New ECB chief must act as Europe again stares into the abyss

Welcome to Bedlam Mr Draghi. Yes, it's Mario Draghi's first day in the office as the new European Central Bank president, and if he was hoping, after last week's "comprehensive settlement", for a reasonably settled start, he had better think again.

We all know what Mr Draghi should be doing; he should be immediately reversing the last two interest rate increases and at the same time engaging in a much more wide ranging programme of quantitative easing through sovereign bond purchases. Tomorrow, Mr Draghi chairs his first meeting of the governing council. It's his chance to start with a bang.

Yet despite the renewed turmoil sparked by the Greek referendum announcement, it seems quite unlikely he'll take it. By temperament, he's quite orthodox in his approach to central banking, and the fact that he is an Italian will, paradoxically, make him even keener to stick to conventional monetary disciplines than if he were an Axel Weber-like, anti-inflationary head banger. He'll want to disprove the Italian steriotype. And he's terrified of doing anything that might upset Bundesbank traditionalists. So there is no reason to believe his arrival will presage an immediate change in approach after the "strong vigilance" of his predecessor, Jean-Claude Trichet.

That's not to say we won't see a cut in interest rates. The last meeting was split in leaving rates on hold, so with a fast deteriorating economy, it's possible the doves will this time gain the upper hand. Eurozone inflation at 3pc is beyond what would normally be regarded as tolerable, but everyone knows that on a medium term view, the inflation rate is going to fall well below the 2 per cent target. So a rate cut can easily be justified.

But I'd be amazed if we saw anything new on bond purchases. The ECB doesn't regard it as any part of its job to monetise the public debts of the eurozone periphery. Of course, there is a fair amount of pretence in this stance.

The ECB has already done quite a bit of bond buying, which it has disingenuously dressed up as a way of helping the "monetary transmission system". The sophistry of this explanation is ridiculous. No, what the ECB has been doing is trying to drive bond yields in the distressed single currency nations down to more tolerable levels.

Even so, the numbers have been very low against what the Federal Reserve has been doing in the US, and the Bank of England in the UK. As long as Germans believe that bond buying by the central bank is essentially monetisation of public debt – the sort of stuff that led to the Weimar hyperinflation of legend – it will be blocked from meaningful action.

Mr Draghi's challenge is therefore to persuade Berlin that bond purchases are for a different purpose – demand management. This is essentially the justification that underpins QE in Britain and the US. In both cases, the intention is eventually to sell the accumulated bond holdings back to markets, or to run down the positions by allowing the bonds to mature.

To better support this justification, ECB bond purchases would have to be much more widely spread than at present. It would have to include German bunds in proportion to the size of the German economy alongside Italian, Spanish and Portugese debt. But as I say, Mr Draghi faces an uphill struggle. Germans would prefer to suffer, or even see the euro collapse completely, than tolerate such an unconventional approach.

Volcker is right: a little inflation is a dangerous thing

Paul Volcker, chairman of the Federal Reserve

Ouch! It's even worse than we thought – or perhaps that should read what forecasters thought. For most of us, news that CPI inflation last month reached 5.2pc won't come as much of a surprise; it's been obvious from our utility bills and shopping baskets for some time now. The older, RPI measure of inflation is worse still, at 5.6pc.

And still the Bank of England likes to pretend it's trying to meet the inflation target. More monetary stimulus in the form of a further £75bn of "quantitative easing", with the inflation rate at 5.6pc? If the economic bind the country finds itself in were not so serious, it would be almost laughable.

Everyone expects inflation to come down sharply over the next year, as the current round of fuel price increases and the January hike in VAT work their way out of the index, but then the Bank, the Government and most City analysts have consistently underestimated inflation for the best past of the last three years. What reason do we have to believe them now?

Sir Mervyn King, Governor of the Bank of England, has long argued that to have taken the action necessary to keep inflation on target would have meant inducing a recession and therefore well below target inflation further out. The elevated inflation we are enduring now is framed as part of a necessary adjustment to living standards as the country adapts to its plainly more straitened circumstances.

It is also sometimes argued in justification for the present "blind eye" approach to inflation, though not by the Bank itself, that it provides a way of gently inflating away the country's debt burden. The first argument may hold more water than the second, but both look questionable.

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises. True enough, fear of unemployment has been sufficient to deter widespread inflationary pay increases so far, but there have been a number of instances of key worker groups managing to obtain them. The danger is that relatively high inflation creates a kind of wage apartheid of those who are able to keep up with inflation and those who can't – mainly the unskilled and those who live off their savings.

It is also impossible to believe that the almost unprecedented amounts of liquidity that have been provided by central banks to western economies over the past three years – and continues to be so – will not in time prove highly inflationary. And even if in the fullness of time it has demonstrably proved only mildly inflationary, as its supporters claim it will, it doesn't necesssarily vindicate the policy.

Here's Paul Volcker, the Federal Reserve chairman credited with finally exorcising the inflation of the 1970s and early 80s from the US economy, writing recently in the New York Times.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

No, inflation is never an economic panacea. Nor does it even help with the debt burden. If wages aren't matching inflation, then it is of no help in eroding the nominal value of household debt, and if taxes aren't keeping pace with inflation, then the same goes for government debt. Worse, many forms of government spending, most notably the bulk of benefit entitlements, are linked to inflation, so that we now have the absurdity of benefit claimants being better protected against price increases than wage earners.

