“Alarm bells are being loudly rung. In panic-prone parts of the City, shrill warning cries can be heard. No sooner has the very real danger of a re-run of the Great Depression been averted than a growing number of pundits are gripped by terror over a new threat. Suddenly, the spectre looming in the imaginations of some economists is the return of 1970s-style inflation.
Never mind that official figures have just confirmed that the first quarter’s slump marked the deepest plunge in GDP for half a century. Never mind that the retail prices index (RPI) presently shows not inflation, but (mild) deflation.
For some, the clear and present danger is from the re-emergence of rampant inflation. In an economic environment fraught with uncertainty, we can be certain of two things: that this emerging inflation scare will become steadily more strident as the recovery takes firmer hold; and that the ensuing panic will prove to be a false alarm.
That inflation fears will intensify over the coming year is easily predictable because of a reversal of the trend in the official inflation numbers that is mathematically inevitable. At present, inflation is tumbling thanks to the collapse in oil prices over the past year from record levels above $140 a barrel to under $40. On the RPI, inflation is being driven still lower, and into negative territory, by the effect on mortgage bills of drastic cuts in official interest rates to their present, 315-year low of only 0.5 per cent.
Over the next few months, inflation on the RPI will slide further into deflationary territory, while on the Consumer Prices Index (CPI) (which excludes mortgage costs) it will sink decisively below the Bank of England’s 2 per cent target to 1 per cent or less. By next year, though, both inflation measures will unavoidably begin to climb as the past falls in energy costs and interest rates drop out of the sums. Adding to the upward pressure will be increases in VAT and petrol duty, which will add about 1.5 percentage points to inflation rates next year.
Although all of this is a simple matter of arithmetic, it is bound to inflame the anxieties over inflation already being stoked by some analysts. Those concerns are driven by three main factors: the belief that the moves by central banks, including the Bank of England, to infuse economies with newly “printed” money must inevitably prove inflationary; the worry that damage done by the recession to the economy’s capacity to grow will make it easier for inflation to take hold; and the fear that the huge public debt pile run up in fighting the slump will tempt governments to try to inflate this away.
Yet all three of these fears can be readily dispatched. Consider them in turn. First, fears over central banks’ “printing” of money under quantitative easing schemes, or “QE”. As the first chart shown here, from Goldman Sachs, illustrates, the Bank’s vast £125 billion QE programme has hugely expanded the quantity of money as gauged by “M0” — a narrow measure reflecting notes and coins in circulation plus commercial banks’ reserves at the Bank itself. For monetarists, since inflation is always a monetary phenomenon, emerging as “Too much money chases too few goods”, creation of new money on this scale must surely lead to an inflationary nightmare.
Fortunately, this is a complete misconception. In reality, the money created through QE isn’t chasing anything much. Most of it is simply sitting in banks’ reserves, rather than finding its way to businesses and consumers. Normally, giving banks bigger reserves would lead to inflation through the “multiplier effect”. Since banks use leverage, lending out each pound that they hold several times over, any rise in their reserves ought, in theory, to be multiplied up by this lending, pumping more money through the economy and expanding the “broad” money supply, which includes loans and credit. Yet this just is not happening.
Banks are hoarding cash and continue to tightly restrict lending. Gauges of “broad money” growth remain extremely weak. This does not mean that QE is pointless — matters would be still worse without it. It does mean that scares over some sort of monetary explosion are plain wrong. If these sorts of effects were to emerge, the Bank could readily respond through higher rates or by quickly mopping up the extra money it has created.
The second concern, over the inflationary threat from a less productive economy, is better founded but equally misconceived. It is true that the economy’s effective speed limit, the sustainable growth rate at which it can expand without igniting inflation, will have been cut by the recession. The slump means that some businesses will have scrapped productive capacity; others will have opted to rely on ageing equipment. The credit crunch has made finance costlier.
These and other effects mean that, as recovery takes hold, the economy is likely to run up against shortages of machinery, labour or equipment at slower rates of growth than before, triggering cost pressures. