The Bank of England’s decision to keep interest rates on
hold today may have been what the markets were ultimately expecting – after
having been conditioned between February and late-April to expect a rise – but
I can’t help thinking that the late change of mind has caused more problems
than was strictly necessary.
The forecast upon which the decision was based was not
hugely different from that presented in February. Growth is a bit weaker this
year but that is primarily due to the weakness of Q1 GDP. Inflation is
moderately lower, but we are only talking about a few tenths of a percent.
However, the BoE did go to great lengths to persuade us that some things have
changed – notably the fact that the pass-through from sterling’s depreciation
in 2016 has operated more quickly than expected, and as a result CPI inflation
does slow more quickly in the early part of the forecast period than in
February. As they pointed out, the March inflation figure (2.5%) turned out
some 0.4 percentage points lower than expected three months ago (when the last
observation was the December inflation rate of 3%).
As noted a couple of weeks ago the weakness of Q1 GDP, which at 0.1% q/q undershot even the most modest of
expectations, was the key factor in the decision. In the past, the Bank has
tended to raise rates only when quarterly GDP growth is at 0.5% or higher, so
the majority of MPC members were clearly uncomfortable with tightening policy
when growth is so far below this threshold.
Questions are increasingly being asked as to whether this
slowdown is a one-off triggered by weather effects, or whether it marks
something more serious. The ONS reckoned that the impact of the snowstorms in
early March explained only part of the weakness. They may be right, but
apparently this deduction was derived from a survey it sent out asking firms
whether output had been affected by the snowstorms. When relatively few firms
responded this was the case, the statisticians deduced that the weather effect
was not so significant. In my view, and one which the BoE shares, the impact of
the snowstorm was greater than the weight attributed to it by the ONS. Indeed,
survey-based estimates suggest that Q1 GDP growth was higher than the initial
estimate of +0.1%. The Bank believes that the figure will be revised up. That
being the case, why did it simply not look through the temporary distortion?
Presumably, the decision was partly based on how raising rates when the economy
is going through a soft patch would play with the wider public. Or it could be
that the BoE believes underlying growth is slowing.
Across the channel, we have already seen signs that the euro
zone economy has lost momentum. And there is a school of thought which suggests
the slowdown in UK monetary aggregates is a sign of weaker growth to come (see
this FT article by Chris Giles). It is always difficult to disentangle the direction
of causality between monetary growth and real economic activity. But as Giles
notes, “simple correlations show that
measures of money have moved closely with the cycle this decade, raising the
possibility that monetary indicators are due for a revival in economics.” But
the slowdown evident in the money data is not yet evident in survey-based
estimates (although last month’s retail sales activity was weak according to
the British Retail Consortium). Consequently, the jury is still out on where
the economy goes from here, but it seems set to continue growing much more
slowly than prior to the EU referendum.
Not surprisingly, the big issue at the Inflation Report
press conference was the BoE’s communication strategy. Having built markets up to
expect a rate hike in May, only to backtrack in the face of the data, has led
to accusations of inconsistency in expectations management. The BoE will point
out, of course, that the decision was conditional – in this case on the data – so
that a change of heart was the rational response. And there was a sense of testiness
on the part of Bank officials when faced with intense grilling on the subject.
Governor Carney sought to deflect criticism of misleading markets by referring
to the fact he is trying to appeal to firms and households rather than just markets.
But since markets set prices which impact on the decisions of firms and
households, I am not sure I fully buy it.
However, I can see both sides of the debate. The BoE makes
conditional forecasts and when the conditioning assumptions change it is
entitled to change its view. The press in particular may not always understand the
nature of a conditional forecast. Arguably, however, the BoE has to work harder
to make sure that the conditional nature of its forecasts is better understood.If the BoE wants to improve its communication strategy, this might be a good place
to start. But
there is a wider problem. The MPC is comprised of nine members, each of whom is
independent. Given the tendency of economists to disagree on any given issue,
one could be forgiven for suspecting that it will prove almost impossible to
get the MPC to speak with one voice, thus reducing the effectiveness of the forward guidance strategy.
Thursday 10 May 2018
Saturday 5 May 2018
Immigration as a problem of time inconsistency
Time inconsistency is a much-used term in economics and
describes a situation where a policymaker announces a policy option only to
renege on it later when it is evident that the costs of adhering to the
original policy are higher than the costs of cheating. It was originally
popularised in the macro literature in the context of monetary policy whereby a
central bank announces a target – a money supply growth rule for example – only
to find that the costs of maintaining it are too high because it requires implementing
a policy which is too tight (or loose) for overall economic conditions.
