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Investment principles and risk


Foward guidance goes on

Steve Williams

When the Bank of England introduced its policy of ‘forward guidance’ in August 2013, it linked the future path of interest rates to the Labour Force Survey unemployment level.

As the current unemployment rate of 7.6% shows every sign of falling to the 7% threshold, there has been mounting excitement among some commentators about the potential for an increase in the main policy interest rate. The November 2013 issue of the Bank’s Quarterly Inflation Report (QIR) – outlining its three-year forecasts for GDP, inflation and employment – was therefore eagerly anticipated.

Should the Bank’s central predictions come to pass, over the forecast period GDP will rise at an uninterrupted rate of between 2% and 3%. Simultaneously, inflation will drop to the 2% target and stay there. The Bank has growing confidence that a broad-based and sustainable recovery has taken root; against this background, there are even odds that unemployment will fall to below 7% by the end of 2014 – almost a year sooner than previously forecast.

The unemployment rate will not be the decisive factor in the Monetary Policy Committee’s (MPC) policy actions, however. Rather, it will be the Bank’s judgment about the amount of slack in the economy – the difference between how much is produced and how much can be produced with existing resources – which will determine when and how far Bank Rate is lifted.

Right now, the MPC judges there to be a significant amount of slack. That’s great news, because it implies an expectation of a significant economic growth before we see inflationary pressures building. In the economic restaurant, that’s about as close as you get to a free lunch. And with output still 2.5% lower than it was five years ago, it might be some time before that slack is taken up.


Secular stagnation

John Housden

Secular stagnation doesn’t sound very pleasant, and it isn’t, but it might be a long-term reality.
Larry Summers is one of the world’s leading economists, so when in he used a recent speech to the IMF to suggest that rich countries were suffering from ‘secular stagnation’, his words received considerable attention.

Summers was looking at the lacklustre recovery of advanced economies from the 2007/08 financial crisis. He cited the United States, where “in the four years since financial normalization [in autumn 2009], the share of adults who are working has not increased at all and GDP has fallen further and further behind potential…”

To Summers, this was not simply a post-crisis problem. He sees “something a little bit odd” in the economy’s performance before the crisis. For all the imprudent lending and other easy money policies, there was no great economic surge and unemployment did not reach any remarkably low levels. To Summers, the lack of boom times before 2008 is key to understanding the post-crisis experience.

He sees that failure of the monetary stimulus as a clear sign that real (inflation-adjusted) interest rates were too high to achieve full employment.  He argues that “the short-term real interest rate that was consistent with full employment had fallen to -2% or -3% sometime in the middle of the last decade.” Based on current central bank rates and inflation, real short term rates are about -0.75% in the United States, the eurozone’s are at -0.65%, and the UK’s at -1.7%. To reach Summers’ equilibrium real interest rate, nominal interest rates would, in theory, be negative. As Summers says, “we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever.”

His conclusion is not reassuring: “…my lesson from this crisis… is that it is not over until it is over, and that time is surely not right now, and cannot be judged relative to the extent of financial panic. And that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies back below their potential.”

Not everyone agrees with Larry Summers. At the same IMF conference, the current Fed chairman, Ben Bernanke, suggested that capital spending by the public sector – funded at zero rates – could prevent secular stagnation.


SMEs to receive access to funding support

Steve Williams

In November 2013, the Bank of England and HM Treasury agreed to eliminate the element of incentive to lend to households that is currently contained in the Funding for Lending Scheme (FLS). The announcement was made by the Bank of England’s Financial Policy Committee (FPC) – the new regulatory body tasked with ‘identifying, monitoring and taking action to remove or reduce systemic risks’.

The FPC is keen to avoid excessive household indebtedness and leverage in the banking system, particularly now that a fuller recovery is in sight and there seems to be a global trend towards rising long-term interest rates.

The effect of this move will be to reduce the high street banks’ access to cheap funding which has so far underwritten an improvement in mortgage lending volumes. In the short term, that’s bad news for home-buyers. But it’s good news for savers as increased the competition for capital will probably see some rise in savings rates.

The FLS will remain a feature of the credit landscape, but its purpose will be focused on encouraging banks to lend to small and medium-sized enterprises (SMEs). Such smaller companies particularly need this support because they have fewer funding options than their larger compatriots. In the five years since the onset of the credit crunch, net lending (gross lending less repayments) to UK businesses has been consistently negative. The Bank of England’s most recent Trends in Lending report reveals that lending contracted by a further £2.4 billion in the three months to August 2013 alone.

According to, 99% of the 125,930 manufacturing firms in the UK are SMEs. Lending to small businesses ought to be a key concern for policymakers if they are serious about encouraging a rebalanced, better-diversified economy



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