Apocalypse Then: The 5% Lower Bound in 2008

The Office for National Statistics’ current data on quarterly UK nominal GDP growth in 2008 is as follows, at Seasonally Adjusted Annual Rates:

• Quarter 1: 4.3%
• Quarter 2: -1.7%
• Quarter 3: -5.2%
• Quarter 4: -3.4%

That collapse in nominal spending has no precedent in the data, and is certainly worse than anything since the 1930s.  Who cares about nominal GDP (nominal demand)?  This is what the Bank of England said in the Inflation Report from August 2008:

Monetary policy affects inflation via its influence on nominal demand. Four-quarter nominal GDP growth was relatively robust in 2006–07, but slowed to 5.3% in 2008 Q1 (Chart 2.1), close to its average over the past decade. With inflation rising sharply (Section 4), a stable path for nominal demand growth implies slowing real spending growth.

(Note the figure for Q1 has been revised since the contemporary data available to the Bank in 2008.)

UK monetary policy is tasked to control inflation, and it does that by influencing nominal spending.  If nominal spending collapsed in 2008, we should hence surely blame a failure of monetary policy?

Jonathan Portes considers the state of demand management, and is not so sure:

But just as this approach [primacy of monetary policy for AD management] was motivated by pragmatism more than theory – monetary policy was better suited to this task – my change of mind is similarly motivated. If monetary policy alone was indeed enough in practice, we wouldn’t be where we are now, with unemployment a million higher than the OBR’s estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

(My emphasis.) What practical constraint can Mr Portes mean, which has allowed the UK to plunge into a deep demand-deficient slump?  Let’s review the Bank of England’s base rate decisions during the first three quarters of 2008:

• January: Bank Rate left at 5.5%
• February: Bank Rate lowered to 5.25%
• March: Bank Rate left at 5.25%
• April: Bank Rate lowered to 5%
• May: Bank Rate left at 5%
• June: Bank Rate left at 5%
• July: Bank Rate left at 5%
• August: Bank Rate left at 5%
• September: Bank Rate left at 5%

The problem is now obvious: Mr Portes can only mean the dreaded 5% Lower Bound on interest rates, described throughout the macroeconomics literature.

After the fact, that looks like a catastrophic policy error.  But surely everybody spotted what was happening at the time?  Martin Weale was doing Mr Portes’ forecasting job at the NIESR in 2008; here is his comment on the September 2008 rate decision:

The Bank of England’s decision to keep the interest rate at 5% p.a. is to be welcomed. It will be very difficult for the Bank to cut the rate before inflation turns clearly down. At the same time it needs to be recognised that a cut now would have no real impact on the growth rate for the rest of this year and it therefore is not in a position to alter the risk of an imminent recession.

It certainly looked “difficult” to cut rates below 5%!

During September 2008, Lehman Brothers failed.  In October, already well behind the curve, the Bank of England dramatically cut the base rate to… 4.5%.

By March 2009, Bank Rate was finally lowered to 0.5% and the Bank began a program of gilt purchases, with the explicit aim of boosting nominal spending:

Accordingly, the Committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term.

The nominal GDP outturns for the subsequent quarters of 2009 were as follows, annualised growth rates again:

• Quarter 2: -0.4%
• Quarter 3: 5.0%
• Quarter 4: 3.7%

A tepid recovery rate, but a recovery nonetheless.  So which should we worry about more, the 0% lower bound in 2009 onwards, or the 5% lower bound in 2008?

(Here’s a happy ending: Martin Weale was appointed to the Bank of England Monetary Policy Committee in July 2010.)

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