These figures are not just uncomfortable for the Bank of England and the Government. They are a disaster. It took twenty years finally to exorcise the ghost of Britain's post war inflationary past, and to win credibility as a stable, low inflation economy. All that work is in danger of being thrown away

Volcker is right; a little inflation is a dangerous thing

Ouch! It's even worse than we thought – or perhaps that should read what forecasters thought. For most of us, news that CPI inflation last month reached 5.2pc won't come as much of a surprise; it's been obvious from our utility bills and shopping baskets for some time now. The older, RPI measure of inflation is worse still, at 5.6pc.

And still the Bank of England likes to pretend it's trying to meet the inflation target. More monetary stimulus in the form of a further £75bn of "quantitative easing", with the inflation rate at 5.6pc? If the economic bind the country finds itself in were not so serious, it would be almost laughable.

Everyone expects inflation to come down sharply over the next year, as the current round of fuel price increases and the January hike in VAT work their way out of the index, but then the Bank, the Government and most City analysts have consistently underestimated inflation for the best past of the last three years. What reason do we have to believe them now?

Sir Mervyn King, Governor of the Bank of England, has long argued that to have taken the action necessary to keep inflation on target would have meant inducing a recession and therefore well below target inflation further out. The elevated inflation we are enduring now is framed as part of a necessary adjustment to living standards as the country adapts to its plainly more straitened circumstances.

It is also sometimes argued in justification for the present "blind eye" approach to inflation, though not by the Bank itself, that it provides a way of gently inflating away the country's debt burden. The first argument may hold more water than the second, but both look questionable.

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises. True enough, fear of unemployment has been sufficient to deter widespread inflationary pay increases so far, but there have been a number of instances of key worker groups managing to obtain them. The danger is that relatively high inflation creates a kind of wage apartheid of those who are able to keep up with inflation and those who can't – mainly the unskilled and those who live off their savings.

It is also impossible to believe that the almost unprecedented amounts of liquidity that have been provided by central banks to western economies over the past three years – and continues to be so – will not in time prove highly inflationary. And even if in the fullness of time it has demonstrably proved only mildly inflationary, as its supporters claim it will, it doesn't necesssarily vindicate the policy.

Here's Paul Volker, the Federal Reserve chairman credited with finally exorcising the inflation of the 1970s and early 80s from the US economy, writing recently in the New York Times.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

No, inflation is never an economic panacea. Nor does it even help with the debt burden. If wages aren't matching inflation, then it is of no help in eroding the nominal value of household debt, and if taxes aren't keeping pace with inflation, then the same goes for government debt. Worse, many forms of government spending, most notably the bulk of benefit entitlements, are linked to inflation, so that we now have the absurdity of benefit claimants being better protected against price increases than wage earners.

These figures are not just uncomfortable for the Bank of England and the Government. They are a disaster. It took twenty years finally to exorcise the ghost of Britain's post war inflationary past, and to win credibility as a stable, low inflation economy. All that work is in danger of being thrown away

House price cuts helped sales surge by nearly 10pc last month

The great house price stand-off, where vendors are reluctant to cut prices to levels at which buyers are willing and able to buy, may be about to end with a burst of activity. But will vendors or buyers blink first?

Property sales increased by 9.5pc last month as prices continued to drift 2.3pc lower over the last year, according to analysis of Land Registry figures by LSL Property Services, owners of estate agents Your Move and Reeds Rains.

David Newnes, a director of LSL, claimed: “It’s certainly not all doom and gloom for homeowners. Buyer activity is picking up as transactions have been much higher than we would normally expect at this time of the year.

“Increasing activity means buyers currently feel properties represent good value and that shows there is still plenty of confidence among both buyers and mortgage lenders that prices won’t plummet in the coming months. Add to that the fact that mortgage finance is currently cheaper than ever before, and there are plenty of positives to focus on when assessing the market.”

David Hollingworth of London & Country Mortgages was less bullish: “There are certainly two ways of looking at this from a homeowner’s perspective. On the negative side, prices appear to have fallen but on a positive note there is buyer demand with purchasers ready to go ahead when they feel they are getting the right price.

“We may now be seeing some vendors readjusting their expectations about what price they can realistically achieve. It appears that those vendors that are prepared to accept buyers’ offers are finding that the sale can go ahead.”

Bank of England base rate remaining frozen at 0.5pc for 31 months has helped support sales and prices, according to Stephen Smith, a director of Legal & General Mortgage Club: “Improved availability of higher loan to value deals is starting to help engender some movement in the housing market, and this may be making sellers feel that now is the time to strike a deal.

“Although the main high street lenders may still be restricting lending to those with larger deposits, a range of smaller building societies and specialist lenders have become active over the last few months.”

But housing turnover remains far below normal and Ray Boulger of John Charcol said it is too early to predict how the stand-off between buyers and vendors will end: “The market varies so much in different parts of England and Wales that there is no single pattern to the increased number of transactions.

“In some areas it is definitely a buyers’ market but elsewhere sellers have the upper hand. Furthermore, strong rental demand has pushed rents up to a level where rental yields are close to underpinning property values.”

Births, deaths and divorce – along with less dramatic factors such as moving to find work – prompt hundreds of thousands of property sales in a typical year. But many of these transactions have been put on hold since the credit crisis began. September's figures suggest that dam may be about to break but it is not yet clear whether this will be the start of a decisive downward movement in house prices.

Why the squeeze in living standards is very welcome

Austerity isn't all bad news (Picture: Howard McWilliam)

OK, so the headline was written to provoke, but from a macro-economic point of view, there is a sense in which the Institute for Fiscal Studies' finding of the longest slump in household finances on record is actually a quite positive development.

