Bank of England drops its optimism on productivity

After years of over-optimism on UK productivity, the Bank of England threw in the towel on Thursday.

The central bank ditched the idea that Britain’s economy could sustainably grow at about 2.5 per cent a year, as governor Mark Carney believed when he took on the job in 2013. The BoE even stopped predicting the economy could grow at about 1.4 per cent a year, which it said in 2019.

The UK economy is in a difficult place, the BoE’s Monetary Policy Committee concluded, and that meant it could only grow at an annual rate of 1.1 per cent over the next three years without fuelling damaging inflationary pressure.

Ben Broadbent, BoE deputy governor for monetary analysis, was gloomy. “We no longer expect much of a pick-up [in productivity growth],” he said. Productivity is a crucial ingredient in determining how fast an economy can grow.

The BoE did not quite spell out the implications of its forecasts about the so-called potential growth rate of the economy following its annual “supply stock take”, but they are profound and risk sending a shiver down the spines of ministers in Boris Johnson’s government.

The BoE predicted a sustainable growth rate that is so slow it would severely limit any rise in real living standards, leave the public finances struggling to meet the demands for better public services, and constrain government efforts to boost the performance of weaker regions.

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And if growth exceeded 1.1 per cent, quite soon the BoE could feel compelled to raise interest rates to slow the economy and prevent it from overheating.

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Against this backdrop, the BoE marked down its growth forecasts over the next three years without a large change in its inflation prediction.

Allan Monks, economist at JPMorgan, said the changes “set a very low bar for growth to return to an ‘above trend’ pace”, raising the prospect, should a Brexit bounce happen, of higher interest rates quite quickly.

Mr Carney, at his last MPC meeting before stepping down, wanted to avoid comparing the timescale of his forecast for the economy’s potential growth rate with chancellor Sajid Javid’s ambition of raising annual expansion to 2.8 per cent.

But he said Mr Javid should recognise that a concerted effort was needed to raise growth rates because “this is not something you change overnight”.

Line chart of UK real GDP, annual % change showing The BoE has downgraded its medium term forecast for economic growth

The BoE’s pessimism — it has a lower estimate for the potential growth rate of the economy than the Office for Budget Responsibility, IMF or OECD — raised questions about why the central bank was so downbeat and whether its view was reasonable.

The BoE was transparent. Compared with the days when it thought 2 per cent annual growth was sustainable, Mr Broadbent said half of the downgrade was roughly due to a shortage of potential workers given the employment rate was already at a record high and the remainder because the BoE had capitulated on its productivity growth forecast.

In the future, the BoE expects productivity growth to average about 0.5 per cent a year, similar to the 0.4 per cent recorded over the past decade, rather than a pick-up to the 1 per cent-plus as it previously had hoped.

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Brexit was partly to blame, added Mr Broadbent and Mr Carney, although they said they could not put a precise number on a damaging effect.

Leaving the EU has created uncertainties that have served to reduce business investment. Brexit has become a distraction for companies, forcing them to plan for various scenarios rather than getting on with improving their businesses.

Line chart of Annual % change in UK CPI showing Inflation has been running below the BoE's 2 per cent target

Brexit “is likely to have diverted time and effort away from other activities”, said the MPC’s monetary policy report.

Private sector forecasters were broadly supportive of the BoE’s move to downgrade the potential growth rate of the economy, even though most have more optimistic predictions of about 1.7 per cent per year by 2023.

They took the downgrade as a signal the BoE was unlikely to cut interest rates this year.

A modest pick up in growth anticipated by the MPC in 2020 should now be enough to “leave policy on hold in 2020”, said David Page, economist at Axa Investment.

The MPC members, however, cautioned against this logic, pointing out that there were many aspects of the economy they did not understand, which might still change their outlook for monetary policy.

In particular, members noted that despite low productivity growth, wages had been strong yet inflation was persistently weak.

The MPC raised the possibility that this was because of long-term pressures on prices, especially in the retail sector where high-street companies were struggling with a squeeze on profit margins.

The MPC said it would do extra work on this topic in the future, and even with a slow economy, if price rises are persistently weak, interest rate cuts could rapidly come back on to its agenda.

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