Warwick Business School

Steering the UK economy through global turbulence

Professor Andrew SentanceWarwick Business School and Former Member, Bank of England MPC

WBS Special Lecture – Tuesday 25 October 2011

UK business cycle expansions

Source: Bank of England Historical Database and External MPC Unit calculations

The five longest business cycle expansions since the mid-19th century

Period DurationAverage growth

over period

Cumulative increase in

GDP

1948-1973 26 years 3.0% 107.6%

1992-2007 15 years 3.2% 60.1%

1932-1943 12 years 3.8% 54.4%

1868-1877 10 years 2.6% 25.5%

1982-1990 9 years 3.2% 29.8%

Note: Periods of continuous growth have been measured on an annual basis from the first year of growth following one recession to the last period of growth prior to the next recession

UK economic growth

Source: ONS

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011-8

-6

-4

-2

0

2

4

6

Previous data Latest data Trend

% per annum change in non-oil GDP

UK inflation persistently above target

Source: Office for National Statistics

1995 Jan 1997 Apr 1999 Jul 2001 Oct 2004 Jan 2006 Apr 2008 Jul 2010 Oct0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Value Target Ave 2008-11

% per annum increase in consumer prices index

Key issues

• Impact of global volatility

• Control of UK inflation

• Monetary policy and economic growth

• The importance of the supply-side

• Policies to support economic recovery

UK and world economic growth

* EU, US and 11 other economies accounting for 85% of world GDP

Source: IMF World Economic Outlook and The Economist (consensus forecasts)

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

-6

-4

-2

0

2

4

6

UK World

% per annum change in GDP in UK and G-13 economies*

Forces creating ‘New Global Economy’

Technology

Political change

De-regulation

Trade liberalisation

Key changes in 1990s and 2000s

• Demise of alternative paradigm to market economy - collapse of Soviet communism

• Integration into global market economy of China, India and former Soviet bloc

• WTO established in 1995 (now 153 members covering 97% of world population)

• Globalisation impact extends from trade & investment to labour and capital markets

• A long global expansion with strong growth in Asia and emerging markets

The rise of Asia

*: Includes Australia, China, India, Indonesia, Japan, Malaysia, Singapore, South Korea, Taiwan Province of China and Thailand.

Source: IMF World Economic Outlook

Percentage share of world GDP, current market prices and exchange rates

0%

5%

10%

15%

20%

25%

30%

35%

40%

1980 1990 2000 2010

US EU-27 Asia-pacific G10 *

Shares of world GDP and population

*: Apac G10: Asia-Pacific G10, including Australia, China, India, Indonesia, Japan, Malaysia, Singapore, South Korea, Taiwan Province of China and Thailand.

Source: IMF World Economic Outlook, World Bank and Eurostat.

2010 figures

US, 23%

EU-27, 26% Apac

G10*, 27%

Other, 24%

GDP at market prices

US, 5%

EU-27, 7%

Apac G10*, 46%

Other, 43%

Population

The global credit boom

• Low inflation in late 1990s and early 2000s allows global monetary expansion

• Globalisation of financial markets encourages expansionary bank behaviour

• Experience of steady growth and low inflation supports financial risk-taking

• No substantial regulatory or monetary response to rein in excessive credit growth

• Large financial imbalances emerge – mainly within existing currency “blocs”

G20 current account balances

Source: IMF, October 2009 World Economic Outlook

Percent of GDP

-10

-5

0

5

10

15

20

25

30

35

Sau

di A

rab

ia

Ch

ina

Germ

an

y

Ru

ssia

Jap

an

Arg

enti

na

Can

ad

a

Ind

on

esia

Ko

rea

Eu

rop

ean

Un

ion

Mexic

o

Un

ited

Kin

gd

om

Bra

zil

Ind

ia

Fra

nce

Italy

Au

str

alia

Un

ited

Sta

tes

Tu

rkey

So

uth

Afr

ica

2005-2007 average2008

Sources of global instability

• Increased global interdependence through supply chain linkages

• Highly integrated global financial markets support rapid transmission of shocks

• Rapid transmission of news and information through media and IT networks

• Upward pressure on global energy and commodity prices & increased volatility

• Lack of effective economic policy co-ordination

Real oil and commodity prices

Source: IMF and Thompson Datastream.

Deflated by US consumer price index; 2000=100

0

50

100

150

200

250

300

350

1980 1985 1990 1995 2000 2005 2010

S&P GSCI Agriculture and Livestock index

S&P GSCI Industrial Metals index

Brent crude spot price

Global primary energy consumption

Source: BP Statistical Review 2010

Million tonnes oil equivalent

2000

2500

3000

3500

4000

4500

5000

5500

6000

6500

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

OECD

Non-OECD

The global economy and UK inflation

Global economy

Cost of imports

Demand

Pricing climate

Exchange rate

Domestic demand

Expectations and credibility

UK inflation

Impact of monetary policy

MPC – The inflation record

Source: Office of National Statistics

Period Target High Low Ave

May 1997 - Dec 2003

RPIX = 2.5% 3.2% 1.5% 2.4%

Jan 2004 - Dec 2007

CPI = 2.0% 3.1% 1.1% 2.0%

Jan 2008 – Sep 2011

CPI = 2.0% 5.2% 1.1% 3.4%

UK inflation: What has gone wrong?

• Global inflationary pressures

• Large sterling depreciation

• Persistent services inflation

• Limited impact of spare capacity

Global inflation on the rise

% per annum change in consumer prices

Source: The Economist

USEu

ro

China

Japa

n UK

Braz

il CaIn

dia

Russia

Aust

r...

