Caveat emptor

We have just finished the fifth full trading week of the year, yet it seems an awful lot has been packed into the past 25 sessions. We started with the assassination of Qasem Soleimani which spooked markets – albeit only briefly – and followed this up with the accidental shooting down of a Ukrainian aircraft in Tehran which further inflamed Middle Eastern tensions. The current big source of concern is the coronavirus which prompted a market sell-off last week but which has subsequently been reversed. Add to this the bizarre spectacle of the Trump impeachment, his subsequent acquittal and the travails of the Democrats in Iowa and you have all the ingredients for a classic risk-off market.

But not a bit of it. The US equity market reached an all-time high on Thursday, taking the year-to-date gain on the S&P500 to 2.7%. If it carries on at this rate (which it won’t) we are on track for another 20%-plus gain following last year’s 29% increase. Whilst market measures of implied option volatility are off their recent lows reported at the end of last year, they remain far from elevated (chart above). The VIX measure of equity volatility currently trades at 15.6 versus a long-term average of 19.1. A similar picture is evident in the fixed income market where the MOVE index ended the week at 61.2 against a long-term average of 92.7. Despite the recent increases, the extent to which investors have expressed their concerns about the long-term economic effects of the coronavirus suggests that recent moves look fairly muted in a wider context

Markets have thus looked through the recent concerns and appear to have concluded that the only thing they have to fear is fear itself. To the extent that the initial reaction reflected fear of the unknown, selling was a natural response but now the shock has worn off. However, it feels like the recent equity surge reflects nothing more than a relief rally. And relief rallies can run out of steam. After all, we have no idea what the near-term implications will be for the Chinese economy but it is unlikely to be good for corporate earnings. Reports from China point to significantly reduced activity as people stay at home, either by choice or as a result of state directive. Burberry has already warned about the potential hit to earnings and has closed 24 of its 64 shops on the mainland whilst ripping up its earnings guidance for the current fiscal year. They are unlikely to be alone as companies with significant exposure to the Chinese economy begin to assess the damage (other luxury goods producers and airlines are sectors which spring immediately to mind). Meanwhile, supply chain disruptions might well become more pronounced and as the hit to corporate earnings materialises, so markets will be forced to revise their expectations.

That said, if the situation mirrors the SARS outbreak in 2003, markets will be expecting a big rebound in activity in the second half of the year with the result that they may simply be looking through the (hopefully) short-term disruption. But we cannot be sure what will happen. Consequently it would seem prudent for investors to take some risk off the table. The fact that they are not doing so reflects the great faith they have in central banks to keep markets afloat with exceptionally lax monetary policy. The rational economist in me does not share that optimism, but viewed from the perspective of the market, the absence of decent financial investment alternatives suggests that any market correction is likely to be brief. If you are a forward looking rational investor, this is a good reason to stay in the market because you avoid the transaction costs associated with selling and buying back in again.

Having been burned in the past with regard to calling the market top I am reluctant to do so again. But a market where valuations look stretched is always going to be vulnerable to unexpected exogenous shocks and it may be that the coronavirus effect turns out to be the catalyst for a rethink. Even if it doesn’t – and there are good reasons to believe that much of the current concern is overblown – it should act as a warning sign that good times do not last forever. So far, the fact that the US economy is holding up continues to support the bullish case and although I do not believe that the economy will crack this year, it may pay to dance near the door in order to beat the rush if the stampede begins.

If ever an indication were needed that something is afoot, take a look at the rally in Tesla stock. Investors have shorted it for the last year, believing the company would struggle to deliver on its plans. Yet since the start of the year its price has risen by around 80% and its market cap now exceeds that of Volkswagen (chart above). Such a sea change reflects more than a simple shift in attitude towards electric cars and Tesla’s ability to deliver – that is a bubble waiting to pop. My natural investor caution is based on the premise that if something cannot continue to forever, it will stop. There again, maybe this time really is different. But they said that in 2000 and 2007 as well. Caveat emptor!

