Wednesday, 18 February 2009

The Bank of England calls up the inflationary monster

The Committee unanimously agreed that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money using the APF.

Minutes of the Bank of England Monetary policy Committee, February 2009

There it is; the fateful sentence where the MPC begins to debauch the currency and tries inflate its way out of trouble The MPC have just called up the Kraken from the deep. Of course, they arrogantly think they can control this inflationary monster. They will quickly discover that the monster will control them.

As we look out at the rest of the year, it is hard to imagine a huge surge of inflation suddenly coming upon us. The economy is slowing quickly; unemployment is rising and firms are going bankrupt across the country. This doesn't seem like fertile ground for an surge of inflation.

Look beyond a six to 12 month horizon, and things look very different. An election will be on the horizon, the government will be running the largest deficit since the war and the Bank of England will be providing the cash to finance this fiscal gap.

By then, the Bank of England will also be politically trapped. It will be caged by circular economic logic, which starts with the idea used to justify quantitative easing; that the BoE needs to print money to prevent a recession.

The increase in the money supply, however, will end up financing the government's deficit through the purchase of government bonds. This will keep public expenditure at elevated levels, and of course, the government will pressurize the BoE to keep the easy money flowing. Without it, the government will have to cut back on all that public sector gravy it loves to spread around. Any attempt to curtail monetary growth, in turn, will cause a recession, which is why the BoE started printing money in the first place.

In a mechanical sense, all inflationary surges occur when central banks print huge amounts of money, but fiscal pressures provide the incentives to keep inflation going.

At the moment, everyone has compartmentalized UK economic policy. So far, no one has paid much attention to the interaction of monetary and fiscal policy. The Bank of England has just re-established a link that will lead to the monetization of the fiscal deficit. That is all you need for double digit inflation and economic chaos.

16 comments:

Mitch said...

now I'm really worried because they wont stop for economic reasons it will continue for political reasons and that's how that nice Mr Mugabe started down this road.

Markbaldy said...

Alice - some news regarding Obama's
bailout for people that can't afford to pay their mortgages would be good...
Does this mean that their mortgage debts will be written off ?

Anonymous said...

Alice,

On June 17th last year you wrote…

"If the Bank of England doesn't get a grip of the situation, inflation will probably hit 4 percent by the end of the summer. Once inflation hits 4 percent, then 5 percent doesn't look so far away. In fact, a rate somewhere close to 5 percent by Christmas is beginning to look like a real possibility. Then, in January, the UK starts its annual wage setting negotiations. By then, inflationary expectations will be running wild, the surge in inflation that we have experienced over the last few months, could well become deeply entrenched.

There is, thankfully, an alternative. It requires the Bank of England to immediately raise interest rates by 0.5 percent."

So, with interest rates at 5% and GDP already declining you were advocating a rise to 5.5%. Thankfully the MPC didn't follow your advice. Instead, it cut aggressively to 2% by Christmas and just 1% now. Has inflation surged out of control as you suggested? Are inflationary expectations running wild? Are the unions pressing for 5% plus settlements as your June post implies? No they aren't. In fact inflation has fallen to just 3% (CPI) and 0.1% (RPI).

If you were so wrong in June, why should we believe your even wilder predictions in today's post? At least the June post had the advantage of sobriety. "Inflationary monster", "Kraken from the deep", "double digit inflation", "economic chaos" – fairy stories my dear girl!


Young Mark

Rick said...

The worrying thing, as I've pointed out on other sites, is that we have only had the first wave of problems - there are resets of huge numbers of alt-a mortgages to come which will only add to the deteriorating situation. Then there's all the unforeseeable problems e.g. everyone has their fingers crossed that there is no trouble in the derivatives market.

If the BoE are prepared to take such drastic measures so early on God only knows what will happen when the real trouble hits! The only point of reference we may have is France in the 1790s - everything else is falling into place - massive public debt, rising food prices, the political elite taking liberties with taxpayers money.

sobers said...

I think the danger with QE is not the printing of the money initially, its the political pressure not to remove it from the sytem at a later date. Because there will always be, as you say, political pressure for one reason or another not to stop the printing, and start the mopping up operation.
I also agree the govt may get addicted to the 'free' money way of financing its profligacy, and fall into a trap whereby the longer QE continues, the larger the risk premium demanded by foreign investors would be. So the govt never makes the jump back to real funding from QE, and the whole thing just spirals out of control.
We are in very dangerous territory.

sobers said...

Maybe Young Mark is too young to remember the 1970s. Inflation is a pussycat when you have it under control, as we have had for the last 10-15 years. Let it get out of control, and the damage it can wreak is immense. It is very difficult to tame again as well, without causing massive damage to the economy. If you haven't lived through such times, you can't understand.

Alice Cook said...

Young Mark

Thanks for the comment.

Actually, inflation did go beyond 5 percent in September. Moreover, it is still surprisingly high, given that the economy has nose-dived.

As for inflationary expectations, again, they are surprisingly high (see BoE's survey, 20 year yield on government paper).

