Swan song for a hawk
Andrew Sentance has been voting for higher UK interest rates for nearly a year. Today, in what reads like his final speech as a member of the Monetary Policy Committee, he offers a cogent defence of his position.
As Sentance says himself, this is not a question of tactics. The fact that he has been in the minority for so long on the committee reflects a substantial difference of view about the prospects for inflation and growth in the UK and - crucially - the role of UK monetary policy. Even the doves on the MPC would have to admit that his arguments have strengthened in the past year, if not in the past few weeks.
He thinks the doves are wrong on four big issues.
First, he thinks it is both wrong and inconsistent with past MPC policy to assume away "global price shocks" such as higher commodity prices when setting interest rates. I have looked at this issue, at length, in a previous post (see "A Case of Asymmetry?") Suffice to say that Sentance thinks the upward pressure on prices from this source is likely to carry on for a while, and ought to command a response from the Bank.
Second, and more controversially, he thinks the Bank should not have been so relaxed about the fall in the pound, which has added to inflationary pressures at a very inconvenient time and, by squeezing disposable incomes, actually "offset the boost to growth we might be seeing from improved trade performance."
His remarks here chime with recent gloomy comments about the loss of Britain's manufacturing base, with big firms complaining that they have no domestic component suppliers to turn to, to take advantage of the weaker pound. This is something the Bank recently investigated for itself, with depressing results. Here's Sentance again:
"..it is not clear that the export-based manufacturing activities which could benefit from a large depreciation have the capability to respond quickly by scaling up output - particularly when their demand is already being boosted by a recovery in global demand."
Put bluntly, he thinks the bank has allowed the pound to fall further than is "necessary or desirable to support the growth of manufacturing and exports." He says that allowing sterling to rise by about 10% from its current level against the euro (£1 = 1.13 euros) would still leave it at a relatively competitive level by historical standards.
You may disagree with him. I suspect Mervyn King does. But you'd be silly to dismiss out of hand the views of a man who has spent much of his professional life as an economist considering the strengths and weaknesses of UK industry.
The third big area of disagreement is more familiar: the amount of spare capacity in the economy, which he thinks the doves are over-estimating. Here he has one weak argument and one strong. The weak argument is that OECD estimates of the output gap since the mid-1990s have been consistently revised down - in other words, that the economy has consistently turned out to have less room to grow than we thought.
While factually accurate, I don't think it tells us about the underlying capacity of the UK economy so much as it tells us that forecasters have often mistaken the cycle for the trend and even more often turned out to be wrong on the question of how fast the economy could grow. That's why discussion of the output gap is usually so fruitless. Even years after the fact, you simply never know how much of the economy's growth was "structural" and how much due to short-term policies. Indeed, the closer you look at the distinction between the two, the more slippery it seems.
In the late 1990s we had less capacity than we thought - because domestic inflationary pressures were being offset by falling world prices. But arguably, we made the same mistake, in reverse, coming out of the recession in the early 1980s. And Adam Posen would argue that Japan's big mistake, coming out of its financial crisis, was to underestimate its potential.
The much stronger argument for any hawk - which I have banged on about in the past - is the simple fact that producers have been able to pass on all these price rises, and then some, without suffering much of a hit to sales (or at least, not until recently).
As Sentance points out, this is particularly evident in the service sector, which should have been less affected by global price pressures:
"If we look at the services component of the consumer prices index, this 3-4% level rate of inflation has been a fairly consistent feature in the decade prior to the recession. There is not much evidence here of spare capacity and weak demand pushing down on services inflation. And whereas relatively high services inflation in the late 1990s and early 2000s was offset by flat or falling goods prices, this is no longer the case. So if services prices continue to rise at a 3-4% rate, and goods prices continue to be pushed up by external factors and the weakness of the pound, it is very difficult to see how the MPC will be able to return inflation to the 2% target, even over a number of years."
You'll remember the counter-argument to all this - which is that the low level of pay growth will ultimately put a lid on price rises. We may have seen some of that at the retail level in recent months. But no-one can be sure, yet, that shrinking pay checks will ultimately do what the MPC has chosen not to do.
As I've said before, it's a matter of judgment whether you think inflation will adjust to pay - or the other way round. But even Mervyn King would have to admit that the jury is still very much out.
Which leads us to Sentance's final point, which is about the MPC's credibility. As he admits, inflation expectations may only be "flashing amber" right now. There's not much sign that the Bank's reputation for curbing inflation has been permanently hit. But underneath, he worries that the Bank's credibility has been eroded by the MPC's reluctance to take action, and that this will make things harder for the committee - not to mention the rest of us - when the Bank does finally raise rates.
Once again, you don't have to agree with Andrew Sentance. Most of his MPC colleagues have disagreed with him for many months. But all should admit that he makes an important case, which should still get a hearing at the MPC, even after the person who first had the courage to make it has left.