More than deregulation is required

One of my more astute colleagues, who is an ardent Remainer, recently played devil’s advocate by asking whether the UK was likely to gain anything by diverging from the EU’s regulatory regime. After all, regulation represents a business friction which raises costs and lowers output. This is an interesting question which goes to the heart of the economics of leaving the EU and it is worth setting out some of the issues in detail. 

The first point is that the UK is already one of the least regulated economies in Europe, with OECD data showing that it has one of the least regulated product markets and the most deregulated labour market  in the EU. The corollary is that the bang for the buck from additional deregulation would be limited. There are some who believe that legislation such as the Working Time Directive is a hindrance but I am not sure that the majority of workers would necessarily be in agreement, since it guarantees them the right to benefits such as paid holidays. In any case, measures to increase labour input do nothing to resolve one of the economy’s bigger long-term challenges of low productivity. Working longer hours allows you to produce more but does not raise output per hour.

One of the features of the forecast in the BoE’s Monetary Policy Report, released on Thursday, was the downgrade to the medium-term rate of potential growth. When the exercise was last conducted a year ago, the Bank estimated it at 1.4% but it is now put at 1.1%. Compare this with the period 1998 to 2007 when the economy was estimated to have a potential growth rate of 2.9% (my own estimates are shown in the chart below). The underlying reason for this downgrade is the rate of productivity growth which has slowed from a rate of 2.2% in the decade prior to the crash of 2008 to just 0.5% subsequently. It is notable that for many years the BoE assumed that productivity growth would recover, if not to pre-crash levels at least to something higher than of late. This time, however, it has thrown in the towel and acknowledged that a recovery is unlikely in the near-term. This partly reflects cyclical factors, with some evidence of labour hoarding, but structural factors also play an important role. Brexit is expected to compound the difficulties, with trade frictions likely to weigh on productivity, and even though a modest recovery is expected over the next 2-3 years, the economy’s speed limit is not expected to recover very far which calls into question Sajid Javid’s ambition to restore UK growth rates to “between 2.7 and 2.8 per cent a year”.

Regulatory changes are thus going to have little impact on the UK growth rate unless there is a game-changing boost to productivity growth as a result. One possible way for this to happen might be through a surge in foreign investment which significantly boosts the capital stock. If, for example, there is a huge increase in Chinese or US manufacturing capacity in the UK, it could benefit from productive FDI in a similar fashion to Ireland which has been supported by the actions of US multinationals over the last three decades. It’s not totally impossible now that China is the UK’s “new best mate” following the decision to allow Huawei a role in building the 5G network, but I wouldn’t hold my breath. 

Nor should we expect the UK to derive the same apparent deregulation boost that it enjoyed in the 1980s during Thatcher’s term of office. For one thing, the idea that the recovery in the UK’s performance was all down to deregulation is bit of a myth. It also owed a lot to the reallocation of economic resources that came about as a result of the decision to stop providing subsidies to heavy industry. When people think of 1980s deregulation they think of the privatisation programme that reduced the size of the state. But the evidence that it actually improved the economy’s performance is limited: Some things worked, some things didn’t. Admittedly the 1980s Tory administration did break the stranglehold of trade unions which did ultimately help to improve productivity. One industry that did benefit from deregulation was financial services with the Big Bang of 1986 helping to revitalise London as a global financial centre. However, one of the downsides of the reforms of the 1980s is that it was associated with a significant widening of income inequality (chart below) with the excesses in the City of London standing as a metaphor.

Furthermore, in contrast to the situation today, growth in the 1980s was helped by the last of the baby boomers entering the labour force which was a major contributory factor in helping to boost the labour contribution to growth and enabling a potential growth rate which averaged around 2.8% throughout the decade. Then of course, the economy was sheltered by the advent of North Sea oil output which provided a windfall gain to the government. And whatever else people may think about Thatcher’s economic policy, she did recognise the importance of the EU as a market for British exports and was one of the prime movers behind the creation of the single market.

