November 14, 2012 7:14 pm
For the past five years of the financial crisis, Bank of England inflation reports have often painted a bleak picture of the economy. Few, however, have been quite as gloomy as the one published this week.
Weak global demand and subdued spending by consumers and businesses mean that economic growth will be weaker than previously thought. The bounce enjoyed during the summer – when the economy grew by 1 per cent – is expected to peter out. The economy is unlikely to return to its pre-crisis peak until late in 2015.
To add insult to injury, inflation – which the Monetary Policy Committee thought it had well-nigh tamed – has crept up again. The consumer price index rose by 2.7 per cent in the year to October. True, much of the acceleration was due to one-off factors, such as the near-trebling of university tuition fees. However, rising energy prices mean the BoE now expects inflation to stay above the 2 per cent target until 2014.
Stubborn inflation and shy growth create a dilemma for policy makers. So far, Britain has pursued an expansionary monetary policy to compensate for the government’s programme of fiscal consolidation. But given the MPC’s pessimistic view that there is limited slack in the economy, the BoE is likely to be increasingly reluctant to pursue new rounds of quantitative easing until inflation is brought back under control.
The admission of near impotence by the monetary authorities will no doubt trigger calls for George Osborne, chancellor, to use next month’s autumn statement to relax fiscal policy. This would be a dangerous move. The BoE says there is little spare capacity in the economy. If so, expanding demand via tax cuts or higher spending would make it harder for the MPC to meet its inflation target.
The key challenge for the coalition is lifting the rate of growth of productivity, which has been stagnant. This means ensuring the flow of credit to businesses, so that they can invest. While the “Funding for Lending” scheme, which offers banks financial incentives to extend more credit to UK borrowers, may mitigate the problem, it will not solve it altogether.
In the longer-term, the problems run deeper. Banks are not lending because much of their credit is locked in unproductive companies and impaired assets, artificially kept alive by bank forbearance. Eventually more losses will have to be realised for the economy to grow sustainably again.
This means girding the system for another wave of losses – in companies and banks. The government need not become directly involved. But there may need to be further restructuring of RBS, the largely state-owned bank. Another option, put forward by bankers this week, is that all existing senior unsecured debt should be available to absorb losses. The government should consider this.
Monetary and fiscal policy cannot alone end stagnation without more reform of the banking sector. How Mr Osborne plans to do this is more important than what he says about deficit cuts.
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