Monetary policy will not be enough to spur the UK into growth
THE OECD has now joined the ranks of organisations highlighting the fragility of the UK economy. Its leading indicator showed that UK growth momentum is slowing, from 0.2 per cent monthly growth in September, to an anemic 0.01 per cent in January.
Sterling has plunged to two-and-a-half year lows against the dollar on the back of recent macabre assessments of the UK economy. The pound currently hovers around $1.49 – down by nearly 5 per cent over the last year. Against the sclerotic euro, the pound has also fallen by 3.5 per cent in the last 12 months, currently sitting around €1.15.
Monetary policy has only had a limited impact on stimulating a recovery, and government policy has not done enough to make the economy more competitive. Some argue that sterling’s devaluation will improve UK competitiveness, as the price of UK exports falls for foreign buyers. But this argument is flawed.
With the Eurozone in recession, there is little chance of an export boom, since Europe accounts for over 40 per cent of the UK’s export market. Weaker sterling will, however, make imports more expensive and, since the UK is a net importer, this will drive inflation upwards and continue to squeeze consumers, thereby weighing on economic growth. And since loose monetary policy is inflationary, the Bank of England’s ability to use it as a policy tool is becoming constrained.
A CHANGE OF POLICY
It seems unlikely that chancellor George Osborne will deviate from his deficit reduction plans any time soon. Indeed, in its downgrade of UK credit, Moody’s cited the long-term fiscal consolidation plans as a positive.
Speculation is therefore mounting that the chancellor may amend the Bank of England’s remit at his Budget next week, and give the Bank a longer time horizon to bring inflation, currently 2.7 per cent, back down to its 2 per cent target. This would also open the door to more monetary easing.
But Ian Stennard of Morgan Stanley is concerned that “the chancellor will have to increasingly rely on monetary policy to provide stimulus to the UK economy,” where monetary activism offsets fiscal tightening. Stennard argues that “this is traditionally a negative policy mix for a currency,” and believes that expectations of higher inflation and more easing will weigh on the pound, potentially driving it down as low as $1.43.
And many are sceptical about whether allowing the Bank of England to tolerate higher inflation will ultimately be able to boost economic growth. Jens Larsen of RBC Capital Markets argues that the macroeconomic outlook has not changed substantially to warrant a change in strategy. The risk is that the new policy could undermine the Bank’s credibility. This would be dangerous, and would likely put more pressure on sterling.
Former Monetary Policy Committee (MPC) member Andrew Sentance has also highlighted the potential danger, arguing that currency devaluation does little to spur growth, but leads to higher inflation and volatility. He says “it is difficult to see how monetary policy can do much more to support growth,” and suggests that the MPC should be “stripped of language that encourages support of these policies”.
The market has shown that activist monetary policy and a weaker currency is not a substitute for solid government policy. In order to reverse sterling’s decline, and propel economic growth, the chancellor needs to be bolder. The hope is that he takes this direction in next week’s Budget. But don’t hold your breath.