The position today is much less favourable. You simply cannot deregulate your way to prosperity, particularly in a world where the Chinese can produce everything on a bigger scale and more cheaply. There are greater headwinds from demographics as the population ages and the economic speed limit is correspondingly reduced. Consequently the lessons from the 1980s are not a blueprint for the post-Brexit economy. What will mitigate the economic damage are as close relationships as possible with the UK’s main trading partners but the recent rhetoric from the government does not sound very promising in this regard. The old saying that empty vessels make most noise is a phrase we should bear in mind when we listen to the British government issue its “demands”. Its hand became a lot weaker on Friday night and if ministers have not recognised it yet, they soon will.

AdiEU

After 47 years as a member of the EU, the UK is about to head for the exit at perhaps the worst moment in modern history to be pursuing a go-it-alone trade policy. This week’s decision to allow Huawei to take a role in the UK’s 5G network illustrates that the UK will increasingly have to choose its friends carefully, and as Martin Wolf’s recent column in the FT put it, “Britain after Brexit will not be alone, but it will be lonelier.”

As Britain prepares to leave the EU, it is worth reflecting on the fact that more than half the UK population have lived their entire lives as a citizen of the EU. And around 24 hours from now, that will be denied to them. Obviously, nothing is going to change immediately – until end-2020 the UK will still have all the rights of an EU member, apart from the most important one of having any influence over EU decision-making. The vassalage of which Jacob Rees-Mogg made such great play is now a reality. It is only for 11 months, of course. After that, Britain is on its own and will have to fend for itself in a more hostile geopolitical environment than existed in 2016. 

There are huge challenges ahead in order to make the economy Brexit-proof. Having accepted that the UK will now leave the EU, it is incumbent on those who sold their vision of a post-EU Britain to deliver on their promises. What I don’t want to hear from anyone in the course of this year is people telling me to get behind Brexit. That is like saying Liverpool will win the Premiership this year so we should all support them. For the last seven years, I have focused on the economics of Brexit and I have called out those who use spurious economics to justify their entrenched positions. I will continue to do so after 31 January.

Indeed for many of us, the greatest casualty has been truth. Politicians and large parts of the media have never been honest about the trade-off between autonomy and economic well-being and there has always been a sense in parts of the British media that membership of the EU is a zero-sum game. If something is cooked up in Brussels, it must be a plot by the French or the Germans to defraud the British. There has never been any recognition that everyone pools some of their sovereignty in order to get something back. It is true that in the late-1980s the likes of Commission President Jacques Delors had a grandiose vision for the EU which sounded too federalist for many across Europe, and I have long had reservations about the construction of the monetary union which is little more than a glorified fixed exchange rate mechanism. But the high tide of Eurofederalism passed in the early 2000s as the EU expanded eastwards and I suspect it will not easily be able to recapture the ambition (hubris) of the Delors era. Indeed, I maintain that the EU from which the UK voted to leave is not the EU of today, and will not be the EU of ten years hence as it scales down its domestic ambitions and seeks instead to act as a voice for Europe on the global stage.

Even more seriously, Brexit raises question marks against a British political class that is prepared to take a big gamble with the standing of the UK and the well-being of its people. Brexit may work out, but the balance of evidence suggests it will not deliver what its proponents promise. For example, in an increasingly interconnected world, how can people believe that leaving the EU will grant them “freedom”? Freedom from what? As a medium-sized open economy, the UK is a rule taker in the modern global trading system – the only difference in future is that it will not have to accept all the EU’s rules – but it will find that the US and China are even more transactional in their approach to trade and the UK will not be an equal partner. But even “freedom” from the EU will turn out to be a chimera as the UK is forced to adhere to EU standards in many areas in order to retain access to the single market. Throughout the last four years, snake-oil salesmen have sold us a vision of what Britain can be, if only it can shake off the yoke of the EU. It’s all nonsense. And if politicians are prepared to lie to such an extent on matters of fundamental economic well-being, how far are they prepared to go on other issues?

