Memorandum submitted by Mr Ciarán Barr, Chief
UK Economist, Deutsche Bank
In this note we look at the one of the key issues in the Inflation Report, namely the future direction of the consume. The Bank has expected consumption to slow for some time.
Recent falls in financial wealth and a weaker labour market are thought to be key drivers for weaker consumption ahead. But it is unclear whether consumers are still "gearing up" to take advantage of low interest rates (and the "recapitalisation effect", a process which may not slow of its own accord).
The MPC could be faced with the task of slowing the consumer if the coming months do not show a natural easing. This will prove a difficult balancing act given weakness in other areas of the economy, the uncertainty of debt burdens and questions over the current sensitivity of consumers to interest rates. Fiscal policy could potentially play a role in the April Budget through higher taxes.
We are overall sanguine on the prospect for much higher rates this year, expecting only modest increases (4.5 per cent by year-end). Aggressive hikes would likely sow the seed of future sharp consumer slowdown.
Finally, there is a quirk in the Report with downside growth risks but upside inflation risks. This is due to a puzzling viewpoint on the exchange rate. Were growth to collapse and push sterling lower, then we do not believe that depreciation would be inflationary.
"The Committee concluded that some of the unusual strength of consumption was likely to unwind over the forecast horizon, as savings rise towards a more normal level in relation to income and wealth. The rise in the saving ratio will tend to moderate prospective consumer spending growth."
August 2000, Inflation Report
"The Committee continues to expect that household spending growth will slow over the course of the next year or so, reflecting earlier reductions in financial wealth and a weakening in real income growth, as labour market conditions ease."
February 2002, Inflation Report
We are at a difficult point for the UK economy's path, and the consumer arguably holds the key to the future direction, at least in terms of interest rates. As the above two quotes illustrate, the MPC has expected a slowdown in consumption growth for some time now, but thus far they have waited in vain. Since Q2 1997, and the MPC's inception, consumption growth has averaged 1 per cent qoq, compared to its long-run average (since 1955) of 0.7 per cent. This unexpected resilience of consumer demand has actually confounded most commentators, not just the policymakers, and can be attributed to a combination of factors:
strong employment growth
positive wealth effects (from the housing market)
increased appetite for debt (tied into the "recapitalisation effect", of which more below)
and, recently, deliberate monetary stimulus.
The expected outlook for consumer demand lies at the heart of current monetary policy and, thus, the Inflation Report. This can be observed in the latest minutes, which see both the "hawks" and the "doves" using the consumer as justification for their respective arguments:
Hawks: "cutting rates would undesirably stimulate an already buoyant household sector"; "some members placed weight on upside risks to the inflation outlook . . . from the possibility of a depreciation of sterling's exchange rate and from the possibility that consumption would not slow as projected."
Doves: "the arguments for delay (in cutting rates) did not appear convincing given that, despite the buoyancy of consumption, GDP was expected in the short term to remain growing below trend and that the main risk to consumption further out was on the downside . . . not cutting rates because of concerns about growing household indebtedness might imply a higher exchange rate than otherwise."
EXAMINING THE MPC'S REASONS FOR SLOWER CONSUMPTION
Despite, or perhaps because of, the continued outperformance of consumer demand, the Committee's central expectation is that consumption growth will slow down towards the end of this year, and eventually stabilise a little below long-run trend rates towards the end of the (two-year) forecast horizon. This points to a slowdown from the current 4-4.5 per cent annualised growth rate down to around 2.5 per cent a significant deceleration. The thrust of their argument is that:
1. previous reductions in financial wealth will feed through, adversely affecting demand and,
2. real income growth will weaken as the labour market eases (albeit only "moderately")
It is worth looking at each of these rationales in turn:
Certainly financial wealth has declined with the fall in equity markets but one can argue that the sustained increase in house prices is of more importance in terms of overall household balance sheets. The decline in equity values has reduced households' directly held financial assets by £240 billion since their peak in Q3 2000 (and over £300 billion in life insurance/pension fund assets) but over that time house prices have risen by 17 per cent (up to January 2002), providing an offset of some £300 billion in housing wealth. As the chart shows, household net worth thus remains at a high level, despite the smudge in household debt, the take up of which appears to have accelerated in recent quarters.
It is at this point we wish to mention the "recapitalisation effect", first introduced by former MPC member DeAnne Julius and a key part of our thinking on the consumer sector. This is that in essence the granting of operational independence to the Bank of England fundamentally changed for/expectations of the average UK consumer:
The recapitalisation effector money illusion?
Since mid-1998, a year after MPC independence, the average mortgage rate on new loans (actually levied, not the standard variable rate) has been 6 per cent, with a relatively tight range of around 5 per cent to 7 per cent. This is much lower than the mortgage rates seen throughout the 1980s, and below ex ante expectations.
