By Michael Baxter 23 Aug 2010 [0 Comments | 750 views]
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The respected economic think tank, the Policy Exchange, has predicted that UK interest rates will hit 8 per cent within two years. What are they saying? Are they right? If so, what does it mean?
The Policy Exchange’s chief economist, Andrew Lilico, is, to use the correct jargon, what’s known as a pessimist. He signs up to that school of thought which says it is inevitable that UK inflation will rise and rise. But Mr Lilico is without doubt one of the star pupils of this particular school.
Not only does he think rates will rocket, he reckons we are in for a spell of boom and bust, and has forecast very impressive growth indeed for the UK next year, but to be followed by recession again in 2013/14.
In a research note he said: “Once the economy gets growing sustainably, there will be a huge expansion in the money supply, which will lead to inflation.” In the wake of surging inflation, he predicted interest rates rising to 8 per cent. He said: “Since interest rate rises will raise mortgage rates, the initial effect will be even more inflation.” He predicted inflation rising all the way to 10 per cent.
But he is not alone; another enthusiastic member of this school is the Telegraph’s Liam Halligan. He has been banging the inflation drum ever since the UK government started bailing out banks. But in his latest piece he thumped his inflation drum with even more gusto than normal.
“The major analytical blunder that UK deflationists have made,” said Mr Halligan, “has been their focus on ‘spare capacity’. For a long time, now, there has been a widely-held assumption that, in the aftermath of the sub-prime crisis, the Government could print money and borrow like crazy without provoking inflation because of ‘slack’ in productive capacity created by the slowdown.” He then proceeded to outline why he reckons this spare capacity theory is bunkum.
His key argument is this: in any normal recession, spare capacity does indeed build up, but this recession was caused by a collapse in bank lending. Many companies have been forced to sell off assets and subsidiaries just to survive. In other words, capacity has been hived off.
The Bank of England has also been voicing fears over spare capacity, although it has been coming at the problem from a different angle. The bank’s fears relate to the length of the slowdown. If businesses temporarily shut down some factories and laid off workers for, say, a few months, then it is relatively easy to kick back into life. But if these factories remain shut down for an extended timeframe, and if workers fail to find a job rapidly in which they can employ their skills, then there can be a permanent loss in capacity.
And if that happens, then attempts to stimulate demand via quantitative easing are more likely to lead to inflation.
We have also noticed another dangerous trend.
Inflation hawks have been predicting that governments will inflate their way out of debt. This is the fundamental idea behind the book, This Time it is Different, by Carmen Reinhart and Ken Rogoff, which is proving to be one of the most influential books of recent years. The authors draw on an extraordinary amount of data, going back 800 years, to show that debt crises are invariably followed by inflation. We have noticed a growing number of economists talking about having higher inflation targets – it is as though they are trying to prove that Reinhart and Rogoff are right.
The inflation hawks then add into the mix, China. One of the main reasons why we had such modest inflation during the noughties was cheap imports from China. But if China does what it is told and lets the yuan appreciate – and most think it will do this eventually – the result will be a sharp rise in the price of goods imported from the other side of the Great Wall.
Here are a few reasons why the inflation hawks, and in particular Andrew Lilico, may be wrong.
First, if rates did indeed rise to 8 per cent, the result would be a complete disaster across the land. House prices would collapse. Personal bankruptcies would soar. The business of repossessing properties would be the fastest growing business in the UK, and above all, demand would collapse, deflation would set in, and the UK would be on an irreversible road to Japanese-style anaemia.
The second factor relates to what we mean by inflation. In a way, there are two types of inflation. There are rising prices caused by certain one-off factors – including falls in the currency, rises in VAT or rises in food and oil – and then there is inflation which is self feeding. Self-feeding inflation occurs when demand exceeds supply; prices go up, workers demand higher wages to compensate for higher prices, wages rise and as a result, once again demand exceeds supply. So far there is no hint at all of wages rising in tandem with price hikes. In the year to June, average wages including bonuses rose by just 1.3 per cent.
If prices are rising faster than wages, it means we are becoming worse off. If interest rates were hiked under these circumstances, we would be even more worse off.
Off course, low rates at a time of rising prices is unfair on savers. But this is a separate issue.
But if the money supply is rising, then, theoretically, this could lead to wage rises down the line. And this is the key argument being put forward by inflation hawks. Central banks are increasing the money supply, therefore inflation is inevitable.
But then there is more than one type of money supply. These days most economists agree the money supply that matters is the one that includes credit – known as broad money. In the US, broad money has contracted every month this year. According to data from the Bank of England released last week, the twelve-month growth rate for sterling M4 fell to 2.3 per cent from 3.1 per cent in June. M4 lending (excluding the effects of securitisations, etc) decreased by £11.5 billion (0.4 per cent) in July. The twelve-month growth rate fell to 0.5 per cent from 1.3 per cent in June.
The danger is more long term. The central bank has pumped money into the system, but lack of lending has meant that, overall, the broad money supply has barely changed. But if lending starts to rise, and saving falls, then perhaps the money supply, built on quantitative easing, will expand rapidly and inflation could start to build.
Against this, the demographic change means that, if anything, people are more likely to save more and borrow less over the next few years. This is what happened in Japan. This could put downward pressure on the broad money supply.
Finally, there’s the argument related to loss in capacity. There is of course a real danger that job losses and factory closures will spell a permanent fall in productive capacity. But on the other hand, the vacuum created by the recession could be filled by more dynamic businesses. What’s called creative destruction could lead to a rise in capacity. It boils down to whether the government can find ways to encourage entrepreneurs. If it can, then capacity will rise, not fall.