But it goes way beyond monetary policy and I was struck recently by how a couple of the big items on the UK government’s agenda can be described in terms of the time consistency problem. One is the decision to leave the EU. Given the closeness of the referendum vote and the degree of opposition to the decision, together with the fact that younger voters – tomorrow’s older generation – are generally in favour of remaining, it is possible to imagine a situation in which the UK either reneges on its commitment to leave or reapplies at some point in future. If that were to happen, it would render today’s shenanigans regarding Brexit negotiations a time inconsistent set of policies.
However, the time inconsistency issue particularly came to mind in the context of the recent scandal regarding the first generation of immigrants from the Caribbean in the late-1940s and 1950s. To recap, many thousands migrated to the UK seeking work – and let us not forget, this policy was welcomed as a way to alleviate post-1945 labour shortages. Crucially, they were entitled to come to the UK without having to give up their original nationality, thanks to the passing of the 1948 British Nationality Act, which granted UK citizenship to those from Commonwealth countries. Consequently, many people simply did not feel the need to formally apply for UK citizenship – it was conferred upon them. But the 1971 Immigration Act changed the law to grant only temporary residence to most people arriving from Commonwealth countries which came into force in 1973. However, people born in Commonwealth countries (and their dependents) who arrived before 1973 were given indefinite leave to remain.
So far, so uncontroversial. But the time inconsistent element of immigration policy can be dated to May 2012 when then-Home Secretary Theresa May declared: “the aim is to create here in Britain a really hostile environment for illegal migration.” She then steered the 2014 Immigration Act through parliament that gave new powers to help the Home Office and other government agencies make life difficult for illegal migrants. Amongst other things, this required people to have documentation to work, rent a property or access benefits. Just to complicate matters, the Home Office did not keep a record of those granted leave to remain under the 1971 legislation, or issue any paperwork confirming it. It also destroyed the landing cards (or registry slips) of first generation immigrants in 2010 as part of the drive to eliminate the huge pile of paper records in the archive.
Now you might say that this is simply incompetence on a massive scale, and I would not disagree. But what policy has done is to confer a set of legal rights on citizens only then to change the rules by insisting on a burden of proof which was never initially required. That is a classic example of time inconsistent policy. We find ourselves in this situation because of a change in the political climate – we can argue about whether government was responding to a change in voter preferences or whether it indeed fanned the flames. What we can say for certain is that government policy changed over the years, from welcoming immigrants as a source of labour to actively discouraging them.
Such time inconsistency issues are not confined to the UK. In France, for example, the Immigration Act of 2006 abolished the automatic right of immigrants to attain French nationality after having lived without authorisation in France for at least ten years (here for an overview of French immigration policy since 1945). This policy is officially designed to “restrict the immigration of unskilled workers and persons who would become a burden on the French State” but as in the UK, it is surely no coincidence that it followed a rise of popular discontent.
Whilst Germany has dealt relatively better with its Gastarbeiter policy introduced in the 1950s and 1960s, the longer term consequences of allowing in huge waves of migrants in 2015 have yet to unfold. There is no doubt that as a humanitarian gesture, it is without parallel in recent years. But the surge in support for the AfD in last September’s election suggests that not all voters share Angela Merkel’s view. The experience of the UK and France is that immigration policy – and indeed many other policy areas – can experience a 180 degree turn. Governments seeking re-election every 4-5 years may simply not be able to make promises that their successors are willing to keep and it is a reminder that nothing lasts forever – even what appear to be binding policy commitments.Jacob Rees-Mogg, Boris Johnson et al take note.
But it goes way beyond monetary policy and I was struck recently by how a couple of the big items on the UK government’s agenda can be described in terms of the time consistency problem. One is the decision to leave the EU. Given the closeness of the referendum vote and the degree of opposition to the decision, together with the fact that younger voters – tomorrow’s older generation – are generally in favour of remaining, it is possible to imagine a situation in which the UK either reneges on its commitment to leave or reapplies at some point in future. If that were to happen, it would render today’s shenanigans regarding Brexit negotiations a time inconsistent set of policies.
However, the time inconsistency issue particularly came to mind in the context of the recent scandal regarding the first generation of immigrants from the Caribbean in the late-1940s and 1950s. To recap, many thousands migrated to the UK seeking work – and let us not forget, this policy was welcomed as a way to alleviate post-1945 labour shortages. Crucially, they were entitled to come to the UK without having to give up their original nationality, thanks to the passing of the 1948 British Nationality Act, which granted UK citizenship to those from Commonwealth countries. Consequently, many people simply did not feel the need to formally apply for UK citizenship – it was conferred upon them. But the 1971 Immigration Act changed the law to grant only temporary residence to most people arriving from Commonwealth countries which came into force in 1973. However, people born in Commonwealth countries (and their dependents) who arrived before 1973 were given indefinite leave to remain.
