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Temperatures at the Bank of England are rising over how to drive a recovery in the UK economy without sending inflation soaring.
The three-way split on the monetary policy committee over how much extra cash needs to be pumped into the economy caused a stir in the City although it was hardly a surprise.
But, as Jonathan Loynes at Capital Economics points out, an even deeper divide has emerged at the heart of Threadneedle Street and it is over asset prices. This reflects a debate going on at central banks around the world over how much attention should be given to the price of assets such as houses in setting monetary policy.
Minutes from this month's MPC meeting showed Spencer Dale, the chief economist at the Bank, opposed the decision to extend quantitative easing from £175 billion to £200 billion on these very grounds. He argued that there was a risk “that further substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify, complicating the task of meeting the inflation target in future”.
Dale seems at odds with his boss, Bank Governor Mervyn King. At the inflation report just six days after the MPC meeting ended, King said that it would be “peculiar” to worry about asset prices at the moment, even though the
FTSE 100 index is up 50% since March and house prices between 5% and 10% this year.
King said: “The increase in asset prices that we've seen, particularly in the last eight or nine months, are in part I think a reflection of the fact that a possibility of a real disaster has sharply diminished. The actions that have been taken around the world have very sharply diminished the prospect of something like the Great Depression. That in itself was bound to remove some of the tail risk that would have led to asset prices having fallen so much, and lead to a rebound of asset prices. That's to be welcomed, not to worry about it.
“And it's still the case, if you look at asset prices, they're well below the levels that they reached in the peak. So it's not as if people have re-inflated some bubble based on a rapid expansion of credit that appears unsustainable.”
King went on to say that it was “pretty obvious” that if interest rates stayed at 0.5% and it carried on printing money “indefinitely” then “we would see not only asset prices rise to levels that would concern us, but also inflation would rise to a level that would worry us”.
So, like Dale, King has an eye on asset prices. He just does not think they are a problem yet.
The Governor won the day at this month's meeting but if other members of the MPC start to take Dale's view, the stimulus to the economy the Bank has provided through record low interest rates and quantitative easing could start to be withdrawn sooner than expected. That is the issue in the short-term. In the long-term, that this debate is taking place at all shows that King, Dale and others around the world are reassessing the prevailing view of the last decade or so that central banks should not set policy to control asset prices and prevent bubbles.
Policy in the UK is currently based on the ultra-narrow Consumer Prices Index rate of inflation which does not include house prices or mortgage costs.
“One day, things will change and the MPC will need to take greater care to prevent the build-up of further asset price bubbles,” says Loynes. “At that point, or preferably before, its remit will probably need to be altered to enable it to so do.”
It won't happen immediately, but change is on the way.
Turning up temperature: heated debate over size of stimulus that economy needs
The “experts” were left red-faced last month when official figures showed the economy shrank by 0.4% in the third quarter of the year.
It stunned the City and Westminster where economists and politicians alike had predicted a return to growth in July, August and September to herald the end of the recession and the start of the recovery.
Once the shock had worn off, however, the response was pretty much unanimous: the figures are wrong and will be revised up at the second reading. Well, that second reading is tomorrow, and the consensus view, or should that be hope, is that gross domestic product actually fell by a still less than impressive 0.3% in the third quarter.
As Howard Archer of IHS Global Insight says: “The expectation — or is it just we economists hoping that we were not quite as wrong as it first appeared? — is that the decline was a little less than first estimated.”
The news has been mixed since the GDP numbers were produced, with retail sales stronger than initially thought but industrial production weaker. There are also signs that the key services sector which drives the UK economy was not as bad as feared in the third quarter.
So there is every chance that the grim numbers will be revised up tomorrow — but don't be surprised if they are not. The unfortunate truth about this recession is that the gloomier forecasts for GDP have tended to be more accurate.
