My post yesterday, where I thought that the BoE inflation forecasts hinted at a couple of rate rises, generated a lot of comments. Most of the comments were politely skeptical. My case wasn't helped much by Mervyn King's press conference, where he indicated that rates are likely to remain at their current level for some time to come. Meanwhile, financial markets took the more subdued BoE growth forecast as a strong hint that the next rate move will be downwards. To tell the truth, I was feeling a little isolated this morning.
I read the inflation report "cold" without looking at any of the press reports. As I said yesterday, the higher inflation rate, the upward revision in the central forecast and the subsequent steeper adjustment path only made sense if there was a more vigorous policy response. Well, if the Bank are now saying that rates aren't moving. That can only mean that their inflation adjustment path doesn't make much sense.
Nevertheless, the question remains what is going to make inflation come down? There is a widespread view that that slower growth will do the trick. While a dramatic decline in growth will eventually exert downward pressure on prices, I think that many commentors haven't appreciated just how large the slowdown needs to be for inflation to fall
After all, growth has already slowed by at least a full percentage point, both here and in the US. So far, the slowdown has had absolutely no effect on inflation. Parts of Europe are already experiencing absolute declines in output, and yet, prices keep pushing northward.
This complancy about growth is evident in the inflation report. The BoE are only predicting a marginal further decline in the growth rate. Their central forecast even suggests that the economy would actually avoid a recession. In other words, the BoE are not thinking in terms of a rapid rise in unemployment, bankruptcies and output declines. The BoE are pushing a story about a relatively painless inflation adjustment.
Recent economic history offers very little evidence to support the view that modest reductions in growth rates lead to large declines in inflation. On the other hand,there is another strategy with a very high success rate. That strategy comprises of higher interest rates, especially rates that are significantly higher than the prevailing inflation. However, more of that later; there is more to be said about growth.
Perhaps the BoE is making deeper miscalculation. There may be a mistaken belief that the long run growth rate of the economy has not changed, that the credit crunch has only affected the demand side of the economy, but left the supply side unscathed.
How might have credit crunch affected the supply of goods and services? There are several ways, but I will focus on one - the UK current account. The first victim of the credit crunch might have been Northern Rock; the second victim was sterling, which has fallen dramatically over the last year or so. Before the crunch, the elevated level of sterling kept import prices down and allowed us to consume huge amounts of foreign made goods.
The high value of sterling was an integral part of the debt-financed consumption boom. As banks cranked up the credit, increased consumption demand was not supplied by the domestic economy. The additional supply largely came from overseas, particularly Asia. The counterpart to this increased demand was a huge UK external deficit. The numbers are impressive. Last year, the UK had the second largest deficit in terms of GDP in fifty years and the third largest in the world, when measured in dollar terms.
Our overseas suppliers, particularly India and China, have now run into their own severe supply constraints. Inflation in both countries has picked up, and it should be no surprise that their price increases are showing up in our inflation. This week's producer and input prices provided ample evidence of this effect.
So, the UK can no longer rely on a rapidly increasing world supply to keep its inflation rate down. The UK is also operating at full employment, so domestic firms can not take up the slack. In other words, The UK economy is not lacking in demand; it is short of spare capacity.
Added to this, we must consider the plight of sterling. In the post credit-crunch world, foreign investors are dropping a very strong hint that our huge current account is no longer sustainable and that a painful adjustment is necessary. In short, this means the cheap, foreign financed consumption boom is over.
In this context, does it make sense to keep interest rates low? Of course not. Lower interest rates, which is the counterpart of rapid monetary growth, works on demand. However, if that demand can not be satisfied, lower rates and rapid monetary growth feed directly into higher prices. This is exactly what is happening in the UK right now.
The right policy response is higher interest rates. In the short run, this will restrain aggregage demand, and release the supply constraint. Growth will slow and a recession is probably a necessary short run cost. Over time, inflation will fall, and permit a market driven restructuring of the economy, where consumption is more restrained, households hold less debt, and the external deficit has moderated. The BoE should forget about trying to squeeze out a few pips of growth from a strategy based on low interest rates, rapid monetary growth and general willingness to placate banks every time they squeal about tight liquidity conditions.
Unfortunately, the BoE still think that a modest and temporary slowdown in growth beat down on inflation without the MPC having to throw a punch. I doubt that inflation is going to go away without a serious fight.