So far, so uncontroversial. But the time inconsistent element of immigration policy can be dated to May 2012 when then-Home Secretary Theresa May declared: “the aim is to create here in Britain a really hostile environment for illegal migration.” She then steered the 2014 Immigration Act through parliament that gave new powers to help the Home Office and other government agencies make life difficult for illegal migrants. Amongst other things, this required people to have documentation to work, rent a property or access benefits. Just to complicate matters, the Home Office did not keep a record of those granted leave to remain under the 1971 legislation, or issue any paperwork confirming it. It also destroyed the landing cards (or registry slips) of first generation immigrants in 2010 as part of the drive to eliminate the huge pile of paper records in the archive.
Now you might say that this is simply incompetence on a massive scale, and I would not disagree. But what policy has done is to confer a set of legal rights on citizens only then to change the rules by insisting on a burden of proof which was never initially required. That is a classic example of time inconsistent policy. We find ourselves in this situation because of a change in the political climate – we can argue about whether government was responding to a change in voter preferences or whether it indeed fanned the flames. What we can say for certain is that government policy changed over the years, from welcoming immigrants as a source of labour to actively discouraging them.
Such time inconsistency issues are not confined to the UK. In France, for example, the Immigration Act of 2006 abolished the automatic right of immigrants to attain French nationality after having lived without authorisation in France for at least ten years (here for an overview of French immigration policy since 1945). This policy is officially designed to “restrict the immigration of unskilled workers and persons who would become a burden on the French State” but as in the UK, it is surely no coincidence that it followed a rise of popular discontent.
Whilst Germany has dealt relatively better with its Gastarbeiter policy introduced in the 1950s and 1960s, the longer term consequences of allowing in huge waves of migrants in 2015 have yet to unfold. There is no doubt that as a humanitarian gesture, it is without parallel in recent years. But the surge in support for the AfD in last September’s election suggests that not all voters share Angela Merkel’s view. The experience of the UK and France is that immigration policy – and indeed many other policy areas – can experience a 180 degree turn. Governments seeking re-election every 4-5 years may simply not be able to make promises that their successors are willing to keep and it is a reminder that nothing lasts forever – even what appear to be binding policy commitments.Jacob Rees-Mogg, Boris Johnson et al take note.
Wednesday 2 May 2018
Choose your enemies wisely
As the Brexit clock ticks closer to March 2019 the UK
political landscape is increasingly fissiparous as Theresa May tries to appease
both sides of her fractured party whilst managing to satisfy neither. With regard to Brexit, her main tactic has
been to play for time in the hope that something will turn up. But it is
increasingly apparent that it has not, and will not, and May is reaching the
stage where she will have to demonstrate some proper leadership in order to
ensure that the UK gets the deal that it wants. As Simon Nixon pointed out in a
recent Wall Street Journal article the PM has embraced a number of contradictory positions and she will have to
decide which of them she is going to break. In doing so, the PM will make
enemies – it is merely a question of choosing those who cause her the least
harm.
Consider first the group of backbench MPs, led by Jacob Rees-Mogg, who regard themselves as keepers of the Brexit flame. JRM’s latest stunt has been to warn the prime minister that if she goes ahead with her plan to pursue a customs partnership with the EU, his 60-strong faction of MPs will withdraw their support. Rees-Mogg’s objection is that it would “leave us de facto in the customs union and the single market.” For many – including most economists – that is not such a bad idea. But it is (a) legally not true and (b) the EU27 is not very enthusiastic about a plan whereby the UK collects tariffs set by the EU customs union on goods coming into the UK on its behalf. If Rees-Mogg really wants to play a clever game, his best tactic would be to let the EU sink the plan without the need to create waves at home.
But whilst the pro-Brexit lobby is large and vocal, the Conservatives hold 317 seats in parliament. The awkward squad is outnumbered roughly 5-1 by more moderate MPs, some of whom are opposed to Brexit and others who are not willing to go to the barricades on the issue of the customs union. Admittedly, it would take only 48 Conservative MPs (15% of their parliamentary representation) to issue a motion of no-confidence in the leader, so incurring the wrath of Rees-Mogg and his chums would have consequences. But if Theresa May really wants to demonstrate some leadership, perhaps it is now time to face down those who continue to pursue a ruinous Brexit policy. She may not win a leadership contest, because she does not have the wholehearted support of the Remainers, but it seems doubtful that the Brexit ultras would win either. It is time to force the issue. As I have noted previously, Theresa May might have been the least worst option as leader in summer 2016 but it is not clear that she is the right candidate now to deliver the Brexit deal – at least, so long as she is not prepared to challenge her opponents.