How come? It can surely never be a good thing for living standards to be falling in the way they are. Of course not, but if the relatively high level that living standards reaching in the run up to the crisis was unsustainable, then the present adjustment, painful though it undoubtedly is for many households, was both inevitable and necessary, the latter because it helps to make the UK a competitive economy once more.

This is how it works. If the cost of the things we buy – fuel, food, commodities, imported goods, and so on – is going up, then one way or another we will be forced to pay for it with a corresponding fall in real wages. This can happen in two ways, through inflation or through cuts in nominal wages. In the UK, the Bank of England has chosen the former route; in the eurozone, policymakers are enforcing the latter approach on uncompetitive periphery nations.

The Bank of England could have stopped the inflationary impact on living standards, but only by driving up unemployment to such a degree that workers would be prepared to accept no wage increases or even outright cuts in nominal earnings in order to stay in employment. The choice was between higher inflation, or a deeper rececession. The point is arguable, but the Bank's approach would seem to be the least worst from a social perspective. Certainly, it looks preferable to the depression economics being applied to the eurozone periphery.

In time, this external devaluation ought to make the UK more competitive again, so that companies choose to locate their production in the UK rather than overseas. So far, there's not much sign of this happening, but it takes time for businesses to absorb these relative shifts in competitiveness.

In any case, relative labour costs are improving quite markedly right now when compared with much of Europe and even some emerging markets. If the UK does the right things on supply side reform, ten years from now, it could actually be a model economy once more.

With inflation approaching 5pc, do we really want more QE?

The Bank has announced 75 billion more QE (Photo: PA)

On the basis that inflation is better than depression, I suppose it is just about possible to go along with the Monetary Policy Committee's decision to increase "quantitative easing" by a further £75bn.

But I worry about it. I worry both that it will be ineffective in terms of stimulating investment and growth, I worry that it is going to be very difficult for the Bank of England to unwind these now vast holdings of government debt, I worry that we are now perilously close to outright monetisation of the deficit (a policy approach which all economic history shows ends in abject disaster), and I worry that ultimately, it's bound to be inflationary.

In a speech two or three weeks back, Adam Posen, until recently an outrider on the MPC in demanding more QE, said that such fears were "unfounded" and "unwarranted", but answer me this. How's the further plunge in the value of the pound that greeted this announcement not inflationary? Even the Bank of England's own analysis of the effect of QE to date, which is based on quite questionable methodology, estimates that it has added 0.75 to 1.5 percentage points to CPI inflation for a maximum gain in real GDP of 2pc. That doesn't seem to me to be a particularly good trade off.

And you cannot help but think that the long term impact of all this money printing is almost bound to be highly inflationary. Already, the Bank of England has bought up around 20pc of the national debt, equal to some 14pc of GDP. This will expand it to close to 30pc.

Since a fair old chunk of this debt is in the form of inflation protected gilts, which have not been part of the asset purchase programme, the proportion of the conventional gilts market that will be sitting on the Bank of England's balance sheet by the end of the latest batch of purchases is going to be rather more than a half. When something looks mad, it generally is. Yields on ten year gilts are already at historic lows at less than 3pc. Is it really sensible to be driving them even lower?

In his speech, Mr Posen said "we will know that monetary policy has done enough for long enough when long term interest rates rise due to demand for capital from our private sector taking on risk and making investments". But why would they rise when there's the open cheque book of the Bank of England willing to buy up almost anything that comes onto the market? And if they do rise, it's much more likely to be because investors expect inflation than than a sudden return to rampant business investment.

Despite these concerns, I guess it's just about possible to support what the Bank of England is doing given the extreme downside risks to the economy that have swept in from the Continent over the last month or so. With all this talk of coordinated action, we have to assume that other central banks are poised to follow suit, though I'll believe it when I see it as far as the European Central Bank is concerned. Jean-Claude Trichet is holding his monthly press conference shortly, so there may be more to say on this later.

But it's a disappointment that the Bank's statement made no mention of the "credit easing" flagged by George Osborne, the Chancellor, in his conference speech. This is an idea worth pursuing – a way of getting the newly released funds to the bits of the economy that really need it and stimulating some much needed business investment.

As it is, I fear that it will again be the investment bankers who are the major beneficiaries. QE is like a drug; once hooked, it's very difficult to wean yourself off. Just how many fixes are required before you realise you are an addict?

What's more, as every addict knows, to get the same effect, you have to keep increasing and repeating the dose. The way things are going, the entire gilts market will end up in the hands of the Bank of England. I'm sorry, but I fail to see the difference between such an extreme position and outright monetisation of the deficit, the sort of thing they got up to in Weimar Germany. In that case, the end result was not just the destruction of middle class savings, but the currency itself.

How deposit insurance reduces financial stability

Deposit insurance will not help to stabilise the banking industry. (Photo: AFP)

In a classic 2005 paper from the highly authoritative Journal of Monetary Economics, Asli Demirgüç-Kunt and Enrica Detragiache investigated the question "Does Deposit Insurance Increase Banking System Stability?"  Their answer, based on an empirical study of a large panel of countries from 1980 to 1997, was that it does not; in fact, as they put it: "explicit deposit insurance tends to be detrimental to bank stability".  This was a well-established notion amongst money and banking academics.  When I used to lecture in money and banking, our standard textbooks made much of the failures of deposit insurance in the Savings and Loan crisis in the US in the 1980s.  I had actually developed the somewhat naive idea that everyone whose opinion counted in the US and UK understood this.  That was, after all, why in the UK we never had any form of deposit insurance until 1979, even thereafter only had what was required of us by EU directives, and even up to 2007 only the first £2,000 of deposits was insured.  (There was 90 per cent insurance of the next £33,000, but since even in the epic US banking collapses of the 1930s, depositors typically recovered more than 80 per cent, a 90 per cent level of insurance only in practice provided very marginal additional protection of a few per cent.  I didn't like it; but it wasn't appalling.)

