Huge risks if Bank cannot get it right on inflation

Hugo Duncan
19 May 2009

The question facing the Bank of England this year is: how much money should it print under the quantitative easing scheme, and when should it stop?

Governor Mervyn King and the monetary policy committee are desperate to reverse the economic slump, and prevent a dangerous bout of deflation that could cripple the UK for years.

Figures today showed the Consumer Prices Index rate of inflation, which dictates Bank policy, at a 15-month low of 2.3% last month while the Retail Prices Index sank to minus 1.2%.

CPI threatens to follow RPI into negative territory this summer and, in anticipation of this, the Bank has slashed interest rates to record lows and started printing money in a drastic bid to stimulate growth and return inflation to the 2% target.

The actions are unprecedented in their scale but there is no guarantee of success and, if they do not work, it could spell disaster for the UK as well as the reputation of the Bank and
its Governor.

On the one hand, too little stimulus could result in a prolonged recession and period of deflation, wage cuts and spiralling debt like that which blighted Japan during its “lost decade” in the 1990s.

On the other hand, too much stimulus could see inflation return with a vengeance and force the Bank to raise interest rates at a time when the real economy is still in recession, or only just beginning to recover.

It is a risky balancing act, and one the Bank must get right if it is not to aggravate the downturn or stifle the recovery.

The Bank kicked off quantitative easing in March after rates hit a 315-year low of 0.5% and effectively had no further to fall.

It pledged to pump £75 billion into the economy over three months by buying up assets such as gilts and corporate bonds and this month extended the scheme by £50 billion to £125 billion over the next three months.

The timing of the extension surprised many in the City but it should not have done, coming as it did in the same month as the quarterly Inflation Report when the Bank published its latest (grim) forecasts for the economy.

Tellingly, the Bank completes the £125 billion of asset purchases announced so far in August, the month of the next Inflation Report, so the City would be wise to expect the next significant update to come then, whatever the decision.

There is every chance that the scheme will be extended again to stave off deflation and the Chancellor may even be asked to lift the current limit of £150 billion, which is by no means set in stone.

But while the Bank and many others in the City do not see inflation as a threat in the near term, printing money inevitably leads to uncontrolled rising prices if it goes unchecked.

The Bank must also be wary of the rebound in the oil price (up from $35 a barrel towards $60 since December), the reversal of the cut in VAT, and higher duties on alcohol, tobacco and petrol.

There are those who believe that it is better to do too much rather than too little when it comes to quantitative easing but we are in uncharted waters and this could lead the UK from one crisis to another.

A number of disagreements are likely among the Bank's rate-setters on the monetary policy committee over how much quantitative easing is needed.

Hawks such as Tim Besley will be anxious not to fuel inflation while other members such as Spencer Dale appear to be relatively optimistic about the pace of recovery.

King insists the MPC is ready to act as soon as inflation starts stirring again.

He explains: “The exit strategy is very simple. It is a combination of raising Bank rate and selling some of the assets we have purchased. We are ready to do that whenever it is necessary to do so. Every member of the MPC is ready and willing to follow the exit route when it is appropriate to do so.”

But, as the Bank has discovered, forecasting where inflation will be in 12 months, 18 months or two years is not easy, and some of its recent projections have been wildly off target.

The charts published by the Bank show just how badly it got it wrong.

In May 2008, the outer limits envisaged for inflation were more than 0% and less than 5% with the central projection running somewhere in between.

Last week, the extremes on the chart were minus 3% and plus 6% and the Bank warned that there was a chance of deflation.

Critics of the Bank claim it was too concerned about high inflation for much of last year and should have started cutting rates aggressively well before the collapse of Lehman Brothers in September. That is the view of MPC member David Blanchflower, who leaves the Bank this month, and with the benefit of hindsight he looks to have been correct all along.

But it is worth remembering that the Bank's job is to target price stability, not growth. In July last year, oil hit $147 a barrel and inflation did not start falling until October, making the Bank's job more difficult than it might have been.

Nearly every developed country in the world has suffered this year, no matter what its monetary policy, and there is a good chance the UK would be in recession even if the Bank had acted sooner.

And, despite the Bank's questionable forecasting record, the UK entered recession with low inflation meaning rates could be cut and quantitative easing implemented.

Nevertheless, the lingering feeling is that the Bank was too slow to react and this has undermined confidence in its stewardship of the economy.

The Bank must regain the trust of the public to restore the confidence that is vital to the recovery.