By Michael Baxter 20 May 2010 [0 Comments | 710 views]
Related articles
The release of the latest minutes from the Bank of England Monetary Policy Committee revealed the emergence of a new Rift Valley at the heart of the bank’s rate setting committee. On one side sit the doves, on the other the hawks, and the gap between them is growing. Meanwhile, economists and the blogosphere greet the latest set of inflation figures with dismay, questioning the competence of Mervyn King who seems to have put all thoughts of inflation aside as he dances to the tune of inflating our way out of debt. Yet while the hawks flap their wings, and the doves fly to their cote for shelter, news from the US revealed that core inflation on the other side of the Atlantic has fallen to its lowest level in 44 years.
The letter
Has it occurred to anyone else that the Bank of England’s governor looks a tad like Postman Pat? Maybe it’s the glasses; not sure, but there does seem to be a certain facial resemblance. This is rather apt, because our governor turned postman earlier this week.
Imagine the scene at Number 11 Downing Street. “Boy George,” says the butler. “There’s a letter for you, hand delivered. It looked like Mervyn King, but he rushed off so quick I couldn’t be sure.”
Mervyn of course had to rush across town to drop off a little note. “Dear Chancellor,” went the note, “inflation is above target again, but it’s not my fault, honest.” In fact, inflation rose from 3.4 to 3.7 per cent in April, and commentators were not impressed. The Bank of England has been continuously underestimating the effect of inflation. In fact, only once in the last three years has quarterly inflation been lower than predicted by the Bank two years earlier.
We have learnt to become cynical when the Met Office predicts the weather. Maybe it is time we became even more cynical about the Bank of England’s forecasts. Poor old Michael Fish, he was lambasted for laughing at the possibility of a hurricane (strictly speaking the winds of 1987 weren’t hurricanes, so Mr Fish was right), and the Met Office is ridiculed for having predicted a barbecue summer for 2009. Maybe we should pour even more scorn on the Bank of England’s predictions.
In fact, the note from the governor really said: “The change in VAT and higher petrol prices will continue to be reflected in the overall price level. But, unless they increase further, that should affect the twelve-month CPI measure of inflation for no more than a year. Moreover, the continuing impact of the past depreciation of sterling is still pushing up on consumer prices, but likewise the effects on inflation can be expected to wane over time. As this happens, the MPC expects that inflation will fall back.”
In response, our new chancellor said: “Dear Merv… The MPC’s remit allows it to look through short-term movements in inflation and I note the committee’s view that the current elevated rate of inflation is expected to be temporary.” He continued: “I am sure that you will remain vigilant towards any upside risk to inflation.” And signed it “your humble servant, Boy George”.
The hawks and cynics
But you don’t need to spend much time scanning the blogosphere to see why it is all nonsense. “Two per cent inflation target! That’s a joke,” scream the cynics. “There is only one plan and that is to let governments inflate their way out of debt,” or so goes the gist of what the blogosphere is saying.
There is a snag with the argument that the UK government wants to use inflation to pay off its debts. Much of the existing debt is funded by bonds that are index linked, so as inflation rises so does the yield – but let’s put that inconvenient truth to one side.
Another fear is that, actually, for all its promises to the contrary, the new government will be upping VAT soon, which will of course lead to more price hikes.
And to cap it all, the Bank of England’s hawks have at last flapped their wings and squawked out their true fears. The latest minutes from the Bank of England rate setting committee revealed that some of its members fear that there is less spare capacity in the UK than originally thought, and that as a result we are more vulnerable to an inflation shock down the line.
On the other hand
On the other hand, Capital Economics calculates that around half of the rise in inflation since last September can be accounted for by the rise in petrol. The rest can almost certainly can be explained by the VAT hike and cheaper sterling.
Now, it is very dangerous letting inflation spikes caused by changes in the price of oil influence interest rate setting policy. Monetary policy adopted by the Bank of England has had virtually no impact whatsoever on the global cost of oil. In any case, there is an argument to say that, all things being equal, rising oil can actually have just as similar an impact upon the economy as a rise in interest rates, in that more expensive oil, just like higher borrowing costs, can suck demand out of the system. (Inflation in the 1970s probably had little to do with the rising cost of oil and was more related to an inflexible labour market and rapidly rising money supply.)
Besides, there are good reasons to believe oil will fall back a good deal further over the next few months. At the time of writing it is already 20 per cent down on its price from just four weeks ago. This column has certainly been predicting a short-run fall in oil for some time.
As for the argument that a new VAT hike will lead to inflation. Well, just remember that Margaret Thatcher upped VAT and yet the medium-term inflationary impact was negligible. In fact, the move was presented as an anti-inflation step, because higher VAT meant falling demand.
If sterling continues to fall then this may lead to inflation. But then again, right now it seems the likely forward trajectory for sterling against the euro is up.
The money supply
As regular readers will know, despite quantitative easing the broad money supply in both the US and UK has been seeing only very modest growth – or in the case of the US, is now contracting. It’s odd. But those who talk about ‘fiat money’ – that’s this idea of banks creating the money supply via credit – are warning us that this practice is leading to inflation. In fact, the reality is the opposite. Fiat money means that as lending reduces, the money supply falls. Right now, the conditions are in place for a very rapid contraction in the money supply.
Fears that there is less over-capacity in the UK economy than originally thought are more worrying. But then again, as fiscal cuts occur, the job losses in the public sector will mount, and create a lot more new capacity.
Demand lags behind supply
The view here is that globally, demand has not been growing as fast as capacity for years. In fact, it is even possible this mismatch between rapidly rising capacity and less rapidly rising demand may be the real cause of the economic crisis. (And for that matter a similar problem may have been behind the 1930s depression, as technology led to massive rises in capacity that were not matched by rising demand.)
And because growth in demand is lagging behind growth in potential supply, the risk of deflation, and that the global economy will go the way of Japan, is very real.
House price inflation is spanner in the works
The matter is made complicated of course because while there is good reason to expect deflation in manufactured goods, inflation in commodities and asset prices is a very real threat.
In his letter to the Bank of England governor, George Osborne wanted to know more about ideas to include house prices in the inflation target. And that really is a tough one. In the noughties we saw modest inflation in consumer goods, but ridiculous inflation in house prices. It seems that the right interest rate for one type of inflation is different from the right interest rate for another type. And some truly original thinking is required to solve that problem.
US inflation crashes like a wingless hawk
And yet while the debate in the UK seems to take a dangerous surge to the hawk side, in the US the headline rate of inflation was minus 0.1 per cent month on month in April. The annual core rate of US inflation, that’s with food and energy taken out, was just 0.9 per cent, the lowest rate since 1966.
Inflation nutters and why the fiat money conspiracy theory is dangerous
In The Telegraph earlier this week, Roger Bootle referred to some ECB members as “inflation nutters”. And he was slammed for saying so.
But the truth is, for the economy to expand it needs a growing money supply. Until the invention of what’s called ‘fiat money’, economic growth was always modest, and the economic cycle used to be far more severe than it is today. Before fiat money, we were dependent on finding new reserves of gold to be able to fund growth. Karl Marx reckoned that finding gold in the New World funded the industrial revolution. He was probably right.
The last few years have seen extraordinary advances in technical innovation. At the same time, globalisation has led to rapid rises in global capacity. Under such conditions, there is a very real risk that demand won’t keep up with supply, deflation will settle in, and potential will be lost. The current fears over inflation really are quite nutty.