Indeed, the political class are entirely responsible for the mess we find ourselves in today. Whilst people voted as they did in 2016 for various reasons, I maintain that a common denominator was the desire to strike back against politicians who failed to manage the fallout from the economic collapse of 2008-09. Voters were promised that normality would soon be restored. It wasn’t, and those believed to be responsible for the collapse – primarily bankers – were not properly held to account. Meanwhile the subsequent austerity policy introduced by the Cameron government penalised some of the poorest in society. Then to compound their error, MPs spent two years arguing about how to proceed and singularly failing. It is tempting at this point to launch into my “j’accuse” post that I have been wanting to write for years, in which I point fingers and call out those politicians who enabled and facilitated Brexit. But somehow it does not seem like the right thing to do today.

There are many economic and political challenges ahead. Although many people will doubtless celebrate their “liberation” from the EU, the more thoughtful Brexit supporters realise that the real hard work starts now. It won’t be easy and frankly I believe much of what was promised is undeliverable. But I say to Boris Johnson, Michael Gove, Iain Duncan-Smith, Jacob Rees-Mogg, Nigel Farage, Daniel (“absolutely nobody is threatening our place in the single market”) Hannan, Dominic Cummings, Matthew Elliott and all those who believe the UK is about to enter the promised land, this is on you.

Will they, won't they?

The BoE’s Monetary Policy Committee meets next week to decide whether to cut interest rates. It is likely to be a close call. The markets currently assign a 50% probability to such an outcome (chart). Never before have we been so close to an MPC meeting with the markets so undecided, which would appear to put some questions against the policy of forward guidance by which outgoing Governor Mark Carney set so much store.

Turning first to the rate decision, I am, like the markets, unsure how the MPC will vote next Thursday. There are equally good arguments in favour of a rate cut and for rates on hold. The case for a cut is derived from dovish comments from MPC members in recent weeks and a raft of data showing that activity slowed sharply towards the end of last year. GDP in November contracted by 0.3% versus October, suggesting that Q4 GDP will struggle to register positive growth, whilst CPI inflation remains well below the 2% target with the 1.3% rate in November representing the slowest pace in three years. On the basis that if a rate cut is likely to happen at some point, now is as good a time as any.

Against that, survey data has shown a significant rebound in recent weeks with the CBI balance of industrial optimism rising from a recession-indicating -44 in October to a much more comfortable +23 in January. In addition, the flash PMI estimates on Friday showed a sharp rebound, particularly for services, with the index rising to 52.9, the highest since August. The calculation that the MPC must now make is whether this rebound is likely to translate into the hard data, or whether it represents a false dawn, in much the same way as the post EU-referendum weakness in the summer of 2016 did not herald an economic collapse. There is also a question of whether the MPC wants to bind the hands of incoming Governor Andrew Bailey who will take up the reins in March.

Whether the BoE should be cutting rates at all is another issue entirely. I have long argued that the era of low interest rates is having adverse effects on the economy, with my particular concern being the impact on savers, particularly those saving for pensions. But in his most recent speech, Carney argued “the vast majority of savers who might lose some interest income stand to gain from rising asset prices that result from monetary policy stimulus.” That does not wash I’m afraid. Most households’ wealth is held in the form of housing, and unless you can somehow realise the wealth, whilst still maintaining a roof over your head it is not going to compensate for the income foregone in our pension pots. But it does illustrate the relaxed view of many central bankers, particularly in the Anglo Saxon world, towards low interest rates. It is not necessarily a good indicator of where Carney’s sympathies will lie next week but it is evident that he is not averse to taking rates lower if necessary.

I will provide a more comprehensive retrospective of Carney’s tenure another time but whilst he has generally done a good job as Governor there are some areas where his policy prescriptions have proved more controversial than anticipated. Recall that seven years ago, when Carney was about to be installed as BoE Governor, he extolled the virtues of forward guidance as a way of reducing the kind of uncertainty that markets are experiencing today. It is designed to supplement policy options when interest rates are at the lower bound and I discussed some of the pros and cons in this post. But it is ironic that ahead of Carney’s final MPC meeting the BoE’s communications remain as opaque as ever. In my view, this raises the question as to whether the policy itself is flawed or whether it is the BoE’s execution which is the problem.

