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

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.

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.