Hamish McRae: Growth is returning but what will happen when QE is wound up?

Economic Life: There is an artificial element to the growth which people are worrying about
Click to follow
The Independent Online

So the monetary policy accelerator remains on the floor. It remains on the floor here and will remain on the floor in the US too for a while yet – and there is only the slightest hint that the European Central Bank will ease back at all soon. Not only do interest rates remain unchanged, as was of course expected, but more money is being pumped in both here and in the States.

Yet the response of the real economy, not just here but throughout the developed world, remains sluggish. More ought to be happening. It isn't. Why?

I think it is important at a time like this not to be too bogged down in the data, to crawl over numbers that are probably wrong anyway or to over-analyse the supposed motives of the various central banks. When you get people writing paragraphs of interpretation about a three-word change in a central bank communiqué or a couple of phrases by a monetary official you know we are in trouble. As for trying to guess when the next rise in interest rates will be, here, in Europe or in America, that really is pointless. The central bankers have no idea of the likely profile of interest rates, so why should the rest of us?

What we do know is that the UK growth figures are wrong in that they underestimate the level of activity in the economy. They run counter to all the survey data and it is perfectly possible that far from contracting in the third quarter, the economy may have started to grow. We will not, however, know this for a couple of years; helpful indeed.

Our data is particularly bad at the moment and one of the tasks for the new independent body that oversees our statistical service is to try to work out what has been going wrong. But it is hard to have much confidence in European or US data either. I suspect the strong US third-quarter growth will eventually be revised down and I am not comfortable with the French and German figures. If statistics feel wrong they usually are.

Having said that, it is pretty clear that the main economies of the developed world are growing again, as they should be given the amount of welly they have received. It is also clear that there is an artificial element to that growth, which people are starting to worry about. Deep down, we know the fiscal and monetary policies are unsustainable and people are therefore factoring in another dip once they are withdrawn. I am not saying that the growth policies are misguided, though like many I feel profoundly uneasy about a UK budget deficit that may reach 14 per cent of GDP. What I am saying is that they are becoming ineffective. They are generating adverse expectations about the future course of the economy that undermine their objectives. The policies are so extreme that they are damaging confidence.

That is a particular problem in Britain because we have a discredited Government but it would be naïve to think the forthcoming general election will radically improve things. The confidence in the Bank of England is none too high either. But then the confidence in the US Federal Reserve is just as fragile and US fiscal policy is in almost as big a mess as our own. Investors are prepared to cut the ECB a little more slack, partly because it is felt to be more ready to stand fast against any incipient rise in inflation and partly because there is confidence in the fiscal policies of its largest member country. Germany, people feel, will not renege on its debts. But investors everywhere remain worried and rightly so.

So what will happen? The analogy that best explains why the response of economies everywhere has been so muted is the "brick on an elastic" one. You attach a brick to a piece of elastic and try to pull it along. Nothing happens for quite a while then suddenly, when the elastic is fully stretched, the brick starts to move. I tried it in the garden the other day, and no, the elastic did not break, and yes, the brick did start reluctantly to move. The elastic represents what the governments and central banks are doing; the brick is the economy. We should not be surprised that it is so hard to get it to restart growth.

You can catch some feeling for the possible profile of growth in the UK by looking backwards at the main post-war economic cycles. The big graph shows how we have had quite a few quarters of negative growth over the past 40 years: on that sort of long view this experience does not look beyond our experience. The problem is that we allowed ourselves to be sold the idea that there could be no return to boom and bust and accordingly when the economic cycle reasserted itself, we were unprepared. Those figures are based on the present official estimates for GDP and, if I am right, the profile of this cycle will not be as dire as it appears. But even on the data as it exists, there is a reasonable prospect of a return to secure growth. The small graph shows some estimates through to the end of 2011: from Capital Economics; from the Bank and the Treasury; and the consensus view of economic forecasters. As you can see there is a prospect of some growth next year and rather better growth in 2011.

If you accept this as the likely big picture, you can start to sketch a possible profile for the return to monetary normality. The idea that growth will falter at some stage next year seems to be most plausible. You could still have overall growth of, say, 1 per cent, yet have a quarter of decline. But by the end of next year, unless something utterly off the radar happens, self-sustained growth should be established. So a year from now everyone will be adjusting to the idea that interest rates are on the up and that quantitative easing will be being unwound. Nothing much may have happened come next November, though if the more bullish forecasters, such as Goldman Sachs, prove right, I would guess that we will have had at least one rise in rates. Goldman Sachs forecasts 1.9 per cent growth for the economy next year, with most of it coming through in the second half, and an above-trend 3.5 per cent in 2011.

If that is anywhere near right, come 2011 we really will be back to "normal" interest rates and people will have to get used to that. It is easy to see that. The question that some of us feel very uncertain about is the impact of the unwinding of QE on asset prices. If, as seems to be generally accepted, it has been in fair measure responsible for the recovery in share prices, what happens when that prop is withdrawn?

You see the point? The detail of what the central banks do and say right now is unimportant. We are still in exceptional circumstances. What matters will be how skilfully they engineer the path back to normality and they, and we, have no idea how well they will manage to do that.

Comments