Early in my career I was gently warned by a senior manager to never say “I told you so” in investments – it is not inconceivable that in my cocky youth I was guilty of such! – because it would not be too long before I was spectacularly wrong. I have tried to follow that advice ever since, which is partly why I have not written an article for four months. In the latter half of 2020 and early this year I wrote a series of articles that defended the UK’s policy response to the pandemic, particularly the economic response, and predicted that the UK would recover from the crisis much more strongly than the then consensus suggested. It is now conventional wisdom that the UK recovery in 2021 and 2022 will be amongst the strongest, if not the strongest, in the developed world. How could anything I wrote avoid at least a touch of “I told you so”?
Two things have changed that stance. Firstly, I spoke recently to the very boss who gave me the initial advice – Dr Johannes van der Horst – and he felt the need for an update even if things were going well. Secondly, a key assumption in the optimistic case was that the Bank of England (BoE) would by now have begun withdrawing monetary stimulus and preparing markets for a gradual rise in interest rates. By acting early this would help prevent a sharper rise in interest rates late in the cycle from derailing the recovery. Recent BoE actions and statements bring this assumption under serious question. We firstly examine in a bit more detail what has gone right in recent months, and then look at the risks posed by the BoE’s unduly lax monetary policy.
The Things That Have Gone Right
The UK’s hugely successful vaccination programme has clearly been a key factor in the turnaround in the UK’s prospects. Critical to this has been the UK’s world class scientific expertise – notably in medical science and genomic sequencing – as emphasised in my pandemic policy assessments. Equally critical has been the freedom made possible by Brexit for the UK to diverge very markedly in its vaccination programme from that of the EU. This is the first big “Brexit Dividend” and a massive one it has been.
It is also now clear that, in line with the comprehensive analysis provided for B4B by Graham Gudgin, the consensus hopelessly overstated the short-term negative impacts of the Brexit transition. UK exports to the EU fell sharply in January, partly but not wholly due to post-Brexit costs and paperwork, but had already recovered to normal levels by March. More notably, imports from the EU also fell sharply in January but only rose slowly thereafter, while imports from non-EU countries rose to a new record level in March. March was the first time since a monthly data series started in 1997 that UK imports from non-EU countries were larger than from the EU. This early data suggests that a sharp shift in UK trade patterns away from the EU has already begun. The weakness in EU exports to the UK is especially notable because the UK granted the EU a six- month grace period before UK customs controls were enforced, whereas the EU imposed immediate controls. This shift away from EU imports also reflects the introduction from January 1st of the UK’s own Global Tariff schedule, which eliminated or reduced large numbers of tariffs on non-EU goods. The EU’s bureaucratic obstructionism – presumably designed to “punish” the UK for Brexit – is simply accelerating the shift in trade away from the EU. The EU’s massive trade surplus with the UK will rapidly melt away.
UK trade policy continues to confound Project Fear warnings that UK trade deals, if any, would take 7-10 years to secure. Already 68 EU-derived trade agreements have been rolled over (some with significant augmentations and/or pledges for further liberalisation), and the UK now has its first independently negotiated Free Trade Agreement in a deal with Australia (the EU has been trying, without success, to negotiate a deal with Australia for the last four years). The deal is not only significant in itself but also sets a benchmark for future deals with the likes of New Zealand (expected within weeks), Canada and the USA. It also raises the prospect of a successful UK application to join the giant Asian trading bloc CPTPPT, which on UK accession would have a larger GDP and population than the EU and is growing much faster. Negotiations with the CPTPPT begin soon, with the UK the first nation to enter such talks since the formation of the bloc in 2018. Furthermore, the Australia deal signals that the free trade drive has the strong support of the PM and Chancellor. This is vital if the strong protectionist forces in Parliament and outside (predominately and not coincidentally from anti-Brexit organisations) are to be countered. Crucially, according to a poll conducted by the Adam Smith Institute, the Australia deal has strong public support. Although new FTA’s will only come into effect in coming years the momentum of the free trade drive means businesses are already searching out these new markets.
The UK’s fiscal outcomes continue to be much better than forecast by the OBR (Office of Budget Responsibility) and many private sector pundits. This was anticipated in my article “The UK’s Fiscal Recovery Has Begun” (30/11/20). In the November Spending Review the OBR forecast a 20/21 deficit of £394bn or 19% of GDP, and private sector forecasts of £500bn were not uncommon. By the time of the March Budget this had been revised down to £356bn or 17% of GDP. The actual outcome for 20/21 was materially lower at £300bn or 14% of GDP. This improving trend has continued with monthly deficits for April and May also well below OBR forecasts. This fiscal improvement reflects the better-than-expected recovery, as well as well-designed Covid support measures and some prudent fiscal tightening measures. There are persistent and plausible press accounts of some tension between the PM and Chancellor over spending increases. The Treasury will be urging the Chancellor to emphasise the importance of lower deficits as the economy recovers, and this tallies with what we know of the Chancellor’s views. If the inflation threat to the recovery is to be averted it is vital that fiscal policy restores sustainability to the public finances. It would be worrying if the Chancellor were not resisting pressures for more public spending. The appointment of Sajid Javid as Health secretary adds another fiscal conservative to high office. Fiscal policy seems to be in good hands. It is increasingly difficult to say the same about monetary policy….