In a paper published by the BoE in 2017 the authors noted that there are two sources of uncertainty associated with forward guidance. “First, uncertainty stemming from the fact that forward guidance announcements are incomplete descriptions of state-contingent policy behavior”. Secondly, “forward guidance promises may be imperfectly credible ... There is a well-known time-inconsistency problem associated with such promises. Namely, that the central bank has an incentive, once the recovery has taken hold, to renege and tighten policy earlier than originally promised.” This in turn leads “to uncertainty about future policy and an associated reduction in the effect of the forward-guidance announcement on interest-rate expectations.”

Clearly there is no question of the BoE raising rates earlier than anticipated. Quite the opposite in fact. But arguably, the forward guidance policy is an “incomplete description of state-contingent policy behaviour.” Part of the problem stems from the fact that there are nine MPC members, each of whom may have a different view of the current state of the economy, with the result that the state-contingent policy response is likely to differ in each case. We have heard from a number of MPC members since the turn of the year. Carney suggested that “much hinges on the speed with which domestic confidence returns.” On the basis of recent evidence that is an argument to maintain policy on hold. But his colleague Gertjan Vlieghe noted that he would need to see “an imminent and significant improvement in the UK data to justify waiting a little bit longer” – a view shared by another MPC member Silvana Tenreyro. But the big question is whether the recent set of data constitutes such an improvement?

The problem markets have is that they understand the publicly communicated positions of MPC members but they have been left in the dark regarding their reaction to the most recent data. This is a result of the BoE policy which imposes a communication blackout in the 8-9 days leading up to the interest rate announcement. Whilst this policy has been imposed with the best of intentions, it does highlight one of the unsatisfactory elements of forward guidance by preventing communication when it is most needed.

As former Fed Chairman Alan Greenspan said before a Senate committee in 1987, “If I seem unduly clear to you, you must have misunderstood what I said.” More than 30 years later, and after all the efforts by central bankers to improve the way they communicate with markets, it appears that some things never change.

More sabre rattling

In recent weeks I have posed a number of economic questions of Brexit. My issues are never addressed head-on. Instead, the usual response is for supporters of the policy to meet my question with another question which is irrelevant to the issue at hand. I probably shouldn’t be surprised: This has been the modus operandi of Leavers throughout the past four years who have never been able to successfully answer any questions on the economic benefits of Brexit. But we cannot run away from the issues forever, and the latest salvo from Chancellor Sajid Javid in an interview with the FT suggesting there will be no post-Brexit regulatory alignment with the EU raises questions that need to be answered.

To quote directly, “there will not be alignment, we will not be a ruletaker, we will not be in the single market and we will not be in the customs union - and we will do this by the end of the year.” He justifies this stance by arguing that companies have had three years to prepare for a new economic relationship. But they haven’t really. Theresa May’s administration was concerned to minimise trade frictions with the EU and it has never been clear what regulatory arrangement the government was aiming for. It is even less clear today. The fact that the government has postponed EU exit three times in the last ten months means the business community is increasingly unsure which deadlines it has to meet, which has added to the confusion. Following the government’s cancellation of regular meetings with industry groups there appears to be a widening gulf between the needs of business and the government. No wonder that business investment has barely risen in the past three years.

Digging deeper only reveals the flaws in Javid’s thinking. His suggestion that “Japan sells cars to the EU but they don’t follow EU rules” is to ignore the fact that Japan has invested heavily in the UK precisely in order to have production facilities which allow it to comply with EU regulations. His hope to boost annual GDP growth to “between 2.7% and 2.8%” a year also sounds like a big stretch when you consider that the slowdown in population growth appears to have reduced the potential growth rate to something closer to 1.5%. His belief that “Once we’ve got this agreement in place with our European friends, we will continue to be one of the most successful economies on Earth,” was pure hubris. How an economy which neither grows particularly quickly nor has exceptionally high incomes per head, let alone one with a debt-to-GDP ratio close to 90%, can be considered “one of the most successful economies on Earth” strains credulity. The economic situation is not terrible but his is not a description of the UK economy I recognise.

