Bank must be ready to prick the inflation balloon

Next week, for the first time since February 1960, all of 49 years ago, Britain’s most-watched inflation measure will go negative. The retail prices index (RPI) is expected to be 0.5% down on a year earlier, so watch out for the flood of articles and reports it provokes on deflationary Britain.

It will not end there. Negative RPI readings will be with us for the rest of this year, culminating in a deflation number of between 2.5% and 3% by September. This bout of deflation is due to various factors, including the unwinding of last year’s record oil prices and sharply falling mortgage rates and house prices.

The consumer prices index (CPI), the government’s target measure, does not include the last two and, as a result, may only briefly stray into negative territory. But it should be running along at close to zero for much of the second half of the year. The weaker the economy, the greater the danger of sustained CPI deflation.

And yet the worry I detect out there, certainly among business people, is not deflation but inflation. Beyond the valley of temporarily falling prices, they fear, lie the jagged peaks of a nasty inflation problem. Partly this is a micro versus macro perspective. Many businesses have lived with falling prices for years and see it as the norm. But there is a difference between prices falling in individual sectors and across the economy as a whole. Twentieth-century deflation was mainly associated with depression and a rise in the real value of debt, something that has to be avoided.

There is, however, also some logic to these inflation worries. When does “kitchen sink” economics — throwing everything at the problem — go from being bold and aggressive to being foolhardy?

And when does a government that was quick to shelve its fiscal rules also abandon its inflation target? Could a little bit more inflation be presented as a more palatable alternative to permanently high unemployment? And haven’t governments throughout history inflated their way out of debt?

The kitchen sink includes the most dramatic interest-rate cut, proportionately at least, in history. It embraces a 28% fall in sterling’s average value since the credit crisis started in August 2007.

This time last year a £60 billion annual figure for public borrowing would have been unacceptably high. Now we are heading for an officially admitted £118 billion, with the City looking for more, perhaps £150 billion. It is not clear whether November’s £20 billion fiscal stimulus will be followed by another significant dose in the April 22 budget, with Alistair Darling apparently resisting pressure to do much more.

Then, of course, there is the banking rescue in all its glory. If you add the cost of the banking recapitalisation to the credit-guarantee scheme, the asset-protection scheme, the long-term discount window scheme and the rest, you get to a very large number indeed; well over £1 trillion. That is not necessarily a sensible thing to do — it involves adding apples and pears — but it underlines the scale of the intervention.

The star of the show is quantitative easing, which has sparked the greatest unease among inflation fretters. It may be just that none of the other big central banks is doing it, including the US Federal Reserve. It could be because Gideon Gono, Zimbabwe’s central-bank governor, has praised it and come out as its intellectual godfather. But “creating” money feels like the road to perdition for some.

So how worried should we be? The Bank, in its February forecast, predicted that negligible inflation would not just be with us for this year but beyond. If it is right, then by the time of the 2012 London Olympics we will have looked back on a long period in which CPI inflation has averaged 1%.

Is this plausible? The Bank, to be fair, has incorporated sterling’s weakness into its numbers, though on the other side it also thinks consumers and businesses could get locked into a falling-price mentality that might be hard to shift.

Its main reason for thinking inflation will stay low, however, is that the recession will increase spare capacity in the economy to such an extent that even if firms wanted to raise prices they will find it hard to do so. High unemployment will tend to keep wage demands down.

History, it should be said, is on the Bank’s side. Recessions are good at destroying inflation. That is why, traditionally, they were engineered by policymakers.

The last time Britain had a combination of a sharp sterling fall, plunging interest rates and big budget deficits, at the time of the pound’s September 1992 exit from the European exchange-rate mechanism, the fear was also of a resurgence in inflation. But it was followed by 16 years of low and stable inflation. This time the recession started with inflation already low, hence the worries about deflation.

All that is fine, except that this time the policy response has taken us into uncharted territory. I am not so concerned about quantitative easing. It is fairly easy to unwind and the risk is that it is ineffective, not that it is excessively inflationary.

The risks come from the combination of very low interest rates, sterling’s fall and big budget deficits. Fathom Consulting, in a new report, argues that the three are related, most importantly in the strong sense that the pound’s weakness is directly related to a loss of credibility for Britain’s macroeconomic framework. Certainly, the failure of anybody in authority to speak up for sterling is surprising.

Credibility, once lost, is not easily regained, but there are things that should be done. November’s pre-budget report contained some measures for reining back public borrowing over the medium term, but there needs to be a lot more. A large part of the April 22 budget should be about medium-term fiscal consolidation, which regrettably will have to involve both higher taxes and lower government spending.

Mervyn King and his colleagues have to show there is an iron fist inside that velvet glove. From a time when tiny changes in Bank rate were thought to have a big impact, we are in an era where huge changes are assumed to have not much effect. Calibration is hard but maybe we should be a little more patient and wait for normal policy lags to work.

Most of all, the Bank has to be ready to raise rates as quickly as it cut to avert any medium-term inflation problem. It would also give a powerful signal that the worst was over. That won’t happen for a while. But for once, when interest rates go up, it will be a cause for national celebration.

PS: Things they wish they hadn’t said: Gordon Brown’s “no return to boom and bust” is in a class of its own but there are a few others that some of our leading politicians might wish were forgotten.

Oliver Letwin, then Tory shadow chancellor, now in charge of its policy review, said in July 2004 an incoming Conservative government would abolish or rein back the Financial Services Authority (FSA) because of its “intrusive regulatory regime”. The FSA, according to the Tories, was “increasingly a tool of the Treasury”, and threatened to squeeze the life out of the City by over-regulating it.

Mind you, and at risk of encouraging hate mail by speaking ill of a national treasure, when Vince Cable commented on the Tory proposals he also favoured light-touch regulation for markets “so that growth and enterprise are not stifled”. He returned to the theme in 2006, in a speech to the Association of Foreign Bankers’ spring luncheon, warning of the dangers of excessive regulation of the City and favouring “a lighter touch”.

I am not blaming him. The past is another country. We now know the regulators failed, but it is worth a reminder that it was not obvious at the time.

Originally published at David Smith Economics UK and reproduced here with the author’s permission.

One Response to "Bank must be ready to prick the inflation balloon"

  1. John Gapper   March 15, 2009 at 1:42 pm

    As far back as 7 years ago, on Tuesday, 26 February, 2002, 08:49GMT the BBC published this article entitled “A scandal waitingto happen?” which Sir Howard Davies, then chairman of UKregulator the Financial Services Authority, was quoted warningabout the perils of dealing with toxic financial instruments.During a speech on insurance regulation, Sir Howard remarked:”One investment banker recently described synthetic CDOs to meas ‘the most toxic element of the financial markets today’. Whenan investment banker talks of toxicity, a regulator is bound totake a heightened interest.”A year later this inconvenient regulator with “a heightenedinterest” was getting in the way of this new way of pumping upthe money supply via the backdoor, and had often been reportedwarning of the asset bubble in property in the UK. So, in trueYes Minister fashion, Sir Howard Davies was shunted off to a newjob at the London School of Economics.Why did our governments, particularlyin the US and UK deliberately let this happen? Stupidity? Orelectoral convenience?