Lax Monetary Policy Threatens to Derail the Recovery
The overall context of this argument is the extraordinary fiscal and monetary reflation carried out by the major western economies in response to the Covid crisis. As the pandemic recedes and economic activity begins to return to trend, there is an obvious risk of higher inflation as a wall of monetary growth and government spending meets a supply capacity constrained by the effects of lockdown. My March article “The UK can Avoid a Boom/Bust Recovery” drew particular attention to the inflation risks in the USA, with sustained fiscal deficits as high as 20% of GDP and broad money growth higher than at anytime in US history outside of war. The US inflation danger is compounded by the remarkable complacency of the US Fed, which until recently was not expecting to raise interest rates until 2023. They expected only a mild and transitory rise in inflation. However, the US CPI inflation rate has already risen much higher than they forecast, reaching the 5% level in May – for only the second time in the last 30 years (In my March article I “confidently forecast US inflation will move to and beyond the 5% level for a sustained period” – I told you so!). In response to this shocking data the Fed is still sticking to its “transitory” theme and merely indicates that rates may start rising in 2022 rather than 2023.
Unfortunately, the western world’s major central banks – staffed full of intelligent and highly qualified people – have developed a dangerous “group think” mentality. They have persuaded themselves that the massive money supply growth of the last eighteen months, likely to continue for months to come, is not inflationary. Commodity prices have risen by 40 -60% in the last 9 months (depending on the commodity index used), labour shortages are reported in a wide range of industries in the US, UK and the EU and wage growth is clearly picking up. Supply bottlenecks are widespread and major new infrastructure spending programmes are just getting underway. Inflation rates have risen above target levels in the US, UK and the EU. And yet apparently, this is all transitory and central bankers insist that zero or near zero interest rates are still necessary, as are continued asset purchase programmes (QE).
In my March article I argued that the UK could avoid the boom/bust recovery that seems inevitable in the US. Fiscal expansion in the UK is far less aggressive than in the US, and money supply growth lower (though still too high at 15%). Supply side initiatives driven by Brexit freedoms (free ports, free trade deals, deregulation, new policies on immigration, agriculture and fishing, increased public and private investment) should raise UK productivity. There are encouraging early signs that the EU’s intransigence is emboldening the UK into more rapid divergence. However, a further key assumption – was that the Bank would take a firmer line on inflation than the Fed. Recent developments place grave doubt on this assumption. After its last policy meeting the Bank agreed to continue with the asset purchase programme and passed up the opportunity to signal to the market that Bank Rate will be raised before long. Peddling the Fed’s line, they see the recent rise in inflation as transitory. Yet, the Bank is still forecasting a robust recovery. If they were to halt asset purchases and raise Bank Rate from the current 0.1% to 0.5% by year-end, what possible threat to the recovery would this pose? If they prove right that inflation recedes, little or no harm is done. Indeed, a rise in interest rates may be taken as a sign of confidence and actually boost consumer and business sentiment.
But what if they are wrong? The longer a tightening of monetary policy is delayed the sharper the eventual rise in interest rates will have to be, bearing in mind the long lag between monetary policy actions and their effects. Clearly, the Bank’s Chief Economist, Andy Haldane, thinks along these lines. He voted to end the asset purchase programme at the last meeting – the only member of the MPC to do so – and recently warned that the rise in inflation may not be short lived. Sadly, Mr Haldane is leaving the Bank, thus no doubt reinforcing the “group think” mentality of those that remain.
There is undoubtedly a deep-seated fear among current central bankers of the impact of significantly higher interest rates on a deeply indebted global financial system. Perhaps they think along the lines of Ernest Bevin, Foreign Secretary under Churchill and Attlee, when he wrote “I don’t think we should open that Pandora’s Box, because you never know what Trojan Horses might fly out”*. Unfortunately for central bankers, if they don’t take the initiative, the “Trojan Horse” that will fly out is a major bond market sell off that drives interest rates much higher and takes matters out of their control. The Chancellor is right to resist pressure from the PM for higher public spending. He would be well advised to start pressuring the BoE, privately and publicly, to take the inflation threat a lot more seriously. The longer the delay the more likely it is that the current recovery will come off the tracks.
Robert Lee June 28th 2021
*Mr Bevin was actually resisting any effort by the UK to join the embryonic stages of what ultimately became the EU. An early Brexiteer!