A little less conversation (a little more action please)

The investor community was distinctly unimpressed with the BoE’s decision to leave interest rates on hold yesterday with accusations that it had raised expectations ahead of the MPC meeting, only to dash them again. I have a lot of sympathy with those who were caught out, having spent years trying to discern the messages from central banks, and it is always immensely galling when policymakers drop hints only to act contrary to these messages. But it is equally important to understand that central bank messaging is always ever conditional and this subtlety is often overlooked during the media frenzy. However, this episode calls into question the usefulness of forward guidance as a policy tool and the BoE will clearly have to work on its communication strategy. There is also a question of whether a rate hike to counter a supply-side boost to inflation was ever the right approach in the first place.

Communication breakdown

Starting first with the communications, Governor Andrew Bailey told an online panel discussion organised by the G30 group on 17 October that "monetary policy cannot solve supply-side problems - but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations … And that's why we at the Bank of England have signalled, and this is another such signal, that we will have to act." There were mutterings at the time that such a strong statement, made on a Sunday when markets were closed, should not have been made unless it signalled a shift in policy communications. A few days later the BoE’s new chief economist, Huw Pill, said in an FT interview that “I think November is live” and went on to add “the big picture is, I think, there are reasons that we don’t need the emergency settings of policy that we saw after the intensification of the pandemic” (a view I would endorse). But Pill also tried to take some heat out of the debate by noting “maybe there’s a bit too much excitement in the focus on rates right now.”

The latter point is the bit that was overlooked in the media commentary that followed. The BoE really ought to know better by now that markets simply do not do subtlety. Interest rate decisions are viewed as binary and markets are very poor at determining the distribution of risks unless they are spoon fed. There were also a couple of exogenous factors to take into consideration. Central banks are generally wary of moving ahead of the Fed, and with the FOMC having kept rates on hold the previous evening, the BoE may well have been sensitive to the prospect of acting unilaterally. Moreover, the MPC was not helped by the timing of the tax-raising Budget, released at the start of the MPC ‘purdah period’, which allowed the BoE no time to nudge expectations.

Better ways to communicate

A couple of years ago, former MPC member Gertjan Vlieghe gave a speech in which he suggested there were better ways of communicating monetary policy than the BoE does now. The speech was somewhat overlooked but in my view was a very thoughtful contribution to the policy debate that deserved more consideration. Vlieghe argued that there was a case for the MPC to communicate end-year forecasts for the policy rate. In his view this would take some heat out of the debate by reducing the focus on the very near term (though it may occasionally make life difficult at the final MPC meeting of the year). He reported that central banks in Sweden, Norway and New Zealand, which publish explicit forecasts, were satisfied that this method improved transparency. However, I have reservations that such an approach would work in the UK. Although Vlieghe noted that “it would be important to communicate the degree of uncertainty around this path”, my concern is that the commentariat would not necessarily understand the distinction between a conditional and an unconditional forecast. We are thus likely to end up in a situation where failure to deliver on the central case would be seen as a policy error.

If the BoE were to change its communication strategy, my own preference would be for it to adopt something akin to the Fed dot plot in which individual committee members give their own (anonymised) views on how they believe rates will develop. Here, too, there are many arguments against. For one thing, a dot plot does not identify how interest rate forecasts are linked to growth and inflation forecasts. Moreover the markets would likely focus on the diversity of views rather than the median outcome thus missing the point of the communication.

If we do not like this idea there is always the radical option of not trying to appease markets in the first place. Indeed, explicit monetary policy communication is a relatively recent phenomenon with the Fed switching to this strategy only in 1994. It is not as if the forward guidance policy espoused by former Governor Mark Carney has been a great success. If one of the objectives of monetary policy communication is to increase transparency, the outcome in the wake of yesterday’s decision, when sterling fell by 1.5% against the dollar and bond yields declined by 14 bps, is the sort of transparency that investors could probably live without.

Should interest rates be raised at all?

The issue of whether central banks should raise interest rates is one which I will undoubtedly look at in more detail in future. However, a couple of quick thoughts are in order. I have long taken the view espoused by Huw Pill that central banks have been too slow in taking back the emergency monetary easing put in place to cope with exceptional circumstances. In my view, one of the BoE’s errors in recent years has been the asymmetric nature of its reaction function. It has rightly cut interest rates during times of stress to provide support to the economy. But once the emergency is over, it has justified the decision to keep rates on hold by an absence of inflationary pressures rather than referring to a normalisation of economic conditions. This asymmetry has resulted in real interest rates remaining in negative territory for much of the past decade, with all the attendant distortions that have resulted.

Furthermore, with the BoE expecting inflation to get close to 5% next year, it is difficult to understand why a central bank which talks so much about hitting its inflation mandate continues to sit on its hands. Obviously the inflation spike is being driven by energy trends and supply bottlenecks in the wake of the pandemic, neither of which are amenable to monetary policy actions. But if the central bank does not want to raise rates at a time when inflation is heading towards its highest in 14 years, when will it ever?

Matters were undoubtedly complicated by the release of the budget last week, in which the main takeaway was the ongoing squeeze on household incomes. A rate hike would clearly have played badly in those circumstances. But what the episode demonstrates is that the BoE will have to think a lot more clearly about how it communicates its message, and perhaps equally importantly who it is communicating with? The decision to keep rates on hold sends a positive message to households that the BoE does not intend to make their lives harder but rattled markets which got carried away with the central bank’s message (obviously a rate hike would have reversed the two situations).

There are no easy answers to the conundrum of market communication, but clarity and consistency are the watchwords and arguably the BoE has fallen a bit short on both. Perhaps the problem can best be summed up in Alan Greenspan’s famous quote: “I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant.” It is easy to be critical of both the BoE for its mixed messages and investors for reading too much into its pronouncements. But if ever there was a sign that communications need to be rethought, this week's events provided it.

Cop out in Glasgow

Greta Thunberg and The Queen may represent different ends of the age spectrum but in recent days both have expressed irritation that world leaders talk a lot about preventing climate change but do little about it. They have a point: The science of climate change has been known for a long time and economics offers solutions to mitigate the problems. Perhaps understandably, politicians are not willing to inflict on voters the costs required to fully price carbon emissions but it is a debate that societies around the world urgently need to have – and should have been having at least 20 years ago.

The scale of the problem has been known for years

Climate change is just one branch of a field of environmental science that has mushroomed in the past 50 years. The science behind climate change has been known since the nineteenth century but it was not until the early 20^th century that the first attempts were made to assess the impact of man-made activity. Efforts in the 1930s to calculate the future effect of rising CO₂ emissions on global temperatures turned out to be hopelessly optimistic because they underestimated the impact of economic growth[1]. However, in the 1950s, the physicist Gilbert Plass estimated that CO₂ concentrations would rise by 30% over the 20^th century and warned that temperatures would increase by 1.1^oC[2]. Although his calculations did not take into account some of the factors which we know today, his estimate that a doubling of CO₂ emissions would raise global temperatures by 3.8^oC is not far off today’s consensus estimate of 3^oC. Rather more disconcertingly he pointed out that if all known (at the time) fossil fuel reserves were burned, this would raise global temperatures by 7^oC.

Much of the early work remained within the narrow confines of the scientific community but the political agenda began to take note in the 1960s and 1970s, triggered initially by resource concerns. The environmental lobby was radicalised by the publication of Silent Spring by Rachel Carson in 1962 in which she highlighted the effects of agrochemicals on the environment. In 1968, the ecologist Garrett Hardin published his famous article in Science titled The Tragedy of the Commons, in which he argued that individuals acting in their own self-interest would result in sub-optimal social use of natural resources. It was around this time that modern environmental economics started off as a fringe discipline but by the mid-1970s it was rising very rapidly up the agenda.

It is not the intention here to go into any detail on the history of environmental economics. Instead, interested readers are referred to the literature review by David Stern and his co-authors, published in 2014. It is, however, worth highlighting the work of William Nordhaus and Nicholas Stern (no relation to David). Climate issues were first subject to economic analysis in the 1970s and by the 1980s Nordhaus[3] was producing scenario analysis and projections for future CO₂ emissions. Nordhaus can lay claim to being the most preeminent economist working on climate issues and he was awarded the Nobel Memorial Prize in Economic Sciences in 2018 for his work in the field.

One of the most important early policy works was the 2006 Stern Review. Although it met with a mixed reception from economists, it was highly influential and argued that climate change represented a major market failure. One of the basic recommendations was that the benefits of strong, early action far outweigh the costs of not acting and it proposed a number of economic solutions, including the application of environmental taxes, to correct for some of the failures.

Why has it taken so long?

In light of all this the fact that we find ourselves at “one minute to midnight on that doomsday clock”, to quote Boris Johnson at the opening of the COP26 summit in Glasgow, represents a potentially catastrophic policy failure. The summit is being touted as “humanity’s last and best chance to secure a liveable future amid dramatic climate change” and “as one of the important diplomatic meetings in history.” It comes six years after the Paris Agreement when 196 countries signed a legally binding treaty pledging to hold global temperatures no higher than 2^oC above pre-industrial levels, with an aspiration to limit the rise to 1.5^oC. However, Earth’s temperature has risen by 0.08°C per decade since 1880, and the rate of warming over the past 40 years is more than twice that: 0.18°C per decade since 1981 (chart below). Simply put we are running out of time to limit the temperature rise, if we have not done so already.

Although the Paris Agreement imposes binding constraints on countries’ carbon emissions, just three countries account for more than 50% of global emissions (China: 30%; US: 14% and India: 7%). For the record Europe accounts for 11%. However, whilst global CO₂ emissions rose by 59% between 1990 and 2019, European emissions fell by 25% (largely thanks to Ukraine); US emissions were broadly flat whilst those in the Asia Pacific region rose by a whopping 220% and the region as a whole has accounted for 92% of the increase in global emissions since 1990 (chart below).

Whilst the likes of Greta Thunberg rail at politicians in Europe and the US for not doing enough, it is China and India which have done so much to change the carbon balance. This is not to say that the industrialised world should not do much more – after all, a significant portion of Chinese emissions can be attributed to production for western consumers – but it is clear that so long as the rapidly industrialising economies in Asia continue to rely on fossil fuels, the prospect of limiting global carbon emissions appears remote. With Chinese leader Xi Jinping not expected to attend the Glasgow summit, the likelihood that COP26 will result in a global climate deal is next to zero.

What should happen at COP26?

The scientific consensus suggests that greenhouse gas emissions need to fall by anywhere between 25% and 50% over the next decade in order to have any chance of limiting the global temperature rise to 2^oC. This is arguably impossible in the absence of a carbon tax. According to the IMF around 80% of carbon emissions are unpriced and the global average emissions price is only $3 per ton. However it reckons that a three-tier price floor involving just six participants (Canada, China, EU, India, UK and US) with prices of $75, $50, and $25 for advanced, high, and low-income emerging markets, respectively could help achieve a 23% reduction in global emissions below baseline by 2030.

What is likely to happen?

Rather than such a grandiose plan COP26 is likely instead to result in a series of smaller resolutions, all of which mount up to something positive. The US commitment to supporting the Paris Agreement runs counter to the ill-judged actions of Donald Trump. There has also been a commitment to halt global deforestation over the next decade.  Even India has pledged to cut carbon emissions to net zero by 2070. Whilst this is the first time India has made such a commitment, it is not ambitious enough and it was hoped that COP26 would agree a global carbon neutral pledge by 2050. Here lies the nub of the problem as outlined by Garrett Hardin over 50 years ago: Nations acting in their own interest make the global problems worse. Whilst India does have a point that the industrialised nations need to do more because they have contributed far more to emissions over time, India also has a moral duty to its future generations to adopt the new technologies at a faster rate than currently planned – even China is aiming for net zero by 2060 (though China needs to do a whole lot more as well).

The simple truth is that politicians around the globe – and by extension, we the people – have been slow to recognise the need for change and are unwilling to pay the economic price for the action required. I hope I am wrong in my assessment that in 10 years’ time we will still be having the same debate. But with many countries having failed to turn the tanker around in time (the EU plus UK to some extent excepted), I fear that climate issues will get a lot worse before they get better. Still, I blame the dinosaurs. If they hadn’t got themselves fossilised, maybe none of this would have happened.

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[1] Callendar,  G. S. (1938) ‘The  artificial  production  of carbon  dioxide  and its  influence  on temperature’,  Quarterly  Journal of the Royal  Meteorological Society 64: 223-240

[2] Plass, G. N. (1956) ‘The carbon dioxide theory of climatic change,’ Tellus 8(2): 140-154 (here)

[3] Nordhaus, W. D. and G. W. Yohe (1983) ‘Future paths of energy and carbon dioxide emissions’, in T. F. Malone (ed.) Changing Climate: Report of the Carbon Dioxide Assessment Committee, National Academy Press, Washington DC. Chapter 2.1: 87-152

Not what it said on the tin

As I have noted many times before, UK budgets are a strange mixture of policy announcements and pantomime and they exist in their present form purely for reasons of tradition. Once upon a time they were put together behind closed doors with ministers sworn to secrecy in case any of the details leaked out. Back in 1947 Chancellor of the Exchequer Hugh Dalton resigned after an off-the-cuff remark which hinted at forthcoming tax changes. But the era of ‘Budget Purdah’ is no more: We have been bombarded with news of what was likely to be in the autumn budget for weeks as the process morphs from a one-off event to a rolling news story. Indeed, the Speaker of the House of Commons expressed concerns that budget measures were leaked to the press before being announced in the House of Commons, which is a breach of protocol. The Deputy Speaker who presided over proceedings on Wednesday welcomed Chancellor Rishi Sunak to the Despatch Box with the pithy comment that she looked forward to the “remainder of your announcements.”

This does not mean that the process of digesting the information is any easier. The government’s 2021 budget was accompanied by the usual 192 page Budget Redbook, which this year also contained details of the Spending Review, whilst the OBR put out its regular 244 page Economic and Fiscal Outlook. Once we factor in the plethora of supporting documentation, it is clear that there is a huge quantity of material to digest. You can thus be sure that a serious amount of work has gone into the impressive overnight summaries produced by think tanks and the detailed analysis conducted by the quality press.

There are essentially three things to focus on in this year’s budget analysis: (i) what are the economic assumptions underpinning the budget; (ii) what fiscal measures has the government announced and (iii) how big is the spending envelope within which government departments have to work? These allow us to form an overall impression of the fiscal stance: The bottom line is that the projected outturns do not square with the message which the Chancellor has tried to put over. In short, living standards are likely to improve much more slowly than in the recent past; we are all going to be paying more taxes and the voracious health sector will continue to gobble up an increasing proportion of the nation’s resources. If the low tax, small state policies of Margaret Thatcher have long since been buried, this latest budget represents a dance on their grave.

The state of the economy

One of the defining features of the economic forecast is that real output is projected to get back to its pre-pandemic level by end-2021 which is slightly earlier than in the March projection and far sooner than anticipated last year. The OBR also reduced its estimate of the impact of the pandemic and now anticipates a permanent output loss of 2% (this was projected at 3% in March). However, it reckons that Brexit will lead to a permanent output loss of 4% in the longer-term. For all the concerns about the economics of the pandemic, it is Brexit that will inflict the most long-term damage. Obviously the pandemic feels like a big deal because the economic impacts are compressed into a relatively short time frame. Moreover the wider social costs are incalculable (140,000-plus deaths and counting) but much of the economic damage will be recouped quickly.

In many other ways the economy is predicted to quickly resume its pre-pandemic state with the unemployment rate on a two year horizon projected to fall to 4.2% – close to pre-2020 levels. One thing we will have to get used to is higher inflation, which the OBR forecasts will peak around 4.4% in the second quarter of 2022 – more than twice the BoE’s target rate – with risks tilted to the upside. Whilst this will squeeze real household incomes it will also inflate the tax base which will support tax revenues. All in all, there is not much to get excited about in the macro forecast. There are always areas for discussion but on the whole it seems a solid enough assessment. The real areas of disagreement lie in the fiscal detail.

The fiscal measures

The biggest single giveaway represented changes to Universal Credit designed to provide a boost to low earners (a £3bn giveaway over five years). This was welcome following the announcement last month that the temporary uplift to welfare payments during the pandemic was to be scrapped. In response to the storm of criticism that followed this decision, the Chancellor announced that the taper rate at which benefits are phased out as claimants transition back into employment is to be lowered. This was previously set at 63%, meaning that above a certain income threshold claimants lose 63p of every pound of benefit they receive, implying a very high marginal tax rate. This is to be reduced to 55% and is a move I have been advocating for a long time. However, as the Resolution Foundation points out, this is “not sufficient to compensate most UC recipients for the loss of the £20 a week uplift introduced at the start of the pandemic.”

Looking down the list of items, the next biggest giveaway was a further freeze on fuel duties (£1.6bn) – somewhat ironic given next week’s COP26 Summit at which the UK is hoping to take credit for brokering a global climate deal. Sunak also announced a 50% reduction in domestic Air Passenger Duty in order to “bolster UK air connectivity” which is similarly incongruous.

The spending envelope

The good news is that almost all departments will receive an increase in their day-to-day budgets over the period to fiscal 2024-25. The bad news is that in real terms many departmental budgets will remain below the levels prevailing when the Conservatives came to office in 2010. The era of austerity may be over but not by enough to overcome the damage done in the decade prior to the pandemic. One of the lessons we have learned the hard way is that spending on health is important and that it was underfunded prior to 2020. Thus spending on health and social care is projected to be over 40% higher in real terms by 2024-25 than in 2009-10. However, spending by the Department of Transport will be 32% lower in real terms and the Ministry of Justice will suffer a 12% cut (chart below). Sunak made great play of the fact that “the health capital budget will be the largest since 2010” and that the budget “will restore per pupil funding to 2010 levels in real terms.” Yet it is hardly a great boast that spending levels are to be restored to levels prevailing when the Tories took office 11 years ago, and calls into question what was achieved by the years of austerity.

What to make of it all

By common consensus this was a high tax and spend budget. It marks a seismic shift in the fiscal philosophy of a Conservative Party that has extolled the virtues of a small state and lower taxes for the last 40 years. Sunak’s goal may be to reduce taxes, as he told us in his budget speech, but in reality the overall tax burden is set to rise to its highest in 70 years. In some ways this is an inevitable response to the challenge posed by the pandemic. 

In his parliamentary speech Sunak outlined his old-style Tory leanings: “Do we want to live in a country where the response to every question is: “what is the government going to do about it”? Or do we choose to recognise that Government has limits.” The truth is that many people do want more government – or at least, they don’t want less. For a start they want some return on the large slice of income that they hand over in taxes. Furthermore the pandemic has highlighted the importance of having government act as a backstop (ditto the GFC of 2008-09). 

Sunak is an intelligent man and I am sure he knows this. The thought therefore persists that the budget was in part a job application to the Tory faithful in the event that they tire of Boris Johnson as leader, whilst simultaneously following Johnson’s requirement to shower the electorate with money. In the end all budgets come down to politics but this one perhaps more so than usual.