As I can attest from my own experience, just because Javid has worked in a trading environment does not mean he necessarily knows anything about economics and I have no idea whether the man entrusted to looking after the nation’s finances believes this nonsense. I rather suspect he does not, as this gem taken from his Brexit referendum literature in 2016 confirms (see graphic above). Consequently, his comments can simply be seen as a bargaining ploy to get the EU to take seriously the UK’s threat to walk away with no deal at the end of 2020. However, I maintain that such an approach is counterproductive. Nobody doubts that a no-deal Brexit will cause some hardship for the EU but it will only have a problem with one trading partner whilst the UK will have a problem with 27. This type of posturing was tiresome three years ago – today it appears deluded.

There is a clear sense that the government is trying to reboot the economic model, in much the same way as the Thatcher government did 40 years ago. The difference is that the economic failures of the 1970s justified trying out new policies. By the early 1980s, the old industries on which the UK had depended for the better part of a century were no longer globally competitive. One of the ways the UK moved forward was to focus on new sectors, particularly in services, and new markets, particularly the nascent EU single market. The case for such a radical economic change is absent today (though you can argue about the need for political change). If the UK is, as Javid believes, “one of the most successful economies on Earth” what is the argument for such a radical structural change?

Over the last four years, many Brexit supporters have consistently failed to acknowledge the importance of regulatory harmonisation for trade. Industries with cross-border supply chains, for example, do not have to worry whether their products meet local requirements if they are sanctioned for use within the single market. Industries such as pharmaceuticals have to meet stringent requirements before their product is certified for use by the general public. Having the same set of rules across different markets makes it easier to sell across borders, and ultimately reduces costs from which the consumer benefits. Regulatory harmonisation is even more important in service industries where it is so much easier to impose little obstacles that can derail trade. Sajid Javid might believe the UK is no longer going to be a rule taker in international trade rules but he is wrong. Trade rules are what underpin the system and if you want access to the Chinese, Indian or American market you have to abide by the rules in those markets.

I have been upfront about my concerns regarding leaving the EU over the years. Even though I was on the wrong side of the Brexit decision, I can live with the referendum result so long as the economic disruption can be minimised. But I remain opposed to the decision to leave the single market, not only because it was not on the ballot paper in June 2016 but primarily because it threatens to impose higher costs which will lead to a reduction in economic welfare. The Brits do have legitimate concerns about the extent to which the UK may be forced to adhere to future changes to EU law on issues such as the environment, and I will deal with this problem in a subsequent post. Indeed, this may be one of the motivating factors behind Javid’s comments. Nonetheless, for too long politicians have been allowed to get away with economically illiterate arguments to support their political case. This is another such example, and there is a serious risk that one day the EU will call the UK’s bluff.

Monetary policy at the limit

As the global economy recovered in the wake of the 2008-09 bust, many economists noted that central banks would have to raise interest rates as a precautionary measure in order to give monetary policy some headroom when the next downturn struck. That downturn appears to be here and central banks do not have much conventional ammunition left in their locker, even though markets are increasingly pricing a BoE rate cut this month having dismissed such a prospect at the start of last week (chart). Central bankers continue to sound confident about their ability to cope. Is this simply a case of them trying to underpin market sentiment or are there grounds for confidence?

A speech last week by outgoing BoE Governor Mark Carney was a case in point. In summary, Carney emphasised that further asset purchases and additional forward guidance mean that central banks have more scope than is commonly supposed. But the speech had a valedictory air about it, highlighting the successes of the BoE’s monetary policy during Carney’s near-seven years in office without touching on the downsides, and we have to look through some of the spin in order to assess whether some of the policy prescriptions still stand up. That said, central banks have had more policy successes than failures over the past decade so we should cut them some slack. After all, if the likes of the ECB had not done “whatever it takes” to hold the euro zone together in 2012, the economic history of the past decade could have been very different (and not in a good  way).

