Thursday, February 17, 2011

In a post on this blog last June, I expressed concerns that the Office for Budgetary Responsibility was underestimating the magnitude of the output gap in the UK. This underestimation appears to be contagious. A member of the Bank of England's Monetary Policy Committee, Andrew Sentance, has argued in a speech that the output gap is low and that maintaining historically low interest rates is stimulating the economy beyond the point at which inflation can be held in check.

The notion that, with high and rising unemployment, the output gap is low seems to be difficult to defend. There are, to be sure, reasons why prices are rising. Oil and food prices have risen internationally for reasons that have been well documented (here and elsewhere) and which are likely to be transient. Tax hikes have also contributed.

The economy shrank in the last quarter. Fiscal policy is imposing a squeeze which will inevitably increase the challenges faced in the labour market. To move too early to accompany this with a monetary squeeze - and to do so on the basis of price statistics that are probably blipping - would be dangerous. Yes, we need to keep an eye on inflation, but, no, the price increases we have seen up to this point do not suggest that inflation is a significant threat.

Wednesday, February 09, 2011

Project Merlin - the initiative that has aimed at securing more bank lending to businesses by linking bankers' bonus payments to such lending - has finally, after much wrangling, delivered an agreement. The banks will raise their lending to a total of around £190 billion this year. Some 40% of this will go to small firms. The banks will also provide capital (some £200 million) for the Big Society Bank - which is intended to fund projects that are community based. There will be increased transparency in bankers' pay, but this falls short of the hope that bonuses would be contingent on banks meeting lending targets.

Lending will be monitored by the Bank of England which will provide regular reports - which presumably means naming and shaming banks that do not live up to their promises. Beyond this, it is not clear that Merlin has any teeth. Banks will lend, and they will do so at rates of interest that they themselves set. If businesses do not find these rates attractive, they will not look for loans.

In this context, it is a little disquieting to note the continued rise of LIBOR - which is now at 0.80%, some 30 points above the Bank of England's interest rate. There is still a lot of nervousness around the financial markets, and that means that lending is still not going to come cheap.

So the environment in which Merlin has been launched is not altogether promising. A little more prescription might not have gone amiss.