That said, whilst it is easy to criticise Theresa May for her caution, we also have to be mindful of the wider backdrop against which she is operating. As the Withdrawal Bill proceeds through the House of Lords, the government has now suffered ten defeats on important legislative matters. The key vote took place on Monday, when peers voted to give parliament a decisive say on the outcome of the final Brexit negotiations rather than simply allowing the government to decide. Of course, this is not set in stone: When the bill goes back to the lower house, MPs will be able to vote on whether to overturn this amendment. However, it triggered much frothing of the mouth in the tabloid press with the Daily Mail accusing “the Remainer elite “ of “fighting a guerrilla war against Brexit using any weapon it can.”
Consider first the group of backbench MPs, led by Jacob Rees-Mogg, who regard themselves as keepers of the Brexit flame. JRM’s latest stunt has been to warn the prime minister that if she goes ahead with her plan to pursue a customs partnership with the EU, his 60-strong faction of MPs will withdraw their support. Rees-Mogg’s objection is that it would “leave us de facto in the customs union and the single market.” For many – including most economists – that is not such a bad idea. But it is (a) legally not true and (b) the EU27 is not very enthusiastic about a plan whereby the UK collects tariffs set by the EU customs union on goods coming into the UK on its behalf. If Rees-Mogg really wants to play a clever game, his best tactic would be to let the EU sink the plan without the need to create waves at home.
But whilst the pro-Brexit lobby is large and vocal, the Conservatives hold 317 seats in parliament. The awkward squad is outnumbered roughly 5-1 by more moderate MPs, some of whom are opposed to Brexit and others who are not willing to go to the barricades on the issue of the customs union. Admittedly, it would take only 48 Conservative MPs (15% of their parliamentary representation) to issue a motion of no-confidence in the leader, so incurring the wrath of Rees-Mogg and his chums would have consequences. But if Theresa May really wants to demonstrate some leadership, perhaps it is now time to face down those who continue to pursue a ruinous Brexit policy. She may not win a leadership contest, because she does not have the wholehearted support of the Remainers, but it seems doubtful that the Brexit ultras would win either. It is time to force the issue. As I have noted previously, Theresa May might have been the least worst option as leader in summer 2016 but it is not clear that she is the right candidate now to deliver the Brexit deal – at least, so long as she is not prepared to challenge her opponents.
That said, whilst it is easy to criticise Theresa May for her caution, we also have to be mindful of the wider backdrop against which she is operating. As the Withdrawal Bill proceeds through the House of Lords, the government has now suffered ten defeats on important legislative matters. The key vote took place on Monday, when peers voted to give parliament a decisive say on the outcome of the final Brexit negotiations rather than simply allowing the government to decide. Of course, this is not set in stone: When the bill goes back to the lower house, MPs will be able to vote on whether to overturn this amendment. However, it triggered much frothing of the mouth in the tabloid press with the Daily Mail accusing “the Remainer elite “ of “fighting a guerrilla war against Brexit using any weapon it can.”
We have come to
expect such rabid commentaries from this particular organ over the last couple
of years. Clearly, the headline writers do not appear to understand the UK’s
constitutional setup in which the House of Lords has no power to block
legislation. There again, the paper demonstrated a similar lack of
constitutional understanding following the infamous “Enemies of the People”
headline when the High Court ruled that parliament should be given a vote before triggering Article 50.
The political editor James Slack either did not realise that the judiciary is
separate from government, or more likely, did know and planted a fake news
story. This time around, the irony appears to be lost on the Mail that one of
the key themes in the whole Brexit debate was about taking back control –
British laws decided in the British parliament, and all that – and the House of
Lords is giving parliament the opportunity to do just that.
It is precisely because of such vitriolic nonsense that the
prime minister has to be very circumspect in how she deals with the Brexit
debate. She is simply obeying the Machiavellian dictum to keep your friends
close and your enemies closer. But to borrow the old SAS slogan, she who dares
wins.
Monday 30 April 2018
Beware the big data rush
Bank of England chief economist Andy Haldane today gave a speech
entitled Will Big Data Keep Its Promise?
in which he assessed the contribution that big data can make to improving
decision making in finance and macroeconomics. Whilst I agree that this is
indeed a subject that offers significant potential, we do have to be mindful of
the downsides associated with the data trails we leave as we live our lives in
a digital world.
In 2005 there were around 1 billion global internet users; today there are estimated to be almost 3.5 billion. Just as important, there has been a significant switch from the one-way flow of traffic from suppliers to consumers, which characterised the early years of internet use, to a more interactive medium. Today, users send around 6000 tweets, make 40,000 Google searches and send 2 million emails every second. The capacity of text on the internet is estimated at 1.1 zettabytes, which is approximately 305.5 billion pages of A4 paper and which is projected to rise to 2 zettabytes by 2019 (more than 550 billion sheets). And that is without the pictures! To take another example, the Large Hadron Collider generates 15 petabytes of data each year, equivalent to around 15,000 years of digital music.