Given how destructive deposit insurance was – I thought – understood by informed opinion to be, you will appreciate that I was aghast and taken aback that in September 2007 the government introduced blanket 100 per cent deposit insurance in the UK.  Subsequently, though the blanket protection has, mercifully, been removed (with the failure of the Southsea Mortgage and Investment Company this June, where around 5 per cent of the depositors were not insured or otherwise bailed out), the deposit insurance threshold has been raised to £85,000.  I hope that can be taken down to around £10,000, one day, but for now it wreaks its damage – not as bad as unlimited insurance, but damaging nonetheless.

I was reminded of this today when reading the latest Bank of England Quarterly Bulletin.  For in the Demirgüç-Kunt and Detragiache 2005 paper, they suggest that (in addition to the loss of incentive for depositors themselves to shop around for low-risk banks) a key reason why deposit insurance damages financial stability is that the higher and the more explicit are deposit insurance thresholds, the more tempting it is for the government to bail out other creditors such as bondholders.  In the Quarterly Bulletin, there is an article on "Bank resolution and safeguarding the creditors left behind".  This notes that, under the current rules, when a bank goes bust its depositors will typically be transferred to another bank, along with some matching assets.  But under current insolvency law, depositors rank equally with bondholders.  Transferring away the assets to match the deposits might leave bondholders worse off than they would be under standard insolvency proceedings.  So to make sure that no creditor left behind is worse off, the state-backed deposit insurance scheme (the Financial Services Compensation Scheme) pays the bondholders the money it would have paid to insure depositors, had they lost out.  So as a direct consequence of deposit insurance, the state ends up responsible for paying other creditors.

Because the state is responsible for paying other creditors if it lets the bank go into solvency, the temptation to bail out the bank in advance, with the off-chance that it trades its way out of the trouble and the government actually makes money rather than losing it, will often be overwhelming.

The Vickers report contained two useful measures to help with this.  The first is the principle called "depositor preference".  That means that, in insolvency, depositors rank ahead of bondholders.  So the government would not make any bondholder worse off by selling off the deposits with matching assets – and the obligation mentioned above would vanish.  Secondly, and intimately connected with this, is the concept of a bail-in, whereby bank bonds are semi-automatically converted into equity in a failed bank, reducing the temptation for the government to bail them out.

These measures will help.  But they will not solve the ultimate problem.  Deposit insurance – a measure intended by its fans to reduce financial instability by reducing the likelihood of bank runs – actually achieves the opposite.  Bank runs are not a consequence of depositors having a rational fear of losing significant amounts of their capital – depositor capital losses in failed banks are only ever very small.  Bank runs are the consequence of depositors fearing they will lose access to their money (they lose liquidity, not capital).  Deposit insurance works, to the extent that it does, because when there is deposit insurance governments are much more likely to bail banks out, keeping them running, so depositor liquidity access is guaranteed.  But the implicit promise to bail banks out destroys financial stability, by inducing banks to take big risks, leveraging themselves up and making high-risk loans.  By reducing the likelihood 0f bank runs, deposit insurance also means that bank staff receive much higher pay and much greater bonuses than they would otherwise – high financial sector pay is a direct consequence of deposit insurance, as detailed in the famous Journal of Finance paper by Diamond and Rajan, "A Theory of Bank Capital".  It is not a mystery why bank bailouts lead to high bank pay and high bank bonuses – theory told us, all along, that that was a consequence.

There should be totally insured deposits – just not in fractional reserve banks.  Until the mid-1980s we used to have savings banks, 100 per cent backed by government bonds.  The government could insure these, without limit, without damaging financial stability.  If the government wants to ring-fence some parts of banks in response to the Vickers Review, it should ring-fence an old-style savings bank inside every fractional reserve bank.  Then we could have deposit insurance without inducing high pay, high bonuses, high leverage, high risk-taking, and financial instability – and all this without either destroying universal banking (an industry in which the UK excels) or excessive, invasive regulation.

If the Bank of England is going to do more QE, it should get ultra adventurous

The Bank of England.

As regular readers will know, I'm not in favour of a new programme of "quantitative easing" for the UK in current circumstances. Not until there is an extreme deflationary threat does it strike me as warranted. That moment may come soon enough, but we are not yet there.

Yet perhaps I've been a little too dogmatic here, for I have assumed that any fresh programme of QE from the Bank of England would, as before, target mainly UK government bonds (gilt edged stock), where yields are already at record lows and where adding yet another source of demand to markets where investors seem unprepared to invest in anything else other than gilts would seem to be close to insane.

If the rate of interest on bonds is already close to zero, it's not clear that pushing it marginally lower still would persuade investors to put their money in higher risk assets. And if that's the primary purpose of QE, then what's the point of doing it?

But there are other ways in which the Bank could help. One quite attractive idea which the Bank has been exploring with the Treasury is that of so called "credit easing", which would be similar in some respects to QE but with significant differences. Instead of injecting new cash into the economy via the purchase of government bonds, the Bank of England would purchase ordinary banking credit.

