The world has changed since the global financial crisis but the UK’s macroeconomic policy framework has not kept pace, risking the next recession being unnecessarily painful, according to a new report published today (Monday) by the Resolution Foundation.
The report Recession Ready? – published to mark the launch of the Resolution Foundation’s new Macroeconomic Policy Unit (MPU) – offers the most comprehensive assessment of the UK’s macroeconomic framework since the financial crisis, focusing on the roles of the Bank of England and Treasury in setting monetary and fiscal policy respectively.
Traditional monetary policy has carried the burden of supporting the economy in recessions of recent decades – the average interest rate cut in such periods has been over 5 percentage points. In the financial crisis that was combined with asset purchases via Quantitative Easing (QE) – delivering two-thirds of the overall support to the economy that prevented a recession becoming a depression.
However, the Foundation says that the low level of interest rates means the Bank of England will not be able to offer the same level of support in the next recession.
Recession Ready? says that with the Bank of England’s policy rate still only at 0.75 per cent and unable to be cut substantially below zero, it is hard to envisage interest rate cuts of more than 1 percentage point. And while QE boosted the economy in the last recession by reducing longer term interest rates, today even long-term rates are now very close to zero – with 10-year government borrowing costs now below half a per cent.
Taken together the report finds that cuts in interest rates and increased QE could only provide around a quarter of the support to the economy needed in even an average recession.
Recession Ready? notes that while other countries have been reviewing the tools available to their central banks, the UK has not done so. It calls for policy makers to be clear about the constraints facing monetary policy, and argues that any UK review should go beyond examining tweaks to the existing toolkit. Such a review should examine the strong in principle, but challenging in practice, case for a higher inflation target.
The Foundation says that the limits to monetary policy mean that fiscal policy will need to play a much more active role in a future downturn. However, it warns that our wider economic framework has not been updated to recognise that reality. It calls for changes to:
- Clarify fiscal policy’s new role. The UK’s Fiscal Charter rightly explains how the government will maintain stable public finances, but does not spell out explicitly the need for fiscal policy to play a more active role in a downturn. This would not prevent a fiscal stimulus in a downturn but risks reducing its scale, speed and effectiveness.
- Strengthen automatic stabilisers. The Foundation’s analysis shows that the UK’s ‘automatic stabilisers’ – tax and benefit rules that cushion household income shocks during an economic downturn – have been weakened since the last downturn, when a low interest environment means they should have been strengthened.
- Plan for the next recession. Public policy discussions of the most effective fiscal policy response to a downturn would help to ensure that a pipeline of shovel-ready infrastructure projects could be sped up in the face of a crisis, and direct payments be made to households if necessary.
The Foundation’s warning about the UK’s macroeconomic framework comes as the country faces its highest recession risk since 2007, with the economy having already contracted in the second quarter of this year. It adds that lower income households are more exposed to an economic downturn than they were back in 2008, with nearly two-thirds of those on below typical incomes reporting that they have no savings.
Recession Ready? does however say that the UK has several key advantages in recession planning. These include a strong, independent Bank of England bolstering economic credibility, and low borrowing (and borrowing costs) to provide the backdrop to a fiscal policy response.
The fact that the UK government is able to engage in fiscal policy more effectively than the US or Eurozone (which face political and constitutional constraints in doing so) is another key advantage, and means that more radical and risky options, such as the central bank printing money to fund fiscal policy in a crisis, are not necessary in the UK today.
The Foundation says that while the government is likely to be fully consumed by Brexit and Budget planning in the coming months, responding to the next economic downturn effectively is a crucial challenge and there is an urgent need to prepare.
James Smith, Research Director at the Resolution Foundation, said:
“As well as trying to deliver good times, we should be making sure we are able to respond effectively in bad times to minimise the pain of the next downturn. But the UK today is not recession ready.
“The Bank of England in particular used powerful policy tools to fight the last great recession – from slashing interest rates to injecting billions into the economy via quantitative easing. But ultra-low interest rates now mean these tools are blunted. Our plans for fighting the next downturn have not been sufficiently updated to recognise this reality.
“Now is the time to plan for the next recession – because the one thing we know for certain is that it will happen. The UK today faces the highest recession risk since the financial crisis, and lower income households are now more exposed to a downturn than they were back then.”