Where does all this data come from? Some of it is merely the transcription of existing data into an electronic form that makes it more accessible. Wikipedia, for example, has helped to democratise knowledge in a way that was previously impossible. But a lot of it has come into being as a result of technological developments which allow the capture of much greater volumes of information. This has been facilitated by the rise of cloud computing which allows users to store, manage and process vast amounts of information in a network of remote servers (ironically, this is a reversal of the trend of recent decades which saw a shift from centralised towards local data storage). Perhaps even more important, the rise of social media such as Twitter and Facebook has vastly increased the volume of information pumped out (not to mention the rise of microblogging sites in China such as Tencent or Sina Weibo).
Clearly, a lot of this information does not yield any valuable insight but given the vast amount of available information even a small fraction of it is still too much for humans to reasonably digest. Even if we only require 0.5% of the information stored online, we would still need 1.5 billion sheets of A4. The problem is compounded by the fact that we do not necessarily know what is useful information and what can easily be discarded so we have to scan far more than we require in order to stream out the good stuff. As a result, much progress has been made in recent years to devise methods of scanning large datasets in order to search for relevant information.
To the extent that knowledge is power, it stands to reason that those with the data in the digital age are those with the power. This raises a big question of how much control we should be prepared to give up, and there are legal issues about who owns the information that most of us have until now simply given away for free – something that the recent Facebook furore brought into the open.
But whilst social media platforms contain huge amounts of data that can be extracted at relatively little cost, and are often a useful barometer of public opinion, they are biased towards younger, urban-dwelling high income users. Relying on Tweets, for example, without accounting for this bias risks repeating the classic mistake made when trying to predict the US presidential results in 1936 and 1948, when the polling samples were skewed by the inclusion of those picked at random from the phonebook, at a time when telephone penetration was low.
Thus, whilst I agree with Haldane’s sentiment that “economics and finance needs to make an on-going investment in Big Data and data analytics” we need to beware of the headlong rush. As I wrote in a piece last year, “before too long, there will almost certainly be a spectacular miss which will bring out the critics in droves” and it could yet be that the Facebook problems will be a catalyst for a rethink. At the present time, much of society is only operating in the foothills of the big data revolution. The real trick, as former boss of Hewlett-Packard Carly Fiorina once said, will be to turn data into information, and information into insight. We are not quite there yet.
In 2005 there were around 1 billion global internet users; today there are estimated to be almost 3.5 billion. Just as important, there has been a significant switch from the one-way flow of traffic from suppliers to consumers, which characterised the early years of internet use, to a more interactive medium. Today, users send around 6000 tweets, make 40,000 Google searches and send 2 million emails every second. The capacity of text on the internet is estimated at 1.1 zettabytes, which is approximately 305.5 billion pages of A4 paper and which is projected to rise to 2 zettabytes by 2019 (more than 550 billion sheets). And that is without the pictures! To take another example, the Large Hadron Collider generates 15 petabytes of data each year, equivalent to around 15,000 years of digital music.
Where does all this data come from? Some of it is merely the transcription of existing data into an electronic form that makes it more accessible. Wikipedia, for example, has helped to democratise knowledge in a way that was previously impossible. But a lot of it has come into being as a result of technological developments which allow the capture of much greater volumes of information. This has been facilitated by the rise of cloud computing which allows users to store, manage and process vast amounts of information in a network of remote servers (ironically, this is a reversal of the trend of recent decades which saw a shift from centralised towards local data storage). Perhaps even more important, the rise of social media such as Twitter and Facebook has vastly increased the volume of information pumped out (not to mention the rise of microblogging sites in China such as Tencent or Sina Weibo).
Clearly, a lot of this information does not yield any valuable insight but given the vast amount of available information even a small fraction of it is still too much for humans to reasonably digest. Even if we only require 0.5% of the information stored online, we would still need 1.5 billion sheets of A4. The problem is compounded by the fact that we do not necessarily know what is useful information and what can easily be discarded so we have to scan far more than we require in order to stream out the good stuff. As a result, much progress has been made in recent years to devise methods of scanning large datasets in order to search for relevant information.
To the extent that knowledge is power, it stands to reason that those with the data in the digital age are those with the power. This raises a big question of how much control we should be prepared to give up, and there are legal issues about who owns the information that most of us have until now simply given away for free – something that the recent Facebook furore brought into the open.