By targetting credit directly, the Bank of England would be going to the heart of the problem, which is that in a period of vicious deleveraging, there's both a problem with demand for credit and the supply of credit. Bankers tell me that risk aversion has reached a point which threatens another funding crisis, similar to the one that took place in the run up to the Lehman crisis. Interbank funding markets have not yet closed, in the way they did back then, but there is again severe distress.

In circumstances where there are funding difficulties, the supply of new credit will become even more constrained. What the Bank of England must do is provide the funding that markets are refusing. What's proposed is something similar to the Special Liquidity Scheme of early 2008, when the Bank agreed to issue banks with Treasury bills – easily transformed into cash – in return for mortgage securities that at that stage could not be otherwise funded.

But under the SLS, these were legacy assets that the Bank was taking as collateral. What "credit easing" would do is attempt to create new credit by making cash available for new SME lending. The effect would also be to push down the effective interest rate businesses are required to pay for their loans, and thereby reduce what are at present exhorbitant spreads. It's already being done in Japan, and it may be worth a try here.

Sir Mervyn King, Governor of the Bank of England, has made clear that he's against the sort of QE that would involve the Bank in decisions about the allocation of credit, but assuming the Bank is properly indemnified by the Treasury, I can't necessarily see a problem with it.

In an era where bond yields are already as low as low can be, this type of QE promises to be a good deal more effective than simply buying another shed load full of gilts.

Only a brave man would bet against Bank of England policy flipping round again

The Bank is itching to raise rates but needs evidence it wouldn't quash fragile confidence

How quickly the world can change. Three months ago, three of the Bank of England’s nine rate-setters were voting for an increase in interest rates. Now, as the Bank’s minutes revealed today, none of them are and discussion has turned to restarting quantitative easing (QE).

If you think policymakers are fickle, though, try the markets. Earlier this year, traders reckoned it was a nailed-on certainty that rates would have started rising by the May just passed. Now, they are pricing policy to be unchanged until the middle of 2013.

Events have changed, of course, and when they do so, as John Maynard Keynes famously remarked, “I change my mind”. But the one lesson that can be taken is that forecasts must be taken with a pinch of salt. As Sir Mervyn King is fond of saying, the only thing he can promise about his forecasts is that they will be wrong.

Reading policy nowadays is all about reading mindsets. And the Bank has, to my mind, been dropping a few clues recently. As much talk as there may now be about restarting QE, the impression seems to be that it will remain just talk unless Europe’s leaders plunge the world back into crisis.

As for rates, the Bank is itching to raise them but needs evidence that doing so would not quash fragile business confidence and trigger a severe slowdown. It nearly moved in February before data was published showing the shock contraction in the final quarter of last year. And, this time, the rising clamour of voices on the MPC calling for a rate rise has been silenced again by worries about growth – this time global.

For the time being there is no need to risk spooking businesses with the threat of a rate rise. The global slowdown has been confirmed by weak numbers last month from the US and, this week, from Germany and the eurozone. According to the Bank’s agents, business confidence is already ebbing away and hiring intentions are falling.

Today’s jobs data, which showed that unemployment rose from 7.7pc to 7.9pc in the three months to June, is equally unsettling – but is still lower than the 8.2pc official forecast for this year as public sector cuts come through. Latest wage settlements, at 2.2pc, are not about to spark an inflation surge.

But I would not be surprised to see rates start to rise early next year, assuming the world isn’t plunged back into crisis. The Bank has already lowered its estimates of spare capacity twice, which means any pick-up in growth will feed more rapidly through to inflation.

The Bank has said it expects pay rises to accelerate as employees demand catch-up for the sub-inflation settlements of the past two years. Companies may also start to rebuild their margins, it warned today, following a big increase in costs.

“Margin levels in consumer-facing sectors probably remained below their pre-recession levels, and any attempt by those firms to rebuild their margins could put upward pressure on inflation,” the agents’ report said.

The squeeze on households will also ease next year as inflation falls back beneath wage deals, allowing for real-terms pay rises.

In his letter of explanation to the Chancellor on Tuesday,  for soaraway inflation, Sir Mervyn said there is “a limit to what monetary policy can do” – a message interpreted as saying more QE is unlikely.

In the minutes, the suggestion was that QE would only be considered if “some of the downside risks [were] to materialise”. Those downside risks were all to do with the eurozone triggering another crisis rather than domestic issues.

It took three months for the Bank’s hawks to abandon their position and turn the direction of monetary policy on its head. It may seem counter-intuitive, but it would take a brave man to bet against policy flipping round again in the next three months.

The Bank is itching to raise rates but needs evidence it wouldn't quash fragile business confidence

How quickly the world can change. Three months ago, three of the Bank of England’s nine rate-setters were voting for an increase in interest rates. Now, the Bank’s minutes revealed today, none of them are and discussion has turned to restarting quantitative easing (QE).

If you think policymakers are fickle, though, try the markets. Earlier this year, traders reckoned it was a nailed-on certainty that rates would have started rising by the May just passed. Now, they are pricing policy to be unchanged until the middle of 2013.

Events have changed, of course, and when they do so, as John Maynard Keynes famously remarked, “I change my mind”. But the one lesson that can be taken is that forecasts must be taken with a pinch of salt. As Sir Mervyn King is fond of saying, the only thing he can promise about his forecasts is that they will be wrong.

