Monday, August 26, 2019 / 06:30AM / By / Header Image Credit: BoE
Before turning to the focus of my remarks, I would like to begin with a few comments on the UK outlook.
A snapshot suggests the UK economy is currently close to equilibrium, operating just below potential with inflation just above its target.
Both headline and core inflation are around 2%, and domestic price pressures have been picking up notably. In particular, the labour market is tight. Growth in wages and unit wage costs have strengthened considerably as slack has been absorbed, with both now running at their highest rates in over a decade. The strength of the labour market is supporting consumer spending, which is rising broadly in line with real incomes.
But pictures can deceive; two large, volatile forces could push the UK economy far from balance.
Until the start of this year, the UK economy had been growing around its trend rate. Since then, the intensification of Brexit uncertainties and weaker global activity have weighed heavily on UK activity.
Global momentum remains soft, despite the broad-based easing in monetary policy expectations. In part this reflects a significant spike in economic policy uncertainty and the related risk that protectionism could prove more pervasive, persistent and damaging than previously expected. As I will discuss in a moment, these headwinds are now restraining business investment globally and could push down on the global equilibrium interest rate, exacerbating concerns about limited monetary policy space.
Long-term government bond yields have fallen sharply alongside the falls in expected policy rates. US 10- year yields are near three-year lows, and 10-year gilt yields and German 10-year bund yields are their lowest ever. Around $16 trillion of global debt is now trading at negative yields.
As material as these global developments are, the UK outlook hinges on the nature and timing of Brexit.
The UK economy contracted slightly last quarter and surveys point to stagnation in this one. Looking through Brexit-related volatility, it is likely that underlying growth is positive but muted.
The biggest economic headwind is weak business investment, which has stagnated over the past few years, despite limited spare capacity, robust balance sheets, supportive financial conditions and a highly competitive exchange rate. There is overwhelming evidence that this is a direct result of uncertainties over the UK's future trading relationship with the EU, and it serves as a warning to others of the potential impact of persistent trade tensions on global business confidence and activity.
The UK economy could follow multiple possible paths depending on how Brexit progresses with material implications for the stance of monetary policy.
In recent weeks, the perceived likelihood of No Deal has risen sharply as evidenced by betting odds and financial market asset pricing (the UK now has the highest FX implied volatility, the highest equity risk premium and lowest real yields of any advanced economy).
In the event of a No Deal No Transition Brexit, sterling would probably fall, pushing up inflation, and demand would weaken further, reflecting lost trade access, heightened uncertainty and tighter financial conditions.
Unusually for an advanced economy slowdown, there would also be a large, immediate hit to supply. The Monetary Policy Committee (MPC) would need to assess to what extent that reflects temporary disruption to production, with limited implications for inflation in the medium term, or a fundamental destruction of supply capacity because of the abrupt change in the UK's economic relationship with the EU.
As the MPC has repeatedly emphasised, the monetary policy response to No Deal would not be automatic but would depend on the balance of these effects - on demand, supply and the exchange rate - on medium term inflationary pressures.
In my view, the appropriate policy path would be more likely to ease than not, using the flexibility in the MPC's remit to lengthen the period over which inflation is returned to target. But much would depend on the exact nature of No Deal and its impact. In the end, monetary policy can only help smooth the adjustment to the major real shock that an abrupt No Deal Brexit would entail, but even its ability to do that would be constrained by the limits to the MPC's tolerance of above target inflation.
While the possibility of No Deal has increased, it is not a given. Along another path, it is possible that domestic political events or negotiations with the EU could lead to a longer period of uncertainty over the eventual future relationship, even in the event that an agreement is struck. On past performance, the longer these uncertainties persist, the more likely it is that growth will remain below potential raising the prospect of both softer domestically generated inflation and resurgent imported inflation if recent sterling weakness were to endure. Once again, the MPC would need to weigh the opposing forces when setting policy.
Finally, some form of agreement remains possible. After all, that is the avowed preference of both the UK and EU. In this event, consistent with the MPC's most recent projections, as details of the future relationship gradually emerge, business investment recovers and household spending picks up, resulting in excess demand and inflationary pressures gradually building. In the Committee's judgment, this path for the economy would likely require limited and gradual interest rate increases.