Turning first to the issue of forward guidance, this was one of Carney’s big ideas when taking office in 2013 through which the BoE would indicate how it would set monetary policy contingent on economic conditions. Despite the Governor’s claims for its success today, the reality in 2013-14 was very different. Recall that the BoE made it clear it would not raise interest rates so long as the unemployment rate remained above 7%. In the event unemployment fell much more quickly than anticipated, yet rates were kept on hold. Clearly, a commitment not to raise rates so long as unemployment is above a threshold level is not the same as a commitment to raise them when it falls below it. But there was a significant degree of confusion surrounding the policy and it is more than a stretch to claim, as Carney does now, that “people understood the conditionality of guidance.”

One of my retrospective criticisms of the BoE’s forward guidance policy is that it quickly abandoned the published unemployment rate as a target variable in favour of the output gap, giving rise to the suspicion (whether justified or not) that it no longer suited the BoE’s purposes. As I noted in written evidence to a parliamentary committee in 2017, “since the measure of spare capacity was determined by the BoE, this meant that outside observers became increasingly reliant on the information feed from the MPC to determine the future policy stance. The clarity of rule-based forward guidance policy was lost.”

Is there a future for forward guidance? Despite my reservations about the way in which it has been implemented in the past, I believe it does have a role to play – although maybe a less important one than Carney believes. In my view, forward guidance has a much more prosaic role. By communicating its objectives to as wide an audience as possible on a regular basis, it should be possible to remind people of the things that the central bank focuses on and thereby encourage the public to observe a particular set of variables, thereby giving it a better idea of how the central bank is likely to react. I am not sure that the message is getting through, however. Despite numerous BoE communications regarding the current below-target rate of inflation, the most recent Bank of England/TNS Inflation Attitudes Survey, conducted in November, suggested respondents believed the current rate of inflation was 2.9% (it was actually 1.4%) and the 12-month ahead forecast was for a rate of 3.1% (the BoE expects it to be significantly below 2%).

Carney also made the case for additional QE. On the basis of his calculations, further asset purchases of around £120bn (0.5% of GDP) is equivalent to 100 bps of interest rate cuts. Adding in the near 75 bps of conventional rate reductions, which would take Bank Rate to near zero, and the (unspecified) impact of forward guidance he reckons the BoE would be able to deliver monetary easing equivalent to 250 bps of rate cuts, which just happens to be the average in pre-2008 monetary easing cycles. However, it is what he did not say that is telling. It may be possible to deliver a one-off monetary boost of the magnitude that Carney suggests, though that is questionable since it is acknowledged that the marginal impact of QE diminishes as central banks buy more assets. But it is not possible to deliver it on a repeated basis without taking away some of the initial stimulus when the economic picture improves (which is, of course, what European central banks have not done in the past decade).

Another issue that Carney did not address are the long-term consequences of lower for longer. Savers have foregone a significant amount of interest income over the past decade. The response to that is savers should have taken cash out of the bank and bunged it into equities, but that does not seem to be a prudent policy which central bankers should endorse. Indeed, Carney argued that “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus.” But that is not very helpful when the asset in question happens to be your home as it is not so easy to realise the capital gain (unless you plan to significantly downsize). As for pensions, central bankers are aware that keeping rates low has a major impact on future pension returns but they do not talk about it much in public. However, annuity rates continue to fall which means that the future value of our pension pots is a lot less than it used to be. I thus continue to believe that the long-term consequences of a prolonged low interest rate policy will only be felt in the very long-term, by which time it will be too late to do anything about it, and today’s generation of central bankers will be long gone.

For all central bankers continue to tell us that they have more ammunition in the face of a downturn, the ECB under Christine Lagarde is no longer as gung-ho about a lax monetary stance as it was under Mario Draghi, since it realises that negative rates have significant side effects. Although the likes of Carney and Draghi can, with some justification, argue that their loose policy prescriptions were the right choice at the time the real problem is that rates remained low for much longer than was necessary on the basis of prevailing economic conditions. The problems associated with this are becoming increasingly evident and sooner or later I fear we will all pay a price.

No permanent friends, only permanent interests

We do not hear as much these days about the prospect of the UK falling back on WTO rules in the event that a trade deal with the EU cannot be concluded. This is partly because such an outcome is unlikely to happen in the near-term since the UK will enter into a transition agreement with the EU from February. But it also probably reflects the fact that the WTO has been severely damaged by the actions of Donald Trump which in turn has reduced its usefulness as a body overseeing international trade rules.