If we assume that this lower rate is expected to be permanent then it is economically rational that consumers revisit their sustainable borrowing levels (due to reduced income gearing). This resulting increased demand for housing however translates into high prices, given the inelastic supply of homes.
As such, we see (as we have done) an increase in both house prices and associated mortgage debt. In turn, existing homeowners are encouraged to borrow against the rising value of their homes, resulting in higher mortgage equity withdrawal. Consumer credit also sees a boost, while one can even argue that spending on durables receives a benefit as the implicit return is boosted relative to interest rates by the latter's sharp decline.
The key question however is when does this come to an end? Rationally speaking, one can argue that there is some higher equilibrium level where both house prices and debt are sustainably higher (assuming real interest rates have also declined with MPC independence). What happens though if the consumer fails to take into account the need to pay back debt in a low inflation environment? In other words, they suffer from "money illusion" and are confusing the sharp reduction in nominal interest rates with a similar fall in real rates. At present, it is unclear whether this has occurred, but certainly the current growth rates in consumer debt are not sustainable.
It is interesting that the build-up in consumer debt was discussed in the February minutes against the background of the Inflation Report.
Firstly, the recapitalisation effect was discussed: "in an environment of greater macroeconomic stability, households might be able to sustain higher levels of debt relative to income than in the past. They might simply be making that adjustment; the debt-to-income ratio in the United Kingdom was not out of line with that in many other developed economies."
Secondly, the issue of money illusion for the consumer was also mentioned: "the lower nominal interest rates implied by lower medium-term inflation expectations meant that the real burden of servicing and repaying debt was now spread more evenly over the life of a loan than during the higher-inflation late-1980s, when it had been concentrated in the early years of a loan." It should be noted however that, "some members thought that the quantitative significance of this adjustment for most housing-related loans was likely to be small."
Labour market easing
Like most commentators, Deutsche Bank has been wrong-footed by the lack of a significant deterioration in unemployment, despite the raft of survey evidence to the contrary. (One might suggest this gloomy bias by City pundits reflects the widespread redundancies across the investment banking industry). The chart below illustrates how one survey in particular, which had a previous track record in calling the turn in the labour market, has failed to "predict" the current resilience in employment demand. We have several explanations as to why the sharp weakening in labour market surveys has not translated into higher unemployment:
1. Lags/growth revisions: Blaming lags is often the last refuge of poor forecasting but it is certainly true that slower economic growth takes time to "feed through" into falling employment. In addition, GDP in the first half of 2001 (when forecasts of rising unemployment were often made) has since been revised higher: Q1 was originally estimated at 0.3 per cent qoq, it is now 0.7 per cent qoq.
2. Labour hoarding: One can argue that the experience of the early 1990s recession still lies in the minds of many employers. The large swathes of job reductions in that bitter downturn were later reversed as the economy accelerated yet in the interim many employers had been forced to lose some of their best employees. Given the current tightness of the labour market, firms may well be prepared to hold onto their workforce as much as possible in order to avoid the need for costly recruiting when demand picks up once more.
3. Two-tiered labour market: This is perhaps the best explanation; it can be also be expressed as "job creation outweighing job destruction". In effect, there have been significant redundancies in many sectors, such as telecommunications, IT, financial services and so on, areas that benefited from rapid growth in recent years. These have been much publicised, and reflected in most of the survey evidence. On the other hand, however, there has been substantial job creation in other sectors, such as distribution and retailing. These may have been less highlighted than the job losses, but have ensured that the labour market does not deteriorate to any large degree.
Nonetheless, as discussed, the Committee expects a modest decline in labour market demand going forward (although they do not crystallise how much, presumably for reasons of sensitivity). One piece of evidence (as seen in the above chart) they offer is the recent fall in hours worked, driven by lower overtime. It should be noted that the hours worked series is reasonably volatile, although it does confirm other evidence, from surveys and anecdotal.
But what if it (consumption) does not slow?
The MPC's central forecast of gradually slowing consumption, and an overall rebalancing of the economy as external demand accelerates (with beneficial effects for sectors of the UK economy), is straightforward enough. However, at the present juncture, one should examine the various risks attached. We will come onto the downside risks (which is where the Committee has a bias on growth at present) below, but for now let us focus on the possibility that the consumer continues to remain "stronger for longer". The Committee then has three options:
(i) do nothing: we would argue this is the present modus operandi. It is difficult to believe that the recent retail sales data (two consecutive monthly declines) tell the full story about the UK consumer. They sit oddly with other indicators such as consumer confidence, credit/borrowing data and retailer reports. It is quite conceivable that either consumers are spending their cash on no-retail items (new cars, meals out etc) or that the figures are eventually revised higher. Against this background the PMC should wait and see, at least until May and the next Inflation Report before tightening policy to engineer a consumer slowdown. This is especially true since the Budget takes place in April, and one option is to:
(ii) tighten fiscal policy: as we all know, the monetary authorities have one target and one instrument: as such, it is difficult for them to rebalance the economy, whether that involves industry and the consumer, or the North-South "divide". As such, the government still has something of a role to play in overall macroeconomic direction. Were consumer demand to maintain its strength, with the associated (and possibly unsustainable) debt build-up, then higher taxes could attempt to diffuse this. At the same time, the government would presumably appreciate the extra revenue ahead of the summer Comprehensive Spending Review. It is beyond the remit of this note to discuss the form of tax rises, or even their political validity, but it is certainly true that they could allow the MPC to keep policy looser than might otherwise be the case, with benefit to the corporate sector, and manufacturing in particular.