The coming months could be decisive. If there are material Brexit developments, the MPC will transparently assess their implications and set policy to achieve the 2% inflation target in a sustainable manner.
I. Challenges for Monetary Policy in the current IMFS
When Ben Bernanke was retiring from the Fed, his closing remarks to central bank governors at the BIS set us the task of sorting out the deep flaws in the international monetary and financial system ("IMFS"). Six years later, with my demise as governor on the horizon, I'm going to 'pay it forward' by focusing on how the nature of the IMFS challenges monetary policy.
For decades, the mainstream view has been that countries can achieve price stability and minimise excessive output variability by adopting flexible inflation targeting and floating exchange rates. The gains from policy coordination were thought to be modest at best, and the prescription was for countries to keep their houses in order. (This view is summarised in a speech by John Murray, 'With a Little Help from Your Friends: The Virtues of Global Economic Coordination' , 29 November 2011.)
This consensus is increasingly untenable for several reasons. Globalisation has steadily increased the impact of international developments on all our economies. This in turn has made any deviations from the core assumptions of the canonical view even more critical. In particular, growing dominant currency pricing (DCP) is reducing the shock absorbing properties of flexible exchange rates and altering the inflation-output volatility trade-off facing monetary policy makers. And most fundamentally, a destabilising asymmetry at the heart of the IMFS is growing. While the world economy is being reordered, the US dollar remains as important as when Bretton Woods collapsed (Fig 1).
The combination of these factors means that US developments have significant spillovers onto both the trade performance and the financial conditions of countries even with relatively limited direct exposure to the US economy.
These dynamics are now increasing the risks of a global liquidity trap. In particular, the IMFS is structurally lowering the global equilibrium interest rate, r*, by:
In an increasingly integrated world, global r* exerts a greater influence on domestic r*. (See, '[De]Globalisation and Inflation'. 2017 IMF Michel Camdessus Central Banking Lecture given by Mark Carney, 18 September 2017). As the global equilibrium rate falls, it becomes more difficult for domestic monetary policy makers everywhere to provide the stimulus necessary to achieve their objectives.
These dynamics are directly relevant to the current risks of a global slowdown. At present, there are relatively few fundamental imbalances in terms of capacity constraints or indebtedness that would of themselves portend a recession. (See 'The Global Outlook', speech by Mark Carney, 12 February 2019).
However, the combination of structural imbalances at the heart of the IMFS itself and protectionism are threatening global momentum.
The amplification of spillovers by the IMFS matters less when the global expansions are relatively synchronised or when the US economy is relatively weak. But when US conditions warrant tighter policy there than elsewhere, the strains in the system become evident.
These conditions emerged last year. US fiscal policy had boosted growth at a time when the US economy was near full employment. US monetary policy had to tighten consistent with the Fed's dual mandate. The resulting dollar strength and financial spillovers tightened financial conditions in most other economies by more than was warranted by their domestic conditions (two thirds of the global economy was growing at below potential rates at the start of 2019, and that proportion has since risen to five sixths). More recently, the dramatic increase in trade tensions (Chart 1) has reinforced their effects by increasing risk premia.
Today, the combination of heightened economic policy uncertainty (Chart 2), outright protectionism and concerns that further, negative shocks could not be adequately offset because of limited policy space is exacerbating the disinflationary bias in the global economy.
What then must be done?
In the short term, central bankers must play the cards they have been dealt as best they can.
That means using the full flexibility in flexible inflation targeting. To retain the essential credibility of their frameworks, this is best done transparently with central bankers explaining their reasons for targeting specific trade-offs between price stability and output volatility.
Those at the core of the IMFS need to incorporate spillovers and spill backs, as the Fed has been doing. More broadly, central banks need to develop a better shared understanding of the scale of global risks and their consequences for monetary policy. We cannot all export our way out of these challenges.
In a global liquidity trap, there are gains from coordination, and other policies - particularly fiscal - have clear roles to play. And acting earlier and more forcefully will increase their effectiveness.
In the medium term, policymakers need to reshuffle the deck.
