UK’s rebound is becoming a major headache for Mark Carney

 
Allister Heath

COULD Mark Carney’s luck have already run out? Given that he has only been governor of the Bank of England since July, it may sound churlish even to ask such a question. But the timing of his revolutionary announcement that interest rates would stay on hold for three years – barring a spike in inflation or a bubble – is starting to look terrible. It was a signal that the economy remained weak, that it needed historically low interest rates for years to come and that normalisation could wait.

That might have made sense had the economy continued to flatline or grow by a few tenths of a per cent a quarter. But instead we have seen a flood of strong data over the past few months, culminating in yesterday’s astonishingly good services sector purchasing managers index, the best since 2006, taking the composite index for the entire economy to its highest reading since 1998. The economy remains riddled with structural problems but activity is bouncing back dramatically.

Under the previous system, at this stage at least some members of the monetary policy committee would be mulling whether or not to hike rates, if not immediately then perhaps in the next few months. It would have been unthinkable to start notching up quarters of 1 per cent growth or more – as we are now likely to see – and still keep rates so low, and retain quantitative easing at £375bn. Not this time.

The PMI surveys showed that employment growth in August slowed sharply compared with July, which had seen the strongest growth since October 2007. But Markit, which compiles the surveys, believes that this is temporary: order books are bulging, and backlogs of work across manufacturing and services increased by their greatest amount since 1999. The forecaster expects employment to start growing more strongly as we move into the fourth quarter. Assuming that productivity doesn’t suddenly bounce-back instead, with existing workers producing more, Carney’s seven per cent unemployment threshold could easily be hit sooner than he thinks.

No wonder, therefore, that the markets increasingly don’t believe Carney and are doing his job for him, tightening monetary conditions. The pound is up by two per cent since Carney announced his forward guidance; Shaun Richards, an economist, calculates that this is equivalent to a rate hike of 0.5 per cent under the Bank’s model. Gilt yields have also shot up. Carney’s attempt to guide the markets has failed spectacularly.

The return of strong growth is not just a problem for Carney’s dovish forward guidance. Ed Ball’s anti-austerity claims are also in tatters. The cuts did not cause a triple-dip recession and didn’t lead to permanent stagnation.

The Centre for Economics and Business Research estimates that US GDP will be 4.8 per cent above its pre-recession peak this year, while the UK will still be around 2 per cent smaller. What is fascinating about America’s outperformance, compared with the UK, is that it has gone hand in hand with greater austerity than anything seen in Britain.

Douglas McWilliams, the CEBR’s boss, has crunched the OECD numbers, which are most easily comparable: he finds that the US has made a 6.2 per cent of GDP structural adjustment in its fiscal balance since 2009. The UK has made a much smaller adjustment of only 3.9 per cent, he calculates. Thanks to the sequester cuts, austerity has further intensified recently in the US, with the OECD pencilling in a 3.2 per cent of GDP structural adjustment in 2013 alone.

Yes, US growth this year has been disappointing – but its performance has been laudable once one accounts for the fiscal headwinds. The biggest loser from the UK’s recovery is Ed Balls. But it will also soon become a headache for Carney: how long can he really keep interest rates at crisis levels if the economy continues to rebound?

allister.heath@cityam.com
Follow me on Twitter: @allisterheath