Sunday, 20 July 2008

John Major shows the way

Inflation versus deflation? The answer is obvious. While some assets are likely to fall in nominal terms; particularly house prices, the general price level is likely to keep in rising rapidly. There is a simple reason why: monetary growth in the UK is still very fast.

The last time the UK faced such a serious rise in inflation was back in the late 1980s. The experience offers some basic lessons on how to tackle the problem; lessons that the MPC would do well to study.

Back in the late 1980s, the UK went through a housing market inspired boom. Like our bubble, it was caused by excessive credit growth, irresponsible banks, and a UK public obsessed by making easy money on housing speculation. The consequences of the bubble were disastrous. By late 1989, inflation was touching 10 percent. The Major government, who controlled interest rate policy back then, pushed rates up. Inflation fell, but at the expense of a deep recession.

The chart above compares the last significant period of monetary tightening with today. On the horizontal axis we have months, while on the vertical axis we have the 12 month growth rate of M4. The blue line represents the Major government's tightening. They brought monetary growth down from about 18 percent a year to about 5 percent within about 18 months. Interest rates stayed high until inflation was brought firmly under control.

The Major government began tightening well before the bubble reached its peak. The banks didn't realize they were serious for about a year. They kept on lending throughout the early part of 1989, and the housing bubble continued to appreciate. Likewise, inflation kept on rising. Once the bubble had burst, interest rate stayed high until the government had firmly re-established control over the money supply and inflation was firmly on a downward track.

So what are the lessons from the Major government's fight against inflation? First, monetary policy takes time to work. Typically, it takes about 18 months to 2 years before a rate rise puts downward pressure on prices. Second, if you let inflation run out of control, the output costs are huge. By the time the 1989-92 show was over, unemployment peaked at over three million. Third, it takes resolve to beat inflation. Don't cut rates until inflation is definitively on a downward path. Finally, and Brown and Darling should pay particular attention here; the UK electorate appreciates governments who take on and beat inflation; Major was re-elected in 1992.

Today, monetary policy is in a mess. In contrast to the Major government, the MPC reduced interest rate as inflation was picking up speed. In fact, over the last two months, inflation has begun to grow at an alarming rate. As for monetary growth; it has barely slowed. The MPC seem paralysed with fear.

As an anti-inflation strategy, cutting rates as prices accelerate is incoherent. As a crude attempt to protect banks, it may have some temporary success. In the long term, inflation will continue to rise, and it will probably delay a clean-up of banking balance sheets.

Admittedly, John Major seems an unlikely hero. So if the comparision between today and the Major government leaves you unconvinced, then perhaps the most compelling argument against deflation is the data; inflation continues to rise. This should be no surprise to anyone; the monetary growth numbers tell us to expect it.


Slim said...

Major? A hero?

Anonymous said...

Dear Alice,


From The Times
July 19, 2008
House prices tipped to fall 20% in two years



Anonymous said...

A feast - thanks this, Alice, its hugely informative.

Slim: Yes indeed, Major was a hero of the piece, in the end. after the ERM fiasco, the last conservative government bit the bullet firmly and squeezed the excess out of the system. It did for their popularity (along with the sleeze) but that monetary tightening laid the foundation for all of the Blair-Brown government's easy ride.

B. in C.

gpmgroup said...

Ireland should make an interesting study. What happens there? Since they can not set interest rates independently anymore.

Anonymous said...

Many thanks Alice for your investigation into inflation and deflation.

One thing worries me. Who benefits from inflation? Debtors benefit over time, because their real debt is inflated into insignificance.

Who are the debtors? House buyers and credit card users, banks and government. Hmm! What is the incentive for the government to save the savers?

A David


Although I think Major was entirely wrong on the EU - it can't be moderated or trusted - I have often thought he was hugely underrated. Major was svery resilient man in an impossible political position - completely divided party, virtually no majority - whereas Blair was (in my view) a weak man in an enormously strong position. It'll be interesting to see what the historians say in a few years' time.