But whilst social media platforms contain huge amounts of data that can be extracted at relatively little cost, and are often a useful barometer of public opinion, they are biased towards younger, urban-dwelling high income users. Relying on Tweets, for example, without accounting for this bias risks repeating the classic mistake made when trying to predict the US presidential results in 1936 and 1948, when the polling samples were skewed by the inclusion of those picked at random from the phonebook, at a time when telephone penetration was low.
Thus, whilst I agree with Haldane’s sentiment that “economics and finance needs to make an on-going investment in Big Data and data analytics” we need to beware of the headlong rush. As I wrote in a piece last year, “before too long, there will almost certainly be a spectacular miss which will bring out the critics in droves” and it could yet be that the Facebook problems will be a catalyst for a rethink. At the present time, much of society is only operating in the foothills of the big data revolution. The real trick, as former boss of Hewlett-Packard Carly Fiorina once said, will be to turn data into information, and information into insight. We are not quite there yet.
Saturday 28 April 2018
Brexit: According to custom(s)
Discontent with the Brexit process has gathered momentum in
recent weeks as the EU Withdrawal Bill is debated in the House of Lords. There
are two key areas where the Lords disagree with the government’s vision of a
post-Brexit Britain, having voted against that part of the bill which seeks to
withdraw the UK from the customs union and also against the legislation which
peers believe will result in an erosion of workers’ rights. None of this means
that the government will necessarily water down its position, since the role of
the Lords is primarily to scrutinise legislation and challenge anything proposed in the House of Commons and it cannot block legislation indefinitely.
But it may embolden MPs in the lower house to rethink their position on many
elements of the Withdrawal Bill.
The customs union issue is particularly important and has proven to be an area where Brexit protagonists have demonstrated that they do not fully understand the implications of their actions. A customs union implies the abolition of customs duties between member states and the imposition of common tariffs against those not in the union. That is not the same thing as the free movement of goods which is enshrined within the EU single market. For one thing, a customs union may not necessarily cover the full range of goods. For example, Turkey is part of a customs union with the EU but the deal does not cover food or agriculture, services or government procurement.
But failure to secure some kind of customs arrangement with the EU will almost certainly mean significant border delays. Those claiming that the Swiss and Norwegian examples show how a customs union can proceed without any such frictions are wrong. Switzerland and Norway are in the Schengen Area (chart) which allows individuals to move easily across borders, but neither are in the customs union so there can be significant delays as goods are transported across the border into the EU.
Moreover, most of the empirical work which utilises trade gravity models to look at trade flows draws the conclusion that leaving the single market or customs union will lead to a reduction in trade between the UK and EU. Such models explicitly incorporate the zero-tariff option, which can be controlled for in simulations designed to show the counterfactual where tariff barriers exist. A customs union would, of course, be a second best solution compared to what the UK enjoys now. But it is better than no deal at all, and would go a long way towards resolving the Irish border problem.
What is particularly ironic is that the customs union has only become an issue following the referendum. It has been seized upon by those leavers who believe that it is an obstacle to signing trade deals with third countries, but was barely mentioned during the referendum campaign and was certainly not on the ballot paper. There is a sense that some in government are beginning to understand the difficulties involved in the customs union discussion with rumours earlier this week that the prime minister would seek to back away from her previous position (which were denied, of course). This would be the sensible economic decision, although so closely is Theresa May identified with this policy that it would likely spell the end of her tenure in Downing Street. But her departure may be a small price to pay to secure the national interest.
Looking at the issue from outside the UK, financial services remain an area of contention. Two senior EU officials this week rejected the UK’s case for continued post-Brexit access to EU financial markets under something approximating current rules. The EU’s chief Brexit negotiator, Michel Barnier, argued that since the UK would no longer be within the EU’s single market, it would not be covered by its regulations and oversight – a view reiterated separately by Valdis Dombrovskis, the European Commission’s finance chief. This may all be part of the normal poker playing during negotiations, but it highlights that despite the late-March optimism that we may be close to an agreement on a transition period, there are still plenty of areas of disagreement.
Indeed, the Bank of England recently concluded that the transition period would allow non-UK financial institutions operating in the UK to conduct business until the end of the proposed transition period (end-2020) without any change in their regulatory status. But there has been no reciprocal arrangement from the ECB, so firms licensed in the UK are not guaranteed to be able to conduct business in the EU under the current passporting arrangements after March 2019. If ever we needed a reminder that nothing is agreed until everything is agreed, this is it.
The customs union issue is particularly important and has proven to be an area where Brexit protagonists have demonstrated that they do not fully understand the implications of their actions. A customs union implies the abolition of customs duties between member states and the imposition of common tariffs against those not in the union. That is not the same thing as the free movement of goods which is enshrined within the EU single market. For one thing, a customs union may not necessarily cover the full range of goods. For example, Turkey is part of a customs union with the EU but the deal does not cover food or agriculture, services or government procurement.
