Warwick Business School

UK business cycle expansions Source: Bank of England Historical Database and External MPC Unit calculations The five longest business cycle expansions since the mid-19 th century PeriodDuration Average growth over period Cumulative increase in GDP years3.0%107.6% years3.2%60.1% years3.8%54.4% years2.6%25.5% years3.2%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 % per annum change in non-oil GDP

UK inflation persistently above target Source: Office for National Statistics % per annum increase in consumer prices index

Key issues Impact of global volatility Impact of global volatility Control of UK inflation Control of UK inflation Monetary policy and economic growth Monetary policy and economic growth The importance of the supply-side The importance of the supply-side Policies to support economic recovery 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) % 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 Demise of alternative paradigm to market economy - collapse of Soviet communism Integration into global market economy of China, India and former Soviet bloc Integration into global market economy of China, India and former Soviet bloc WTO established in 1995 (now 153 members covering 97% of world population) WTO established in 1995 (now 153 members covering 97% of world population) Globalisation impact extends from trade & investment to labour and capital markets Globalisation impact extends from trade & investment to labour and capital markets A long global expansion with strong growth in Asia and emerging 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

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 figures

The global credit boom Low inflation in late 1990s and early 2000s allows global monetary expansion Low inflation in late 1990s and early 2000s allows global monetary expansion Globalisation of financial markets encourages expansionary bank behaviour Globalisation of financial markets encourages expansionary bank behaviour Experience of steady growth and low inflation supports financial risk-taking Experience of steady growth and low inflation supports financial risk-taking No substantial regulatory or monetary response to rein in excessive credit growth No substantial regulatory or monetary response to rein in excessive credit growth Large financial imbalances emerge – mainly within existing currency blocs Large financial imbalances emerge – mainly within existing currency blocs

G20 current account balances Source: IMF, October 2009 World Economic Outlook Percent of GDP

Sources of global instability Increased global interdependence through supply chain linkages Increased global interdependence through supply chain linkages Highly integrated global financial markets support rapid transmission of shocks Highly integrated global financial markets support rapid transmission of shocks Rapid transmission of news and information through media and IT networks Rapid transmission of news and information through media and IT networks Upward pressure on global energy and commodity prices & increased volatility Upward pressure on global energy and commodity prices & increased volatility Lack of effective economic policy co-ordination 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

Global primary energy consumption Source: BP Statistical Review 2010 Million tonnes oil equivalent

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 PeriodTargetHighLowAve May Dec 2003RPIX = 2.5%3.2%1.5%2.4% Jan Dec 2007CPI = 2.0%3.1%1.1%2.0% Jan 2008 – Sep 2011CPI = 2.0%5.2%1.1%3.4%

UK inflation: What has gone wrong? Global inflationary pressures Global inflationary pressures Large sterling depreciation Large sterling depreciation Persistent services inflation Persistent services inflation Limited impact of spare capacity Limited impact of spare capacity

Global inflation on the rise % per annum change in consumer prices Source: The Economist

UK inflation in international context Source: Office for National Statistics Index of consumer prices, January 2008 = 100

Persistently high services inflation Source: Office for National Statistics % 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

Episodes of Sterling depreciation Index, base year = 100 Number of years from start of period Source: Bank for International Settlements

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.

UK goods price inflation Source: Office for National Statistics % per annum change in goods prices

High inflation squeezing sales volumes Source: Office for National Statistics % per annum growth in retail sales (3-month ave)

Capacity utilisation in UK economy Source: Bank of England 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 Unemployment rate, % of labour force Number of quarters from employment peak

Wage growth picking up Source: Office for National Statistics % 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

UK inflation control – key issues Simple output gap model does not explain recent performance of UK inflation Simple output gap model does not explain recent performance of UK inflation Therefore it is a poor forecasting framework, leading to policy errors Therefore it is a poor forecasting framework, leading to policy errors Exchange rate and international shocks have been much more important influences Exchange rate and international shocks have been much more important influences Services sector inflation suggest pricing behaviour not fully consistent with 2% inflation target 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 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) Monetary policy can help short-term growth (1-2 years) But in the longer-term, growth depends on supply-side performance and fundamentals 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 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 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 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 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 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 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 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 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 Demand-side policies can aggravate underlying structural issues by postponing adjustment

Employment in UK recessions Source: Office for National Statistics, Labour Force Survey 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 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 Employment has held up well – much better than in previous recessions Growth may be understated by current estimates Growth may be understated by current estimates Many corporates have conserved cash and have potential to increase investment substantially Many corporates have conserved cash and have potential to increase investment substantially But confidence is a major issue in the current climate But confidence is a major issue in the current climate More pro-business and pro-growth supply-side policies needed to unlock potential 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 Private sector needs to be the engine of growth Long-term and consistent plan for deficit reduction Long-term and consistent plan for deficit reduction Monetary policy normalisation – shift from emphasis on stimulus to stability focus Monetary policy normalisation – shift from emphasis on stimulus to stability focus Supply-side and structural policies to support business confidence, investment and growth Supply-side and structural policies to support business confidence, investment and growth Greater realism needed about longer-term growth rates Greater realism needed about longer-term growth rates

Conclusions (1) Global volatility likely to continue – leading to fluctuations in growth and inflation 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 Monetary policy cannot fully offset these fluctuations – and needs to focus on medium- term stability rather than short-term growth UKs inflation problem is more deeply embedded than the MPC acknowledges UKs 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 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 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 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 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 Supply-side policies are the key to supporting growth over the longer-term