Anonymous said...

Good discussion Alice. I think M4 is the wrong measure because it doesn't correlate with recessions. But nonetheless a very thought provoking piece and good use of statistics.


aSteve said...

Nick, I agree.

Two examples of components of the M4 figure are:

1. commercial paper, bonds, FRNs and other instruments of up to and including five years’ original maturity
2. 95% of the domestic sterling interbank difference.

I don't have a clue what is meant by the second component, but the first clearly includes a vast array of bonds and asset backed securities. I presume that these bonds are counted at face value for M4 - even though the value of the very best bonds have been given a haircut of between 10% and 30% in the context of the BoE Special Liquidity Scheme. I also suspect that this component of M4 has swelled as banks are forced to accept SIV assets back onto their balance sheets.... I am lead to believe that, for years, many of these have not counted as part of M4...

Patrick Crozier said...

I'm not entirely happy about the top graph. The implication (although to your credit you don't say it) is that the Bank of England has been slower to respond to rising prices than it was last time around.

Well, it all depends on where you start. 1988 was the year when people woke up to the fact that there was an inflation problem and that interest rates had to go up. This time around I would say it was 2007 at the earliest.

But on the general point about dithering I quite agree

alice cook said...


Important point - the growth of m4 is inflation. The CPI/RPI are crude attempts to estimate the inflation rate.

There is no particular reason why inflation should correlate with recessions. Economic growth is determined by such factors as labour supply, productivity growth, and similar factors.

Monetary growth in the long run determines only the price level.


Alice Cook said...


My preferred measure of the money supply is household holdings of m4. This measure is closely associated with the concept of "too much goods chasing too few goods"


Alice Cook said...

Sorry "too much money chasing too few goods".

Woody Finch said...

The thesis seems to be that the Major government raised rates which led to a fall in M4 and then a fall in inflation.

The truth is not so neat. Inflation peaked in the 3rd quarter of 1990 at 10.4% and it was at this very point when they started aggressively cutting rates to try and stave of recession. They were steadily cut from around 14% to 8% over the next 2 years. And despite this, as your graph shows, M4 growth and inflation both collapsed.

What happened there? Why didn't monetary growth and inflation explode as you would have predicted?

And aren't we now in a similar situation? We are experiencing some inflationary pressures, but monetary conditions have tightened significantly, the housing market is crashing and all the signs are of an impending slowdown in growth.
If we did it the Major way surely we would now been slashing rates aggressively, not raising them as you suggest?

CityUnslicker said...

woody finch is right.

Alice the time to raise rates was 2 years ago. We did not and now we are screwed.

Money supply will drop sharply in the next few months as it is a following indicator, just like inflation and unemployment.

raising interest rates now would be gross misconduct; this inflation is real, not home grown but malthusian for the moment.

Rates should be more or less where they are. I note RPI is stready even as CPI rises.

Do you accept that the fall in real wages of people will be hugely deflationary for the economy, together with their savings (house prices for most people and pension pots which are down 20% with the FTSE).


Mark Wadsworth said...

You missed the most important VI off this list:

Back in the late 1980s, the UK went through a housing market inspired boom. Like our bubble, it was caused by excessive credit growth, irresponsible banks, and a UK public obsessed by making easy money on housing speculation.

Namely ... The Government! Altho' Nulab have taken this to extremes, the Tories tried it as well under Barber and Lawson - stoking a housing boom is relatively easy, and creates the illusion of wealth and so on, but it always goes *pop* in the end.

I am gathering evidence to show that Nulab actually colluded in all this (Eddie George's comments to a Treasury Select Committee a year ago and lax supervision of Northern Rock, for example).

Anonymous said...


I saw those comments by Eddie George. He seems to have settled the "dishonest or merely incompetent" question


Peter said...

House prices are up 20 times in 30 years, this just has to mean a crash in a deleveraging phase, see this post for an explanation:
Major of course over did the nasty medicine and put millions out of work, including this writer.