Reading policy nowadays is all about reading mindsets. And the Bank has, to my mind, been dropping a few clues recently. As much talk as there may now be about restarting QE, the impression seems to be that it will remain just talk unless Europe’s leaders plunge the world back into crisis.

As for rates, the Bank is itching to raise them but needs evidence that doing so would not quash fragile business confidence and trigger a severe slowdown. It nearly moved in February before data was published showing the shock contraction in the final quarter of last year. And, this time, the rising clamour of voices on the MPC calling for a rate rise has been silenced, again by worries about growth – this time global.

For the time being there is no need to risk spooking businesses with the threat of a rate rise. The global slowdown has been confirmed by weak numbers last month from the US and, this week, from Germany and the eurozone. According to the Bank’s agents, business confidence is already ebbing away and hiring intentions are falling.

Today’s jobs data, which showed that unemployment rose from 7.7pc to 7.9pc in the three months to June, is equally unsettling – but is still lower than the 8.2pc official forecast for this year as public sector cuts come through. Latest wage settlements, at 2.2pc, are not about to spark an inflation surge.

But I would not be surprised to see rates start to rise early next year, assuming the world isn’t plunged back into crisis. The Bank has already lowered its estimates of spare capacity twice, which means any pick-up in growth will feed more rapidly through to inflation.

It has said it expects pay rises to accelerate as employees demand catch-up for the sub-inflation settlements of the past two years. Companies may also start to rebuild their margins, it warned today, following a big increase in costs. “Margin levels in consumer-facing sectors probably remained below their pre-recession levels, and any attempt by those firms to rebuild their margins could put upward pressure on inflation,” the agents’ report said.

The squeeze on households will also ease next year as inflation falls back beneath wage deals, allowing for real-terms pay rises.

In his letter of explanation to the Chancellor on Tuesday for soaraway inflation, Sir Mervyn said there is “a limit to what monetary policy can do” – a message interpreted as saying more QE is unlikely. In the minutes, the suggestion was that QE would only be considered if “some of the downside risks [were] to materialise”. Those downside risks were all to do with the eurozone triggering another crisis rather than domestic.

It took three months for the Bank’s hawks to abandon their position and turn the direction of monetary policy on its head. It may seem counter-intuitive, but it would take a brave man to bet against policy flipping round again in the next three months.

Inflation: pensioners are biggest victims of RPI/CPI double-dealing

Millions of rail commuters – not to mention their student offspring – are entitled to feel the Government is not playing fair with its double-dealing measurements of inflation. But pensioners are the biggest losers from the way the real value of money is falling.

Rail fares and student loans are uprated in line with the Retail Prices Index (RPI) which is consistently higher than the Consumer Prices Index (CPI), which is applied to things that cost the Government money – such as pensions.

If that sounds like a dry technicality, then beware that new calculations from Saga show that inflation has robbed many older people of nearly a fifth of the purchasing power of their pension since the credit crisis began.

How you measure the rate of inflation depends on what you put in your sample or shopping basket. Excluding mortgage costs and council tax helps keep CPI more than 10pc lower than RPI. The respective  annual rates of increase were announced by the Office for National Statistics today as 4.4pc and 5pc respectively.

But even the RPI does not adequately reflect the way pensioners’ cost of living is rising because they tend to spend more of their money on food and fuel – where commodity inflation makes double digit increases common – and less of their money on electronic goods where prices are falling.

Ros Altmann, director general of Saga said: “Since the credit crisis began four years ago, the effect of RPI has been to reduce the purchasing power of money by 13.9pc – which may surprise some people, as they tend not to notice the cumulative effect of inflation.

“But we calculate the cumulative effect of inflation over the same period on those aged between 65 and 74 has been 18.8pc. If you are living on a fixed annuity, that’s money you will never recover. They have lost nearly a fifth of their purchasing power in four years.”

The Bank of England’s policy of keeping base rates much lower than any measure of inflation has transferred wealth from savers to borrowers by eroding the value of savings and debts. The idea is to prevent higher insolvencies, unemployment and repossessions; all of vital importance to people of working age.

Taking these factors into account, while commuters and students may feel it is unfair that their rail fares and loans are linked to RPI, their standard of living is unlikely to have fallen as much as pensioners’.

Everybody is going to suffer in this financial crisis, according to no less an authority than the Governor of the Bank of England, but older people who must live off their savings and can do little to protect themselves are being hit hardest.

More QE? Give us a break

A head of steam is building up for more quantitative easing in the US and the UK, though apparently not for the eurozone, which is the one place which really needs it. Here’s the case against more QE, which I was going to put on BBC Radio 4’s Today programme on Friday morning, except that we were diverted by the short selling issue.

I’d never say there are no circumstances in which another dose of it would be needed, but the only real justification is the sort of extreme deleveraging, deflationary threat that we saw post the Lehman Brothers collapse in the autumn of 2008. Things look very serious in the eurozone, but we have not yet had that extreme event. Market closure to a major sovereign such as Italy, with no mechanism in place to prevent default, would certainly be the trigger I’m talking about. But as I say, we are not there yet.

In the meantime, it is very hard to argue that in Britain at least with inflation heading towards 5pc and real interest rates deep in negative territory that anything would be gained from further QE. Bond yields are already as low as low can be. If the purpose of QE, by which is meant the creation of new money by central banks to purchase government bonds or other assets, is to depress bond yields, thereby forcing higher risk investment and spending, well, how much lower can they go? They are already at their lowest level in more than 100 years. There’s nothing to be gained by pushing them even lower.

