The UK’s macroeconomic policy faces two decisive moments in the next few weeks: the Bank of England’s Monetary Policy Committee meeting on Thursday and chancellor Philip Hammond’s Budget later in November.
The expectation is for the combined policy to start applying the brake to aggregate demand. Many MPC members have signalled they are ready to raise interest rates; Hammond has let the cabinet know he will stick to his fiscal rules that leave little room for a fiscal expansion or even a let-up on the current pace of continued consolidation.
How can this possibly be the right aggregate demand management for a slowing UK economy?
The background is, of course, the deteriorating outlook for UK productivity. With next to no productivity growth for years, actual growth forecasts going forward are also having to be lowered.
But the question should be whether those rules are warranted. The correct stance of aggregate demand policy — and this goes for both the fiscal and the monetary side — must be sensitive to whether the economy is today below its full capacity, not simply at what rate that capacity will grow in the future. If there is still slack in the economy — if there is room for more demand that will trigger greater activity rather than simply accelerated inflation — then contractionary policy should be put off until a time when capacity is used up.
As both Duncan Weldon and Simon Wren-Lewis have explained in recent days, in the context of monetary policy, that means the interest rate setters must believe this slack has been exhausted. There is no other justification for raising rates — if that is what they choose to do. (This is why Weldon insists that a rate rise would be an expression of resignation, not optimism, about Britain’s economic prospects.)
But the same argument could be applied to fiscal policy: unless monetary policy is expected to be loosened, it cannot be macroeconomically correct for fiscal policy to be tightened unless the economy has reached full capacity. Indeed the chancellor knows that monetary policy is more likely than not to be tightened, and the MPC knows that fiscal policy is on a contractionary course. If there is any slack in the economy at all, one or both sides ought to change course, lest macroeconomic policy cause gratuitous harm.
But as Wren-Lewis also points out, you do not need to look very hard to see that there is still slack. There is no pressure on wage inflation, even in the presence of price rises due to the fall in sterling: “there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know.”
The one factor that could justify supply-side pessimism is Brexit. Leaving the EU will make the full-employment capacity of the UK economy smaller than it otherwise would be, in part because of costlier trade with the rest of Europe and in part because of less immigration.
But this will happen in the future. Even if investment is already being held back because of it, the supply-side effect of Brexit will work itself out over time. Aggregate demand, meanwhile, could be cut back abruptly in anticipation of future economic costs. The slowdown in growth since last year is surely driven by less buoyant demand. True, consumption demand has held up better than most economists (and Free Lunch) expected, but the very fact that it is credit-fuelled makes it vulnerable.
So the calculation should be whether demand today is falling (relative to what it would have been without Brexit) faster than supply. If it is, aggregate demand policy should add stimulus, not withdraw it. And since the immediate risk of a demand shortfall is greater than that of curtailed supply, it would be reckless to exacerbate that risk by withdrawing demand through concerted policy.
Both fiscal and monetary policy should, in other words, be kept loose: the MPC should hold rates where they are and signal its readiness to cut further; the chancellor should soften up his fiscal rules, or at the very least increase taxes and spending so as to boost aggregate demand (exploiting the so-called balanced budget multiplier, where you withdraw less private demand through tax rises than you add to public demand via spending).
But the greatest responsibility lies on the MPC’s shoulders. If only one of the two arms of aggregate demand management can stimulate, that had better be monetary policy. Fiscal retrenchment combined with even lower interest rates could at least help spur investment, which is, in any case, essential to remedy both the chronic productivity stagnation and the acute supply-side hit from Brexit.
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