The Conflicted Bank of England

OXFORD – Andrew Sentance, an outgoing member of the Bank of England’s Monetary Policy Committee, has outlined a credibility-challenging scenario for the BOE. There are two contradictory forces that could keep inflation significantly above its 2% target not only this year and next year, but even in 2013. The dilemma is that any depreciation of sterling increases the level of imported inflation that is not offset by spare capacity in the economy. In other words, the United Kingdom has spare capacity – output fell by 6.4% during the recession and has not fully recovered – but not enough of it. Thus, inflation has been above the BOE’s target throughout the recovery from the financial crisis of 2008. And, according to Sentance, it could stay above that target for the BOE’s two-year medium-term forecast window. Worse still, if Bank of England Governor Mervyn King is right that above-target inflation is due to imported inflation, raising interest rates has little impact unless it induces sterling appreciation, which would reduce the cost of imports. But, sterling depreciation is supposed to re-balance the economy by increasing exports. Indeed, the British government is counting on that. Its new Office for Budget Responsibility forecasts trade contributing as much as consumption to GDP growth in the coming years. Of course, that means closing the current account deficit, which has been about 1-3% of GDP, and that, in turn, implies further weakening of sterling. Obviously, sterling can’t appreciate and depreciate simultaneously. Theoretically, sterling could stay at the current rate of about $1.60 and improve the trade position if the increased volume of cheaper exports outweighed the value of more expensive imports – the so-called J-curve effect. In that case, the trade balance would improve over time, following an initial deterioration. It happened in the early 1990s when sterling weakened after exiting the ERM (exchange rate mechanism), but global economic conditions are now less robust. Another problem is that British exports (particularly services) compete on quality rather than price. And, since the UK doesn’t produce low-end manufactures anymore, they must be imported. In other words, demand for imports and exports is not very price-elastic, and there is only limited scope for substituting domestically produced alternatives. So far, the trade deficit has improved; but, with sterling down roughly 25% on a trade-weighted basis for four years, the upward part of the J seems a little distant. Moreover, there is another dilemma: the output gap. Britain has recovered only one-third of its output lost from a deep recession. With the economy growing by only 1.5% last year and unemployment at 7.8% (not far off a 17-year high), there should be idle factors of production ready to be put to work. But what if the economy’s potential output has been damaged? What if, as has happened in other financial crises, output growth remains sluggish for several years as the banks rebuild their balance sheets and de-leveraging takes place slowly? In that case, the UK might no longer grow at 2.75% annually, but say at closer to 2%. If so, there is a smaller output gap: a lower level of potential output consistent with higher unemployment means that growth will be accompanied by inflation. Of course, the output gap is difficult to compute. But core inflation (which excludes energy and food prices) has been above 2% for much of the recovery, and indirect taxes like VAT – imposed to reduce the fiscal deficit – have contributed to upward pressure on prices. On the other hand, annual wage growth of only 2% means that there are still only minimal second-order effects even after 16 months of above-target inflation. The BOE appears truly conflicted. The majority is voting to keep rates unchanged. But, there are two votes for a 0.25% rate rise, one vote for a 0.50% rate rise, and even one vote for more quantitative easing. This unusual four-way split on its nine-member MPC reflects differences in how the contradictory influences on price stability are assessed. Moreover, with a quarter of the economy contracting (or stagnating when weather effects are discounted), it is not hard to see why the MPC’s members cannot agree. But the BOE’s inaction – even as the ECB raised interest rates in order to begin to normalize monetary policy – could send the wrong signal, according to Sentance. And, as he also warns, if inflation remains above the BOE’s target for another two years, abrupt and sharp monetary tightening would undermine the recovery – and could damage the credibility of the BOE itself. Linda Yueh is a fellow in economics, St. Edmund Hall, University of Oxford, and Bloomberg TV’s economics correspondent. Click here to view her interview with Andrew Sentance. Copyright: Project Syndicate, 2011.