(iii) increase interest rates: assuming that the global economy (especially the US) continues to recover in line with the tentative evidence seen at present, the MPC are likely to hike interest rates in order to produce a consumer slowdown if it is not naturally forthcoming. There are two risks associated with such an outcome: firstly, that it punishes sectors which are more vulnerable (indeed, one can argue corporates as a whole are far from buoyant, cf profit growth/net rate of return): secondly, that higher interest rates, especially a series of hikes, could end up being too successful, especially if one considers the current debt levels to be excessive.
It is a difficult balancing act, one the MPC themselves are finding problematic; encouragingly however, the latest minutes noted: "it was not clear that policy would need to be tightened sharply to restrain demand if rapid borrowing growth continued . . . smaller changes in official interest rates would be required for a given desired effect on spending and saving decisions . . . it was possible that the effect on household behaviour of any increase in interest rates would also depend on the proportional change rather than just on the absolute change."
Our official view is that we will see a combination of events, namely some modest tax increases, slower consumption growth as the debt appetite diminishes, and gently rising interest rates (our forecast if for 4.5 per cent repo rate by year-end, compared to the market's view of 5 per cent or above). Assuming, however, that the consumer does not slow of its own volition, we would at this juncture prefer to see fiscal, rather than monetary policy, do the brunt of the work. This is not a political judgement (and tax changes do need to judge the political, as well as economic, landscape) but rather a view that monetary policy is ill-equipped to deal with the handling of imbalances. We should note that the MPC's willingness to tighten monetary policy will of course depend on their judgement on inflationary pressures. The jump in inflation to 2.6 per cent in January was a surprise to everybody: we do not believe that underlying inflation pressures are increasing rapidly, given the continued competitive backdrop. However, if inflation is genuinely in the system, it increases the risks that the Committee tightens rapidly, with an associated intensification of future downside risks to consumer demand.
Horses and camels, or downside growth risks = upside inflation risks
Sir Alec Issigonis, most famously known for creating the Mini, also coined the well-known phrase, "a camel is a horse designed by a committee". While it would be grossly unfair, and incorrect, to describe the Inflation Report in such derogatory terms, the sobriquet does arguably apply to the publication's discussion of risks. In essence, the MPC argue that the risks to growth are on the downside given their judgement on the balance of risks facing both private final demand and the world economy. This is understandable, and in part explains why we have deliberately focused on the implications of upside risks to consumption in the above discussion.
In terms of those downside growth risks, the downwards bias for consumers and firms largely reflects a judgement that, "high and rising levels of household and corporate debt are a source of vulnerability in the event of a shock to income or a substantial change in interest rate expectations." The Report then argues, "were such a correction to private spending to materialise, there is a risk of an associated fall in the sterling exchange rate." To be fair, it is also envisaged that the widening current account deficit of the continued possibility that the euro might recover also pose downside risks for sterling. Nonetheless, the likelihood that sharply weaker consumption growth would push down the exchange rate is openly discussed (and certainly possible). Where the argument becomes confusing is in the Committee's judgement that the inflation risks are thus on the upside, "as the prospect of a faster exchange rate depreciation and the associated adjustment to the level of import prices is the dominant influence."
We would strongly disagree. Were final demand to slow sharply (and remember that the central projection is for consumer spending growth to ease to around 2.5 per cent yoy), then any resulting exchange rate depreciation would likely find its inflationary implications absorbed in spare capacity, and an absence of second-round effects. In other words, cost-push inflation would be negated by lower demand-pull inflation. The MPC has perhaps struggled with the outlook for the exchange rate since its inception (a problem of course not confined to policymakers, we have all at times, misinterpreted the currency) but the best lesson from this is to react to the exchange rate when it changes, rather than second-guess any movement. This is especially true when the economic arguments are, as discussed, far from controversial. Indeed, the minutes show that members of the Committee are divided on the validity of these upside inflation risks. It is to be hoped that the upside risks to inflation, as currently envisaged, do not lead to an unnecessary "pre-emptive" tightening of monetary policy. Without wishing to tarnish an otherwise excellent Report we would finish with another quote (albeit anonymous this time), which we hope applies to the discussion of the consumer and the exchange rate: "a committee is a cul-de-sac down which ideas are lured and then quietly strangled."
25 February 2002