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The City will be hoping that this month brings fewer nasty shocks than last. Sterling was sent tumbling three times by the Bank of England in August — when it ramped up quantitative easing by £50 billion to £175 billion; when it emerged Governor Mervyn King actually pushed for an increase of £75 billion to £200 billion; and when its gloomy inflation report warned of a “slow and protracted” UK recovery.
But there was another, related, shock in the form of inflation. Official figures showed inflation held firm at 1.8% in July, the same as it was in June and higher than the 1.5% expected by City economists.
It raised two serious questions for the Bank's monetary policy committee to consider as it starts its monthly two-day meeting tomorrow: Has the threat of deflation been overdone? And what should it do next, given interest rates were cut to 0.5% and quantitative easing was launched to stave off deflation?
Inflation has fallen much more slowly in the UK than in other economies such as the US and the eurozone, as the graph (see right) shows. This largely reflects the fall in the pound which has made importing goods from the US and Europe more expensive, keeping retail prices higher than they might otherwise be.
Sterling was trading above $2 against the greenback last summer but spent much of this summer between $1.60 and $1.70. Similarly it was close to €1.30 against the single currency last summer but well below €1.20 this time around.
The impact of the lower pound is easing, however, and it seems that it will not be long before sterling is stronger year on year, driving down inflation.
Prices will also be pushed down by increasing “spare capacity” in the economy. Spare capacity occurs when the economy operates at less than 100% and is increasing as unemployment rises, wage growth softens and businesses go bust.
Against this backdrop, King last month said it is “more likely than not” that inflation will fall below 1% later this year.
But that was before July's shock inflation figure was published and many in the City, wary of rising oil and petrol prices and the “stickiness” of inflation so far, now reckon although inflation has far further to fall, the threat of deflation has passed.
So what does the Bank do next? The subject of “exit strategies” was brought up at the G20 meeting in London last weekend. It was agreed central banks and governments must have a plan in place to reverse emergency measures such as quantitative easing but that now was not the time to implement the plan for fear of derailing the recovery in the economy.
The Bank does not look like it is ready to reverse the programme any time soon. It made it perfectly clear last month that it would rather do too much than too little when it comes to printing money. “The potential adverse consequences of adding another large monetary stimulus might be less severe than the possible costs of acting too cautiously,” the minutes of the August MPC meeting said. The Bank could even extend quantitative easing further. After all, King, Tim Besley and David Miles all voted for an increase of £75 billion as opposed to the £50 billion eventually approved last month.
There is also talk of new unconventional measures being adopted by the Bank. Banks are hoarding cash and are still reluctant to lend to households and businesses, starving the economy of the fuel it needs to grow.
One possibility is that the Bank reduces the interest it pays on banks' reserves held at Threadneedle Street to zero or even into negative territory to encourage lending. It is clearly more profitable for banks to make money on loans than to pay to hold reserves at the central bank.
King said last month that the Bank should look at whether “the effectiveness of our asset purchases could be increased by reducing the rate at which we remunerate reserves”.
But it is far from clear such a scheme would work. Banks have been more than happy to sit on their cash when earning just 0.5%. As Vicky Redwood at Capital Economics puts it: “The big picture is that banks do not want to lend their money into a fragile economy, especially when many are still trying to contract their balance sheets.” So cutting the rate the Bank pays on reserves appears highly unlikely — particularly this week.
The Governor said he was “surprised that people were surprised” by the decision to extend quantitative easing last month. He had a point.
The Bank has made it pretty clear that it prefers to make the big decisions to coincide with its quarterly inflation report, so August was always the date to look for.
As King explained at the time: “It's natural that a good time to reach a decision... is the inflation report month because that's when we carry out a fully updated assessment on the outlook for inflation.”
So barring any dramatic change in the economic landscape, the MPC is unlikely to act again before November, whatever its decision.
Given King's comments last month, and his ambition for monetary policy to be “boring”, it would be a surprise too far if any action is taken on Thursday.
