The Great Unravelling Macro policy-making in uncertain and turbulent times Geoff Riley, Head of Economics, Eton March 2009

Today’s Presentation  Quick macro update – where are we NOW?  Reaching for a Viagra stimulus – are we at the end of fine-tuning  Does the Bank of England matter anymore?  Searching for green shoots

Quick Macro Update for AS and A2  Indicator and latest value (annual % change unless stated)  GDP (Gross Domestic Product) -1.8% (final Q08)  CPI Inflation (Consumer Price Index) 3%  Policy Interest Rate 0.5%  Unemployment (Labour Force Survey) 6.6%  Consumer Confidence (index) (long term average = -10)  Current Account Balance £-7.7bn (final Q08)  Industrial Production -9.3% year on year  House prices -17.2% year on year  Source: ONS and Reuters

Hold on Tight "Now in Britain, we are saying, as you know, that inflation is low, interest rates are low and we expect there to be growth. Gordon Brown, 27 th January 2008

What type of recession? L, V or U?

Did rising inflation in 2008 cause the Bank to move too late?

-450 BP – a race to the bottom

Jobs cull – but (much) worse to come

Consumer confidence has taken a hit

With housing mired in a slump

And mortgages hard to find

Equities take a pounding

Business animal spirits head south

And the ‘accelerator effect’ becomes negative

UK manufacturing is in freefall

Despite the lower pound

Spare a thought for Japan

And Germany

Deflation is a key risk in 2009 Evaluation: Was the decision by Brown to change the Monetary Policy Committee target from retail price index to consumer price index in 2003 a mistake?

Especially if discounting spreads

And commodity prices head lower

BoE survey suggests price pressures are falling – will this be enough for deflation?

The Global Backdrop  Global GDP will shrink in 2009…making this the worst global downswing in the post-war period  Growth in developing world will more than halve  China slips below the 8% growth seen as a minimum target  Japan suffers 4 th recession in 12 years and manufacturing slumps back to 1971 levels  Germany shrinks by nearly 2%  Export-dependent countries hit by contraction in global trade  Bright spots? Brazil, India, Poland

China will need to rebalance

And Japan moves into deficit

Monetary and Fiscal Policy – A Shotgun Marriage

‘Ease his pain’ – pulling every lever  Policy rates have moved to the floor (0.5%)  £75bn quantitative easing (March 2009)  25% depreciation of sterling over last 12 months  Injection of capital into the banking system  Government borrowing of more than 8% of GDP  National debt that > 65% of GDP within 2 years

Adding stabilizers to the cycle  Stage 1: Estimate likely impact of recession on the UK’s GDP – say between 8 or 9%!  Stage 2: Calibrate the likely impact of the policy stimulus  Interest rate cuts: £12-16 billion or approaching 1% of GDP  Fiscal policy: £20 billion or a bit above 1¼% GDP  Huge Sterling depreciation to an open economy: 3% GDP  BoE quantitative easing (impact unknown)  Net effect – stimulus of more than 6% of GDP …  So a contraction in UK of between 2 and 3% in 2009 – a bad recession – but it could (might still) be much worse

Explaining a £120bn deficit  Sharp fall in tax revenues (reverse fiscal drag)  Bringing forward of capital spending  Automatic stabilisers – higher welfare bill because of rising unemployment  Bail outs of banks and selected industries  Deliberate Keynesian style stimulus to demand  Evaluation …. Uncertain size of the fiscal multiplier

A fiscal tsunami – but who will pay? Evaluation: Consider raising a counterfactual in your essays – what would have happened if there had been no fiscal stimulus.

Borrowing and nationalisation

Is the Bank still independent?  Nowhere to go on policy interest rates – liquidity trap reached?  Inflation target is being ignored for now (will there be a change?)  The key rate now is on government bonds - not the base rate  Government committed to HUGE borrowing  Will the Bank buy as many bonds as the government needs?  Will the Bank be strong enough to tell the government to stop?  For most people the base rate of interest is an irrelevance  Look at the cost of unsecured credit  Even if borrowing costs are low, can you actually get a loan?

0.5% - Does anyone pay this?

Borrow now – ask questions later? Evaluation: Is there evidence here of crowding- out? Do bond yields rise when borrowing increases?

Keep a close eye on corporate bonds

Risky Business

The risk of corporate default is growing

The (shotgun) marriage of macro-policy  Monetary and fiscal policy are now joined at the hip  Short term – appetite (demand) for bonds eases the problems of financing an eye-wateringly large fiscal deficit  Good fiscal stimuli are timely, targeted, and temporary  But there is no such thing as a free lunch  Fiscal policy will need to be tightened  There will be some crowding out of the private sector  We cannot ignore the risk of resurgent inflation in a recovery  Weak sterling poses a major credit (solvency) risk for the UK government – even if we are not (quite) an Iceland

Looking for Green Shoots  Financial market recovery is pre-condition  Bank lending to commerce and property  Getting through the 2009 corporate debt crisis  Change in business & consumer sentiment  Aggressive de-stocking might end  Look for data on prices and profit warnings  Impact of policy stimulus – note the time lags  Lower commodity prices – impact on real income  But unemployment will continue rising – a lagging indicator