But failure to secure some kind of customs arrangement with the EU will almost certainly mean significant border delays. Those claiming that the Swiss and Norwegian examples show how a customs union can proceed without any such frictions are wrong. Switzerland and Norway are in the Schengen Area (chart) which allows individuals to move easily across borders, but neither are in the customs union so there can be significant delays as goods are transported across the border into the EU.
Moreover, most of the empirical work which utilises trade gravity models to look at trade flows draws the conclusion that leaving the single market or customs union will lead to a reduction in trade between the UK and EU. Such models explicitly incorporate the zero-tariff option, which can be controlled for in simulations designed to show the counterfactual where tariff barriers exist. A customs union would, of course, be a second best solution compared to what the UK enjoys now. But it is better than no deal at all, and would go a long way towards resolving the Irish border problem.
What is particularly ironic is that the customs union has only become an issue following the referendum. It has been seized upon by those leavers who believe that it is an obstacle to signing trade deals with third countries, but was barely mentioned during the referendum campaign and was certainly not on the ballot paper. There is a sense that some in government are beginning to understand the difficulties involved in the customs union discussion with rumours earlier this week that the prime minister would seek to back away from her previous position (which were denied, of course). This would be the sensible economic decision, although so closely is Theresa May identified with this policy that it would likely spell the end of her tenure in Downing Street. But her departure may be a small price to pay to secure the national interest.
Looking at the issue from outside the UK, financial services remain an area of contention. Two senior EU officials this week rejected the UK’s case for continued post-Brexit access to EU financial markets under something approximating current rules. The EU’s chief Brexit negotiator, Michel Barnier, argued that since the UK would no longer be within the EU’s single market, it would not be covered by its regulations and oversight – a view reiterated separately by Valdis Dombrovskis, the European Commission’s finance chief. This may all be part of the normal poker playing during negotiations, but it highlights that despite the late-March optimism that we may be close to an agreement on a transition period, there are still plenty of areas of disagreement.
Indeed, the Bank of England recently concluded that the transition period would allow non-UK financial institutions operating in the UK to conduct business until the end of the proposed transition period (end-2020) without any change in their regulatory status. But there has been no reciprocal arrangement from the ECB, so firms licensed in the UK are not guaranteed to be able to conduct business in the EU under the current passporting arrangements after March 2019. If ever we needed a reminder that nothing is agreed until everything is agreed, this is it.
Wednesday 25 April 2018
Silence can be golden
If you had asked me a week ago, I would have said that a rate hike of 25 bps by the Bank of England in May was a high probability event. However, I had reckoned without the intervention of BoE Governor Carney who warned in a BBC TV interview last week that any such move was not a done deal. In his words, “there are other meetings over the course of this year” at which a rate hike can be delivered. As a consequence, the implied market probability attached to a 25 bps hike collapsed from 80% last Thursday to 52% today, thereby turning a near-certain rate hike into a toss-of-a-coin event (chart).
It would appear that Carney was trying to warn the market
that a string of weaker data argues against treating a May hike as a given. On
the one hand, CPI inflation has slowed more rapidly than the BoE expected in
its February forecast, coming in at 2.7% in Q1 versus a predicted 2.9%, with
the March rate slowing to 2.5% - the lowest in twelve months. Then there is the
likelihood that Q1 GDP growth will come in weaker than expected, posting a rate
of 0.2-0.3% q-o-q (an annualised rate of 0.8% to 1.2%).
Whilst these are mere statements of fact when viewed in isolation, in my view neither are good enough arguments to postpone the rate hike. For one thing the weak activity data are largely the result of cold weather at the beginning of March (remember the Beast from the East?). In the sense that this is a temporary factor, we should be looking through it to assess the underlying strength of the economy especially since: (a) there may well be a partial countermovement at the start of Q2 and (b) previous attempts by the ONS to measure the impact of a cold spell on activity growth have tended to be revised away (as occurred in Q1 2012 for example when the initial GDP estimate posted quarterly growth of -0.2% but now shows a rate of +0.6%). As for inflation, it has long been known that it would begin to slow after peaking in the early months of 2018. The BoE has been softening us up for a monetary tightening on the basis that inflation is above target but now that it is less above target than expected, it seems they are backing away from their long-held view.
Around the same time as Carney was making his comments, MPC member Michael Saunders argued forcefully that “the economy no longer needs as much stimulus as previously” and that in terms of the pace of hiking “’gradual’ need not mean ‘glacial’”. That was a direct contradiction of Carney’s view – as is the right of external MPC members – but it sends a conflicting message to both markets and individuals and very much calls into question the usefulness of forward guidance as a policy tool.
