GDP, Brexit, and an Economy in no need of additional stimulus
Many people have waited for the latest UK GDP figures for the third quarter to assess the impact of Brexit on the economy. This reflected the suggestion that a vote to leave in the referendum would damage the economy in both the short term and the long-term. The suggestion was that in the short-term a Brexit vote would shock confidence, lower the prices of financial and other assets and lower the exchange rate, raise the price level and provoke a technical recession.
The precise transmission mechanism that would generate these immediate malign consequences was opaque. Their magnitude and speed would have had to been unusually potent, compared to the lead, lags and multipliers that are normally associated with changes in monetary and fiscal policy. The concern about immediate business and consumer confidence and the consequences of lower asset prices illustrate an analytical reflex present in central banks and international organisations, such as the IMF and the OECD. This is an exaggerated perception of the significance of the effects of events on business and consumer confidence and the role that wealth effects have on demand in economies.
These institutions are quick to identify powerful malign effects requiring swift policy responses. In short bad news requires looser policy swiftly delivered. This reflex tends to result in policy that is not just pro-cyclical, but significantly asymmetric in its consequences. The determination to operate macro-economic policies that maintain economic activity at the boundary of often highly optimistic trend rates of growth, along this asymmetry in the assessment of the cycle, is at the heart of the concern that the Bank for International Settlements has that central banks meet every concern about the pace of economic activity with huge cumulative injections of liquidity that raise asset prices fuel international capital flows creating the conditions for asset prices bubbles and the kind of damaging wealth effects that policy makers fear so much.
An economy expanding faster than its trend rate of growth?
In the third quarter GDP grew 0.5 per cent, following growth of 0.7 per cent in the second quarter that was revised up from the initially reported figure of 0.6 per cent. This means that so far this year the UK economy has been growing at a rate of around 2.25 per cent that is slightly faster than a realistic judgement about its trend rate of growth. It is worth noting that the US Council of Economic Advisers and the Federal Reserve Board consider the trend rate of growth in the US to be around 2 per cent and although the UK labour market appears now to be at least as flexible as that in the US, it would be implausible to think that the UK is likely to have a faster trend rate of growth than the US.
Brexit has little impact on pattern of economic activity
There is no reason to think that the pattern of economic activity in the UK has been affected by the referendum or by its result. If anything growth accelerated during the first half of the year in the run up to 23 June and has been maintained at its trend rate since June. The ONS notes that not only was the pattern of growth broadly unaffected following the referendum but a strong performance from services offset falls in other sectors such agriculture, construction, manufacturing and construction. It is worth noting the weights the ONS uses in constructing the national accounts output series. Services account for 78.8 per cent of output, production 14.8 per cent, construction 5.9 per cent and agriculture 0.7 per cent. In the third quarter 0.8 per cent growth in services contributes 64 per cent to the overall growth in GDP.
In the Great Recession output fell from peak to trough output fell 6.3 per cent. In 2009 the fall in output was stabilised and the economy has expanded since the third quarter of 2009. While there have been seven years of growth, the rate of growth has been erratic and there were several quarters where output either fell or was flat. GDP is now 8.2 per cent higher than its previous peak before the Great Recession in the first quarter of 2008.
Capacity Constraints, Skill Shortages and the Balance of Payments
Given that the economy has grown faster than expected so far this year and is growing at or faster than its trend rate of growth, it is not clear that it needs additional stimulus. The impression that the UK is operating close to its practical capacity constraints is reinforced by market indicators such as the level of employment, vacancies and reported skill shortages. It is also illustrated by the scale of the UK’s balance of payments deficit that is running at over 5 per cent of GDP.
Time to think about a non-accommodating domestic monetary policy?
Since the referendum the economy has received a powerful stimulus from a lower exchange rate. The trade weighted sterling index has fallen by 15.6 per cent. In addition the Bank of England chose to provide an additional domestic monetary stimulus with a lower bank rate, a loosening of macro-prudential rules and an extension of quantitative easing. Given the strength of if the economy, its apparent capacity constraints, and the powerful stimulus from the exchange rate, there should now be a debate in the UK about how the domestic monetary stimulus provided this summer is reversed before it begins to have an effect on economic activity ( the performance of the economy reported so far in the statistics does not reflected the post Brexit actions of the Bank of England given the lag before policy takes an effect) and whether the central bank should tighten domestic momentary conditions to ensure that it does not accommodate a lower exchange rate passing through into higher inflation that may result in the bank not meeting its inflation target.