It’s true that money growth in the UK economy is much lower than is consistent with reasonable growth, but it’s been at that level for a year now and it has not driven us back into recession. Anecdotal evidence is that velocity of money, which is the key indicator of economic activity, has fallen quite steeply recently, but let’s see it in the figures before spraying the economy with newly printed money again. In the US, meanwhile, money growth has picked up quite sharply, pointing to significant recovery a year from now. That doesn’t mean it is going to happen, but it is an encouraging sign.

About the only other piece of good news around at the moment is that commodity and fuel prices are falling again, taking the pressure off inflation and putting a little bit of money back in people’s pockets. Do we really want to stoke these prices up again for some kind of short lived and probably quite marginal boost to growth.

QE is like a drug. The first dose was quite potent, but the more frequently it is used, the less effective it becomes and the more the addict demands. QE2 in the US, launched in response to a soft patch in the recovery similar to the one we are going through today, was almost certainly a mistake. Sure enough, it boosted asset and commodity prices, but it did very little for ordinary people. To the contrary, by raising food and fuel prices, it only made them poorer.

To maintain negative real interest rates over such a sustained period is unfair on savers and therefore morally and socially questionable. It certainly softens the deleveraging process, but only by punishing those who have been prudent with their money. Enough is enough. There’s no case for further QE right now. I’ll tell you when that changes.

Bank of England turns a blind eye to euro crisis

What is it about the Bank of England’s growth and inflation forecasts? For nearly two years now, the Bank of England’s quarterly inflation reports have pretty much consistently both underestimated inflation and overestimated growth. The inflation forecasts we can perhaps forgive; the Bank of England cannot target a rate of inflation constantly buffeted by unpredictable external pressures and sudden jumps in sales taxes. But it’s long been hard to see why it is so optimistic about growth.

This pattern has persisted into the latest Inflation Report, published on Wednesday. The immediate growth forecast for this year has been trimmed a little in the wake of recent, weak data, and it takes longer for growth to pick up speed and return to trend than it did in previous forecasts. Yet the Bank is still forecasting pretty robust growth of something like 3pc annualised by early 2014. What is more, the Bank’s famous fan charts point to hardly any probability of outright recession. And the Bank makes these forecasts despite the fact that one of its deputy governors, Charlie Bean, conceded on Wednesday that the Bank had cut its estimate of the economy’s potential output. There is probably less spare capacity in the economy than the Bank had previously thought, he conceded.

Does the Bank honestly think these growth forecasts the way to bet? Somehow I doubt it. One possible explanation is that the Bank, in drawing up its forecasts, has ignored the possibility of calamity in the eurozone, prospects for which appear to have risen significantly over the past week. According to Mervyn King, the Governor, these risks are “unimaginable and unmentionable”, and in any case cannot be quantified in any meaningful way. They have therefore been excluded from the fan charts. (see page 38 of the Inflation Report for a full explanation of this omission)

Yet as the Inflation Report points out, the greatest risks to global growth right now come from the eurozone. This is the greatest uncertainty, and it has just got a whole lot bigger. OK, so no-one knows how to model for meltdown in the eurozone, but if you were only to forecast for things that were certain, then it would be as pointless as forecasting that you will be taking the bus to work as usual tomorrow morning.

Given that this is the biggest threat to the world economy right now, it’s hard to understand why it should be completely ignored. At the very least, the uncertainty it’s causing will act as a further, significant drag on the economy.

While I was out in Japan recently, an economist pointed out that the West used to like lecturing Japan on how its two decades of post bubble lost growth were all the fault of policy error. “Now you see it isn’t so simple, eh?”, he said. It’s looking ever more possible that despite our supposed superiority in policy making, we are heading the same way. Still, if we do, I guess it will all be blamed on poor policy making in euroland. Hey ho.

Failure to meet the inflation target has been the fault of successive Chancellors, not the MPC

Osborne and Brown have ignored the target

Fathom Consulting argues that keeping CPI inflation down to 2 per cent would have come at the cost of risking more unemployment and deeper recession. Broadly speaking, I agree: it would have been a mistake to try to keep CPI inflation to 2 per cent. “Eh?“, I hear you cry.  “Weren’t you the one that wrote this and this and this, urging repeatedly that the Inflation Target has lost all credibility? Haven’t you been voting for half-point rises in interest rates at the Shadow MPC for about a year? Have you suddenly gone soft on us?”

Yes, I did write those things. No, I haven’t changed my position. You see, the fundamental problem with the UK’s monetary policy isn’t that CPI inflation is over 4 per cent. It is that it is 4 per cent when the stated target is 2 per cent, and there is no official admonishment of the Monetary Policy Committee. Credibility is about keeping to what you’ve promised, not about making the same promise every time. In the UK we use inflation targeting. Under an inflation targeting regime the authorities set a target level for inflation (state that they will try to get inflation to that target) over a particular time period: one year – every year the Chancellor of the Exchequer sets a new target for the forthcoming year.

The very essence of inflation targeting – what distinguishes it from other monetary policy regimes such as price-level targeting – is that the target can be set at a different level the next time you set it. The flexibility of inflation targeting and the concreteness of the periods of the target are its great virtues. Because the target is only for a year, we can look and see whether the target has been met, and then admonish the Bank of England if it is not. And because the target is for only one year (and because bygones are bygones – misses on past targets are not carried forward), we can change it to whatever target would now be appropriate.

