Stephen King: Demand will outweigh supply in Bank's thinking

The Monetary Policy Committee are sitting on the fence, thankful the economy appears to have rebounded
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The Independent Online

I realised the other day that my cat is just like the typical economist: it eats, sleeps and sits on the fence. Unlike my cat, though, most economists feel uncomfortable in this position. Apart from the obvious physical discomfort, there's also a sense of intellectual failure: a decision has to be made to jump in one direction or the other, but all too often the evidence to support the required decision is lacking. Failing to choose, however, is often the worst of all worlds: after all, faced with the choice between two identical bales of hay, the indifferent donkey sadly starved to death.

Sitting on the fence does, though, provide time to gather at least a bit of evidence. My cat, for example, may decide that the distracted pigeon in next door's garden is a better bet than the watchful mouse in our own garden. With the possible spread of bird flu, my cat's decision might eventually prove to be a mistake, but at least I can believe that the blood and feathers that might subsequently appear in my kitchen were based on more than a brutal act of random slaughter.

Like my cat, the members of the Bank of England's Monetary Policy Committee are sitting on the fence. Having cut interest rates last August, they have recently been licking their whiskers, thankful that the economy appears to have rebounded after the apparent soft patch in the middle of last year, a time when both consumer and business confidence appeared to be fading fast. Gross domestic product rose 0.6 per cent in the final quarter of 2005, not a million miles away from so-called "trend" or "sustainable" growth. Given the Office for National Statistics' predilection for revising up initial estimates of GDP growth, the Bank doubtless feels comfortable that the economy's coming up smelling of roses.

The Bank knows only too well, though, that the underlying situation for the UK economy is rather more puzzling. The latest Inflation Report talks about a welcome recovery in consumer spending. The much-heralded recovery in capital spending, though, appears not to have arrived. Productivity growth has been decidedly poor in recent quarters. The trade deficit is widening. And, most worrying of all, the labour market is deteriorating. Once upon a time, the UK could point to its excellent employment record relative to its most important competitors, but today unemployment in the UK is rising whereas, in the US, Germany and France, it's in decline.

Of the reasons behind the softening of the labour market, two stand out. Employment prospects are facing the cold turkey associated with the withdrawal of public sector support. The left-hand chart - for which I am grateful to John Butler, my colleague at HSBC - shows that all of the gains in employment in recent years have been in the public sector. Because the Chancellor of the Exchequer has now basically run out of money, this support won't be coming through any more: indeed, he's promised to reduce Civil Service jobs in response to recommendations from the Gershon review.

At the same time, there's evidence to suggest that the private sector may have been hoarding labour in the second half of last year. The recent deterioration in productivity performance may turn out to be a purely cyclical affair and, no doubt, many companies chose not to lay off workers in 2005 in the hope that 2006 would bring better economic prospects. If anything, though, it looks as if companies are beginning to run out of patience. The recent decline in employment may prove to be an attempt by companies to lower costs and, hence, restore competitiveness after last year's feeble productivity performance.

All in all, the combination of a declining public sector desire to hire additional workers and a private sector hunt for better productivity suggests that the climate for employment growth has deteriorated to such an extent that the Bank of England may be forced to re-evaluate its outlook for the economy: hopes that the consumer will somehow take up the slack created by the absence of investment demand may all too quickly wither on the vine, eventually placing pressure on the Monetary Policy Committee to contemplate another rate cut.

So far, so good. The problem for the Bank of England, though, lies in assessing whether the apparent weakness of the labour market is the result of a demand shock - renewed fiscal tightening and the lagged effects of last year's housing weakness, perhaps - or, instead, whether it is the result of a supply shock associated with, for example, the persistent increases in oil and, more recently, gas prices.

David Walton, one of the external members of the Monetary Policy Committee, raised this dilemma in a speech entitled "Has Oil Lost the Capacity to Shock?", given to the University of Warwick Graduates' Association Senior Directors' Forum in London on 23 February (http://www.bankofengland.co.uk/publications/speeches/2006/speech268.pdf).

Mr Walton noted that while higher oil and other commodity prices could have significant demand-side effects, notably on consumer and business confidence, they could also have substantial supply-side effects that might lower potential output. Of the potential supply-side constraints, the most obvious are a reduction in productivity associated with the new-found redundancy of some elements of the capital stock (some machines might be profitable to operate when oil is at $30 per barrel but not when oil is at $60 per barrel), a period of lost output while companies shift from one fuel source to another and, finally, a period of uncertainty as companies choose to hold off on investments until a new longer-term level for energy prices is more clearly defined.

Faced with these uncertainties, the problem for the Bank of England is easy to state. Lower than anticipated growth and employment might indicate a shortage of demand. However, they might just as easily indicate a reduction in the economy's supply potential. In the former situation, actual output falls below potential output, thereby indicating a build-up of undesirable deflationary pressures pointing, in turn, towards a need to loosen monetary policy. In the latter case, potential output might fall even further than actual output, suggesting that the inflationary consequences of a given growth rate are now bigger than before, therefore providing no room for monetary loosening.

It's easy to see why the Bank of England is still unsure of which way to jump. Back in the 1970s, unemployment rose in the light of the first oil price shock. Based on the demand management philosophies of the time, the conventional approach was to loosen monetary and fiscal policy in an attempt to shore up output. The first oil price shock was, though, primarily a supply-side shock. The failure to recognise this essential truth led to stagflation.

Never the less, the Bank doesn't want to be like the indifferent donkey. As the year progresses, I suspect that many of the supply-side concerns will eventually fade: no second round wage effects, declines in the prices of many other goods, notably those that come from China and other low-cost producers and, hopefully if British management can finally get its act together, an improvement in productivity as workers' output is raised through the growing use of new technologies. In other words, the world we live in is a lot more flexible that that of the 1970s. Sitting on the fence is fine while the evidence is accumulating but my guess is that, later in the year, it will be the weakness of demand rather than the loss of supply that will eventually determine the next move in UK interest rates.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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