The Bank of England produced a sobering analysis of the outlook for the UK economy this week.
If this sounds familiar, it is. You’ve heard this story before. Since the onset of the financial crisis, the Bank has been continually revising down its forecasts for economic growth and moving its inflation forecasts up.
The official explanation for these forecast errors is that demand from consumer spending, the public sector, businesses that want to invest and overseas markets has been much weaker than expected. Indeed, Sir Mervyn King majored on the weakness of the global economy as the main factor contributing to the Bank’s weaker forecast of growth in this week’s latest Inflation Report.
But things are not quite that simple. It is true that the UK’s major export markets in Europe (Chicago Options: ^REURUSD - news) are struggling at the moment. But elsewhere in the global economy, growth is more healthy.
In the US, economic growth is forecast to average just over 2pc this year and next, while unemployment is gradually falling. In Asia, Africa and Latin America, economic growth remains strong.
The IMF is projecting 5pc to 6pc growth on average for the developing and emerging market economies this year and next.
The average rate of growth for the world economy is forecast by the IMF (Other OTC: IMFAF.PK - news) to be 3.3pc this year and 3.6pc next year. This is pretty much in line with the historic average (3.5pc) for the previous 30 years. It is not that the global economy is particularly weak, but that the UK economy is not as well-positioned as it could be to benefit from the current growth hot-spots.
A second challenge to the official Bank view of the weakness of the UK economy is the performance of inflation. When demand is genuinely weak, companies cut their prices and the cost of energy and other global commodities collapses. We saw this in 2008/9 the oil price fell from $150 a barrel to $40 a barrel in the space of less than a year.
But we are not seeing similar price movements now. The oil price remains at around $110 a barrel and petrol prices are close to a record high. Other energy prices for gas and electricity continue to rise. Food prices are also picking up. And, despite all the concerns of the weakness of the economy, UK inflation remains stubbornly above the official 2pc target. In October, consumer price inflation was 2.7pc. And in the services sector, prices are rising at double the official target rate at more than 4pc.
So what is going on? In my view, the UK and many other Western economies are now in a “new normal” economy, where economic growth is likely to continue to be weak and inflation will remain relatively high and volatile.
This economic environment is being shaped by three main forces. First (OTC BB: FSTC.OB - news) , the world of easy money we took for granted before the financial crisis has gone perhaps for ever. Not only are banks becoming more cautious, but their regulators are also encouraging them to build stronger capital reserves.
Second, the era of cheap imports has come to an end at least for a while. Western consumers can no longer rely on a boost to their purchasing power from cheaper and cheaper imports from China and low-cost economies.
Growth in these high-growth economies is now adding to the world demand for energy and other commodities and squeezing Western consumers by pushing up our import prices. At the same time, wages are rising in China and other low-cost producers, pushing up the cost of imported manufactured goods.
The third force shaping the “new normal” world is a loss of confidence in the ability of governments and central banks to keep our economies on a steady, low inflation growth path. Now, governments are struggling with rising deficits and debts and central banks are unable to move easily away from the emergency policy settings they put in place to deal with the financial crisis and its aftermath.
The inability of policymakers to take decisive moves to get their economies back on track has a negative impact on private sector confidence.
The economic models used by the Bank of England and other forecasters can’t easily take these shifts into account. They rely on history to predict the future. And most of our history in the past 30 years was in an “old normal” world, shaped by easy money, cheap imports and an excessive confidence that governments and central banks could keep economies on a steady, even course.
Over the past three or four years, the Bank of England has been adapting its view of the economic outlook to this new reality. Its latest forecasts show weaker growth and higher inflation than the previous version, published in August. And they are certainly more realistic in the short term about the likely growth and inflation outlook. But it is not yet clear that the Bank of England has done enough to adapt its thinking about the medium-term direction of the UK economy. At the Inflation Report press conference this week, Sir Mervyn gave the impression that if we wait long enough everything will come right.
He said: “I think if you take a very long-term perspective, of decades, I certainly see no reason at all to suppose that the potential output of the UK will be any less than we thought it was a few years ago.”
In my view, this is a misreading of what is happening in our economy at the moment. The closest parallel I can see to our current situation is the decade of disappointing growth and volatility from the early 1970s until the early 1980s.
The UK and other Western economies benefited from a period of strong growth in the 1950s and 1960s a period of post-war economic recovery. In the 1970s, this post-war growth model was undermined by the collapse of the Bretton Woods exchange rate system, industrial unrest and energy price shocks. After about a decade of slow growth and volatility, growth resumed in the 1980s powered by new drivers financial liberalisation, globalisation, deregulation and tax reform.
We have yet to identify the drivers which will power the next substantial wave of economic growth. For the time being we are stuck in a world akin to the late 1970s and early 1980s slow growth, financial volatility, high energy prices and prolonged uncertainty.
While we should be hopeful that a new growth wave might arrive once the UK and other Western economies have adjusted to our changed economic circumstances following the financial crisis that is not guaranteed.
The Bank of England’s latest forecasts are certainly more realistic than earlier versions. Growth is expected to pick up to around 2pc which is actually quite a healthy performance in the “new normal” world I am describing. And inflation is projected to continue above the 2pc target before subsiding.
My suspicion is that the inflation outlook will be less benign. If as most forecasters expect the world economy picks up again in 2013/14, there may well be another burst of energy and commodity inflation. It is also worrying that UK services sector inflation which accounts for about half of the consumer basket continues to run at 3pc to 4pc.
Inflation performance remains the “Achilles heel” for the Bank of England. It has failed to keep inflation at the 2pc target and has not yet taken any significant actions to contain inflation since the financial crisis.
Restoring credibility in the Bank’s commitment to price stability and low inflation should be high up the agenda of its new Governor, whoever he or she may be.
Andrew Sentance is Senior Economic Adviser at PwC and former member of the Bank of England Monetary Policy Committee