The UK’s inflation target has been changed three times: the first target, which applied for a period of four and a half years from September 1992 to April 1997, was for inflation, on the RPIX measure (the cost of living excluding mortgage interest payments) to be between 1 and 4 per cent throughout the period to the end of the 1992-97 Parliament, and between 1 and 2.5 per cent by the end of the Parliament in April 1997. That target was always met. The target was changed in 1997, in three ways. First, that it should apply yearly instead of over a Parliament. Second, that there was to be a continuous preference for the centrepoint of the range, at 2.5 per cent, rather than a preference for the lower half of the range (as before). Third, that the range would be reduced to 1.5-3.5 per cent (instead of 1-4). That target was always met.

The target was changed again in 2003. As part of trying to achieve convergence with the euro area (so we could join the euro – this was explicitly the reason) the measure of inflation was changed to the European Harmonised Index of Consumer Prices (HICP), as used by the European Central Bank. We re-baptised the HICP the CPI, and set the preferred centrepoint of the target at 2 per cent, with the new range being 1 to 3 per cent.

The third time the target was changed was less formal than the other two. In April 2007, for the first time in its fifteen year history, the UK missed its inflation target, with CPI inflation rising at 3.1 per cent. Mervyn King was forced to write a letter to Chancellor Brown explaining why. Given that this was a target miss, one might have expected the Chancellor to admonish King, to tell him he expected the target not to be missed again, to ask for a detailed rectification plan. But, what with being about to take over from Tony Blair as Prime Minister and not wanting to leave as Chancellor on a sour note, Brown did no such thing – setting a precedent, for no subsequent Chancellor has admonished the Governor for any miss, either. Instead, the Monetary Policy Committee went around making speeches explaining that we had all “misunderstood” the inflation target, and that actually there was no requirement to keep inflation below 3 per cent or above 1 per cent. Of course, we hadn’t misunderstood at all. But because the Monetary Policy Committee was permitted by the Chancellor to do this, the target was effectively redefined – not, this time by the Chancellor, but instead by the Bank of England. The new target was for CPI inflation to be 2 per cent, with no constraint over how far inflation should be permitted to deviate from this 2 per cent figure in the short term.

Since the inflation target has explicitly been changed twice (and in practical terms changed a third time), it obviously can’t be unthinkable to change it. In 2008, and again in 2011, I and a few others urged that the target should be changed again. Since it would be undesirable to try to get inflation to 2 per cent – Fathom is right about that – the target should either (a) have been set, for the year to come (2008 or 2011) at a level that was desirable (e.g. perhaps 4 per cent); or (b) the target should be changed back to one that included a maximum level by which inflation was permitted to deviate from the target in the short-term – e.g. by saying that for the year April 2011 – March 2012, the target is 2 per cent, and inflation should be no more than 5 per cent and no less than 1 per cent, even in the short term. Either way, once announced at a credible level, the target should be enforced.

The failure to set a target one wants the Bank of England to try to meet, rather than a target one hopes they will not try to meet, is down to the Chancellor of the Exchequer, not the Bank of England. It is for the Chancellor to set the target and to hold the MPC accountable for meeting. When I say the Bank of England lacks credibility, I am not saying it would have been better if inflation had been 2 per cent – with all that would have entailed. I am saying that the inflation target should have been (and should now be) set at a level the Chancellor desires and is willing to enforce.

Growth, real terms growth, and inflation

Click to enlarge

In this figure I show you three things. The red line is the standard rate of annual inflation in the cost of living – the all-items retail prices index. The green line tells us how the real value of quarterly output of the economy compared with the real value of output in the same quarter a year earlier (so, for example, real output in the second three months of 2011 is 0.8 percent higher than real output was in the second three months of 2010). I’ll call this “yearly real GDP growth”. The blue line tells us what happened to quarterly output in cash terms – when there is inflation, a rise in cash terms will be greater than the rise in real terms. I’ll call this “yearly money GDP growth”.

We can see that during most of the period 2000-2006, yearly money GDP growth was usually around 5 per cent, real GDP growth around 2.5 percent, and inflation around 2.5 percent. The first major departure comes in 2006, when money GDP growth goes well above 6 percent. Then inflation goes well above 4 percent (reaching 5 percent). Then we see all three series plummet during the 2008-9 recession. But then look at what happens after the recession. Money GDP growth returns to 5 percent, back to its pre-recession norm. There have been those (most notably Sir Samuel Brittan for many years, and more recently Giles Wilkes) who have argued that monetary policy should target money GDP growth instead of inflation. Indeed, some implicit variant of this is very probably an element in the Monetary Policy Committee’s thinking for 2009 onwards (it certainly was in mine). Well, the period after the recession should make Sir Samuel and the MPC happy – since the year following the commencement of quantitative easing (i.e. in our data, since the second quarter of 2010), yearly money GDP growth has been remarkably stable.

Now, if inflation had been around 2.5 percent, then 5 percent yearly money GDP growth would have meant about 2.5 percent real growth – as many hoped. But, in fact, inflation has been much higher than forecast, so real growth has been correspondingly lower. That extra cash the economy has produced just isn’t worth as much stuff. I suspect that is partly because the capacity for the economy to grow isn’t as high as we’d previously thought.

But now ponder this: what will happen if the economy does start to accelerate? If even the paltry growth of the past nine months has been associated with a rise in inflation, what might be the impact on inflation if the economy really starts to motor? The happy path would be if money GDP growth stayed pretty much where it is, but inflation fell back, so real growth accelerated. That is what the Bank of England hopes will happen. The other possibility is that when real growth accelerates, we will see a larger rise in money GDP growth, so inflation will accelerate even further. That’s what I expect.