Economics and Political Science and a former Member of the Bank of England’s Monetary Policy Committee. This is an edited version of his contribution to an OMFIF Briefing on 4 August. To listen to a recording of the briefing, click here.


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