Since June and now, we have had Lehmans, and the near total collapse of the global financial system, so things have changed quite a bit since I wrote that post.

For what it is worth, my story has changed, recognizing recent developments. We are definitely heading into a policy generated recession, which I think could have been avoided. Recent rate cuts, rather than stabilizing the situation, were both unnecessary and created fear that led to a collapse in consumer confidence.

Having said that, I think these rate cuts will eventually work. Between the HMG and the BoE, they have put in place the most expansionary monetary and fiscal combination this country has ever witnessed. This year, we have a one percent bank rate, and an 8 percent of GDP fiscal deficit. Can you imagine who destabilizing macropolicy is going to be when this rocket finally takes off?

Personally, it has stretched my imagination to the very limits.

Alice

Anonymous said...

Sobers,

In 1973 the oil price quadrupled and stayed at this level for several years, before trebling again in 1979-80. Moreover external shocks like this had the effect of provoking second round inflation. This was because militant trade unions had the power to extract inflation-matching (and indeed beating) pay rises.

Today we are in the almost opposite position. Oil has fallen from $147 a barrel in July to around $40 today. Moreover, the unions have lost both their members and their militancy. Indeed, the unions today are instrumental in persuading their members to accept pay cuts, so desperate are they to protect jobs. There isn’t the slightest possibility of double-digit inflation in the near future. I may be a nipper, but I do know my history.

Young Mark

VADO said...

Young Mark,

Sad to say, you don't know your history well enough. Those militant trade unionists had to deal with a government that allowed the the money supply to run out of control. When Thatcher bore down on excessive monetary growth, inflation moderated. It was very hard, but she succeeded.

At the moment, there is double digit inflation in Russia. There are no trade unions there. So why is inflation so out of control over there And don't say oil prices, because it is subsidized.

VADO

Anonymous said...

VADO,

You assert that the Thatcher Government succeeded in controlling inflation by bearing down on excessive monetary growth. This is not so. The Government came to power in 1979 and duly set itself a series of targets for monetary growth. The fact is that it never met these targets. Nonetheless inflation fell sharply. It did so, in the short term, due to the unemployment rate rising to well over three million. Indeed, so unsuccessful was the Thatcher Government's monetarist experiment, that monetary targets were abandoned, not just in Britain, but on a global scale. They have been replaced by the inflation targeting regimes with which we are now so familiar.

You seem to be suggesting we should return to the failed policies of the past to deal with a problem which no longer exists.

Young Mark

sobers said...

"The failed policies of the past" Ha! You just gave yourself away there Young Mark. Sounds rather like something our Dear Leader might say (the enlightened Gordon). You're not one of Dolly Drapers new wave of anti-right wing bloggers are you?

Firstly let me say I am in no way sure that we face a hyperinflationary future. I'm sat on the fence at the mo. Deflation vs inflation? Who knows? If I was sure one way or the other I'd be out there rearranging my investments appropriately.

BUT: I can see exactly what Alice talks about happening. You may have read all the economic history books and can't see how we could get from 3% inflation and falling, to double digits and rising in less than 2 years, but I can.

Imagine that the BoE start QE. It doesn't work. The economy still goes downward. They increase QE even more. The pound begins to fall, and foreigners start to refuse to buy UK debt. The govt can't fund its lavish spending program. Solution - lets use QE to fund the debt! The pound falls even more as foreign money is withdrawn from the UK. A downward spiral occurs. Lower pound equals higher inflation. But we can't raise interest rates because we are still in recession. We can't stop QE because we can't get the money abroad, at any price. Higher inflation equals lower pound. And so on and so forth.

It doesn't take much for such a scenario to spiral out of control. There is a lot of hot money in the UK, which, if suddenly removed, could decimate the pound. Forget parity with the euro, or even with the dollar. We could be at 50c to £. Then what would the oil price be? And all the other commodities and imports we rely on?

Expectations play a huge role in inflation. If they get out of hand it is hell to get them back under control. The Tories in the early 80s may never have hit their monetary targets, but the huge squeeze on the economy (higher interest rates and taxes in a recession, and a high pound) crushed inflation.

Of course it also created 3 million unemployed. That is the human cost of taming the inflation beast. Anyone who lived through those years would NEVER want to have to do it again. And that is what we face if we let inflation out of the bag. Only this time we don't have a Mrs T to put it back in again.

Anonymous said...

I have been saying I think the pound is going to experience a run and hit US .70 cents by the end of the year. Apart from all the other problems, the biggest drag on the UK is the incompetence of the government. Nobody outside the UK believes Brown and Darling know what they are doing, or are able to deliver competently. Brown maybe a nerd when it comes to economic history lessons, but he can't deliver: he lacks capability.

electro-kevin said...

Alice is perfectly right to use hyperbole.

Britain is going down.

Anonymous said...

But there is a beacon of hope. Laurel and Hardy will be replaced within 15 months. For now, we have to just pray.

Alice Cook said...

electro-kevin

hyperbole, moi!!!

Alice

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