-2

0

2

4

6

8

10

12

Year agoLatest

UK inflation in international context

Source: Office for National Statistics

2008

Jan

2008

Apr

2008

Jul

2008

Oct

2009

Jan

2009

Apr

2009

Jul

2009

Oct

2010

Jan

2010

Apr

2010

Jul

2010

Oct

2011

Jan

2011

Apr

2011

Jul

95

100

105

110

115

UK Euro US

Index of consumer prices, January 2008 = 100

Persistently high services inflation

Source: Office for National Statistics

Jan-97 Jan-02 Jan-07-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

Goods Services

% per annum change in consumer prices

Sterling depreciation since 2007

Rebased to 100 in January 2005

Source: Thompson Datastream and Bank for International Settlements

*: Effective exchange rate

70

75

80

85

90

95

100

105

110

2005 2006 2007 2008 2009 2010 2011

Euro-Sterling exchange rate

Sterling EER *

Average EER *, 97-07

Episodes of Sterling depreciation

Index, base year = 100

Number of years from start of period

Source: Bank for International Settlements

50

60

70

80

90

100

110

0 1 2 3 4 5

1967-1971 1972-1977 1981-1986

1991-1996 2007-2010

Euro/UK inflation differential & exchange rate

Source: Thompson Datastream

*: Euro-Sterling exchange rate is expressed as the deviation from its average over the same period.

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1997 1999 2001 2003 2005 2007 2009 2011

Euro-area/UK CPI differential (RHS) *

Euro-Sterling exchange rate (LHS) **

Euro/ sterling %

UK goods price inflation

Source: Office for National Statistics

Jan-97 Jan-02 Jan-07-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

CPI goods Factory gate prices

% per annum change in goods prices

High inflation squeezing sales volumes

Source: Office for National Statistics

1997MAR 1999FEB 2001JAN 2002DEC2004NOV2006OCT 2008SEP 2010AUG-2

0

2

4

6

8

10

Value Volume Average 97-08

% per annum growth in retail sales (3-month ave)

Capacity utilisation in UK economy

Source: Bank of England

Jan-98 Jan-03 Jan-08-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Manufacturing Services

Bank of England Agents’ scores relative to normal

Unemployment in UK recessions

Source: Office for National Statistics, Labour Force Survey * Q3 based on Jun-Aug average

-8 -6 -4 -2 0 2 4 6 8 10 12 14 164

5

6

7

8

9

10

11

12

77Q4-83Q4 88Q2-94Q2 06Q2-11Q3*

Unemployment rate, % of labour force

Number of quarters from employment peak

Wage growth picking up

Source: Office for National Statistics

Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Monthly 3-month m.aAverage since 2001

% per annum growth in private sector average weekly earnings

Large official inflation forecast errors

Source: Bank of England

Mean of forecast percentage annual increases in consumer prices

0

1

2

3

4

5

6

2007 2008 2009 2010 2011 2012 2013

May-09 Nov-09

May-10 Nov-10

May-11 Actual CPI inflation

UK inflation control – key issues

• Simple “output gap” model does not explain recent performance of UK inflation

• Therefore it is a poor forecasting framework, leading to policy errors

• Exchange rate and international shocks have been much more important influences

• Services sector inflation suggest pricing behaviour not fully consistent with 2% inflation target

• MPC responses reinforcing the perception that inflation target has been changed or downgraded

Monetary policy, growth and stability

• Monetary policy can help short-term growth (1-2 years)

• But in the longer-term, growth depends on supply-side performance and fundamentals

• Globalisation has also affected the traditional links between monetary policy, growth and inflation

• The “Great Stability” in the 1990s and 2000s led to excessive faith in monetary stabilisation

• This seems to be continuing in the US and the UK, despite concerns about inflation

• Extreme measures are being taken to provide stimulus, raising questions over effectiveness and sustainability

A salutory lesson from the US?

• A high degree of monetary stimulus was used to head off an economic downturn after 9/11

• Stimulatory policies continued for a number of years, helping to inflate the global credit boom

• The economy did not adjust to correct the excesses of the “dot.com” boom and bust

• Credit growth and housing activity masked underlying structural problems which are now contributing to sluggish growth and high unemployment

• Demand-side policies can aggravate underlying structural issues by postponing adjustment

Employment in UK recessions

Source: Office for National Statistics, Labour Force Survey

-8 -6 -4 -2 0 2 4 6 8 10 12 14 1692

94

96

98

100

77Q4-83Q4 88Q2-94Q2 06Q2-11Q2

Index of employment, 100 = cyclical peak

Number of quarters from employment peak

The UK – a reason to be cheerful

• The UK non-financial business sector has been very resilient through the recent recession

• Employment has held up well – much better than in previous recessions

• Growth may be understated by current estimates

• Many corporates have conserved cash and have potential to increase investment substantially

• But confidence is a major issue in the current climate

• More pro-business and pro-growth supply-side policies needed to unlock potential

Sustaining growth over the recovery

• Private sector needs to be the engine of growth

• Long-term and consistent plan for deficit reduction

• Monetary policy normalisation – shift from emphasis on stimulus to stability focus

• Supply-side and structural policies to support business confidence, investment and growth

• Greater realism needed about longer-term growth rates

Conclusions (1)

• Global volatility likely to continue – leading to fluctuations in growth and inflation

• Monetary policy cannot fully offset these fluctuations – and needs to focus on medium-term stability rather than short-term growth

• UK’s inflation problem is more deeply embedded than the MPC acknowledges

• The pound has fallen further than needed to rebalance the economy and is part of the inflation problem

Conclusions (2)

• Monetary policy played an important role in stabilising economies in 2008/9

• But it now needs to revert to a more conventional & symmetric mode of operation

• Fiscal consolidation is unavoidable for high deficit countries and delay only leads to confidence/financial market problems

• Supply-side policies are the key to supporting growth over the longer-term