Forward guidance is designed to provide greater clarity about the central bank’s view and reduce uncertainty about the future path of monetary policy whilst delivering a robust policy framework. The Governor’s intervention just three weeks before the May rate decision does nothing to enhance clarity; has introduced more, not less, certainty about the path of interest rates and the differing messages from policymakers suggests that the policy framework is anything but robust. It is not as if this is the first time the Governor has blown a hole in the communications strategy. His comments at the Mansion House speech in June 2014 hinted strongly at a rate hike that did not materialise and led MP Pat McFadden to dub Carney “the unreliable boyfriend.”
As I have argued before (here), policymakers are making a mistake by focusing on the change in interest rates conditional on current economic circumstances when what really matters is the level of interest rates conditional on general economic conditions. Even if Brexit is curbing economic activity, as Carney argued, the economy is by no means falling off a cliff and therefore does not need interest rates at levels consistent with the threatened meltdown of 2009.I fully understand policymakers’ caution. After all, it is not just the markets that they have to convince: It is those individuals whose economic prospects are dependent on the path of interest rates. But I cannot help thinking that on credibility grounds, the MPC would be better advised to deliver the May rate hike they had strongly trailed, and allow themselves a more fierce debate about whether there is a need for additional tightening. As it is, they almost now cannot win. If they do raise rates next month it will call into question why Carney needed to wade into the debate. But if they don’t, it will raise questions about the message that the BoE was communicating in the two months prior to last week. Silence can be golden.
Whilst these are mere statements of fact when viewed in isolation, in my view neither are good enough arguments to postpone the rate hike. For one thing the weak activity data are largely the result of cold weather at the beginning of March (remember the Beast from the East?). In the sense that this is a temporary factor, we should be looking through it to assess the underlying strength of the economy especially since: (a) there may well be a partial countermovement at the start of Q2 and (b) previous attempts by the ONS to measure the impact of a cold spell on activity growth have tended to be revised away (as occurred in Q1 2012 for example when the initial GDP estimate posted quarterly growth of -0.2% but now shows a rate of +0.6%). As for inflation, it has long been known that it would begin to slow after peaking in the early months of 2018. The BoE has been softening us up for a monetary tightening on the basis that inflation is above target but now that it is less above target than expected, it seems they are backing away from their long-held view.
Around the same time as Carney was making his comments, MPC member Michael Saunders argued forcefully that “the economy no longer needs as much stimulus as previously” and that in terms of the pace of hiking “’gradual’ need not mean ‘glacial’”. That was a direct contradiction of Carney’s view – as is the right of external MPC members – but it sends a conflicting message to both markets and individuals and very much calls into question the usefulness of forward guidance as a policy tool.
Forward guidance is designed to provide greater clarity about the central bank’s view and reduce uncertainty about the future path of monetary policy whilst delivering a robust policy framework. The Governor’s intervention just three weeks before the May rate decision does nothing to enhance clarity; has introduced more, not less, certainty about the path of interest rates and the differing messages from policymakers suggests that the policy framework is anything but robust. It is not as if this is the first time the Governor has blown a hole in the communications strategy. His comments at the Mansion House speech in June 2014 hinted strongly at a rate hike that did not materialise and led MP Pat McFadden to dub Carney “the unreliable boyfriend.”
As I have argued before (here), policymakers are making a mistake by focusing on the change in interest rates conditional on current economic circumstances when what really matters is the level of interest rates conditional on general economic conditions. Even if Brexit is curbing economic activity, as Carney argued, the economy is by no means falling off a cliff and therefore does not need interest rates at levels consistent with the threatened meltdown of 2009.I fully understand policymakers’ caution. After all, it is not just the markets that they have to convince: It is those individuals whose economic prospects are dependent on the path of interest rates. But I cannot help thinking that on credibility grounds, the MPC would be better advised to deliver the May rate hike they had strongly trailed, and allow themselves a more fierce debate about whether there is a need for additional tightening. As it is, they almost now cannot win. If they do raise rates next month it will call into question why Carney needed to wade into the debate. But if they don’t, it will raise questions about the message that the BoE was communicating in the two months prior to last week. Silence can be golden.
Wednesday 18 April 2018
A shot across the bows
It is now eleven years since the first indications of the
looming financial crisis began appearing on our radar screens. In the summer of
2007, banks began to curtail redemptions from funds which were heavily invested
in collateralised debt obligations and subprime bonds. This set in train a
series of events that culminated in the bankruptcy of Lehman’s in September
2008, which triggered the biggest economic and financial crash in 80 years. A decade
on, and we are only now beginning to see indications that the scars inflicted
upon the industrialised world are healing.
The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).
This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.
However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.
Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.
But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”
Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.
The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).
This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.
However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.
Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.
But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”
Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.
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