The problem is that Trump has consistently blocked appointments to the WTO’s Appellate Body – the high court of international trade – as the terms of sitting judges expire. The Appellate Body (AB) was established in 1995 and is comprised of seven judges who rule on trade disputes between WTO member countries. Each judge is appointed for a four year term, which can be renewed only once, and the Body requires a quorum of three in order that its rulings are accepted as valid. Following Trump’s tactic of blocking the reappointment of existing members, the AB was reduced to the minimum number of three in 2019 and with the terms of two of them expiring in December, it can no longer command a quorum. In theory, the AB can continue to hear pending appeals because members are able to rule on existing cases even after their mandate expires, but it is no longer able to hear new cases. As a consequence, a country which loses a dispute can file an appeal knowing that it will not be heard, and as a result can continue to act as before.

How have we got into this position? Quite simply, the Trump administration believes that the WTO is biased against the US. It is true that compared to the pre-1995 period the US is less able to throw its considerable weight around on international trade issues. Under the old GATT system, there was no settlement mechanism in place to hold countries to account for trade violations and in the 1980s and early-1990s the US exploited this to introduce a series of unilateral tariffs, ostensibly to force countries to open up their domestic markets. This policy, dubbed “aggressive unilateralism” by US-based trade economist Jagdish Bhagwati, served only to anger major trading blocs such as the EU and in any case its rate of success was limited. To assuage these concerns, the Uruguay Round of GATT began in 1986 which eventually led to the formation of the WTO in 1995, including the Appellate Body.

On a global basis, the WTO has been a great success in as much it has reduced the extent to which trade disputes spiral out of control. But it does constrain the US to work within the rules. However, the US wins around 85% of the cases that it brings before the AB – hardly evidence of bias against it. As long ago as 2007, the US Council on Foreign Relations suggested that “the dispute settlement system reflects a delicate balance between toughness and respect for sovereignty; rather than criticizing the result, U.S. policymakers and legislators should invest more energy in defending it.” Furthermore, the dispute settlement mechanism “curbs the protectionist instincts of U.S. trade policymakers and so underpins prosperity” by acting as a counterweight to the intense domestic lobbying by politically influential, but inefficient, domestic industries.

Ironically, the US is today reported to have reached out to Japan and the EU for support to introduce tougher WTO regulations on government subsidies in a bid to further increase the pressure on China, where the US believes state support is distorting competition. To the extent that this may be a way to bring the US back into the WTO fold, it has found support from the EU. But it comes just a day before the US and China are supposed to sign their phase one trade agreement, in which China will agree to buy at least $200 bn of US exports over the next two years whilst the US will commit to rolling back some of the tariffs it has levied on China (though by no means all).

One of the concerns ahead of the publication of the deal is the extent to which the phase one agreement will fall foul of WTO rules. If, for example, it requires China to import a specified amount of US produce, this would amount to managed trade and thus violate WTO rules. There is also a concern that China may simply import less from other WTO members whilst raising its imports from the US. All this goes to reinforce the views expressed by nineteenth century British prime minister Lord Palmerston that “nations have no permanent friends or allies, they only have permanent interests.” China is very much in the sights of the US but the EU fears that it, too, could fall foul of the Trump administration’s trade policy. Meanwhile, China may well be prepared to acquiesce to US demands for now but at the expense of trade with other nations. And who is going to do anything about it? Not the WTO, which has been hobbled by the US!

At the current juncture, it does look as though we are going back to an era of power politics on trade issues, with the US and China increasingly operating in their own interests. I did point out last August that this was not the right time for the UK to go it alone on trade policy and I maintain – as I have done for the last three years – that the decision to leave the European single market is a dumb and short-sighted policy. As I noted in my last post, it is imperative that the UK strikes the best possible trade deal with the EU for it cannot rely on the kindness of strangers in what looks to be an increasingly hostile trade environment.