That is, we need to improve the structure of the current IMFS. That requires ensuring that the institutions at the heart of market-based finance, particularly open-ended funds, are resilient throughout the global financial cycle. It requires better surveillance of cross border spillovers to guide macroprudential and, in extremis, capital flow management measures. And it underscores the premium on re-building an adequate global financial safety net.
In the longer term, we need to change the game.
There should be no illusions that the IMFS can be reformed overnight or that market forces are likely to force a rapid switch of reserve assets. (The analysis of Gita Gopinath, Emmanuel Farhi, Matteo Maggiori and Jeremy Stein, amongst others, emphasises the persistence in the structure of the current IMFS.)
But equally blithe acceptance of the status quo is misguided. Risks are building, and they are structural. As Rudi Dornbusch warned, â€œIn economics, things take longer to happen than you think they will, and then they happen faster than you thought they could".
When change comes, it shouldn't be to swap one currency hegemon for another. Any unipolar system is unsuited to a multi-polar world. We would do well to think through every opportunity, including those presented by new technologies, to create a more balanced and effective system.
II. Growing Challenges in the Current IMFS
The structure of the current international monetary financial system is making it increasingly difficult for monetary policy makers to achieve their domestic mandates to stabilise inflation and maintain output at potential.
According to the mainstream view, these objectives are best achieved through operationally independent central banks adopting flexible inflation targeting and allowing their exchange rates to float.
That view rests on two pillars. The first is that floating exchange rates are effective absorbers of global shocks, insulating domestic employment and output from developments abroad. If import prices are fully flexible and international financial markets are complete, then changes in exchange rates pass through fully to import prices, and the optimal monetary policy response is to accommodate the effect on inflation, keeping output close to potential and the price of domestic output stable. (See Corsetti, G, Dedola, L, and Leduc, S (2010), 'Optimal Monetary Policy in Open Economies', Handbook of Monetary Economics, Vol. 3, Chapter 16, pp. 861-933; and Benigno, G and Benigno, P (2006), 'Designing targeting rules for international monetary policy cooperation', Journal of Monetary Economics, Vol. 53(3), pp. 473-506. In the standard welfare-based analyses of optimal monetary policy in an open economy, a key consideration is the extent to which sticky prices in different currencies lead to deviations from the law of one price (LOOP) for different goods. The first-best (efficient) outcome is for goods to sell for the same price when converted into different currencies. If this is not the case, demand is misaligned internationally, which in turn creates an inefficient allocation of factor inputs. Under PCP, the full flexibility of import prices means the exchange rate can act as an efficient shock absorber, adjusting to ensure that the LOOP holds.)
That leads directly to the second pillar - that there are only modest gains from international policy cooperation and coordination in such circumstances. This long-standing and widely held view reflects the beliefs that any externalities that might exist are almost trivially small and that trying to address them would be fine-tuning to the nth degree.
The mainstream view is increasingly anachronistic for several reasons.
First and foremost, international linkages have risen dramatically over the past few decades, increasing the importance of cross border spillovers. (World trade as a share of global GDP has doubled since 1970. Over the past two decades, 80% of the increase in total trade has come from intermediates goods trade, driving up the value added of imports as a share from 10% of exports in 1990 to around 20% in 2015. Cross-holding of countries' assets and liabilities increased almost fourfold since 1990, and measures of stock market integration are at their highest ever (see Bastidon, C, Bordo, M, Parent, A, and Weidenmier, M (2019), 'Towards an Unstable Hook: The Evolution of Stock Market Integration Since 1913', NBER Working Paper No. 26166.)
Growing cross border trade means external demand has greater effects on domestic resource allocation and therefore inflation. The integration of low-cost producers into the global economy has imparted a steady disinflationary bias through its direct effect on prices. The expansion in global value chains has increased the synchronisation of producer prices across countries. Financial linkages have increased leading to a faster and more powerful transmission of shocks across countries. And globalisation has increased the contestability of markets, weakening the extent to which slack in domestic labour markets influences domestic inflationary pressures (For more detail on these changes, see '[De]Globalisation and Inflation', ibid.)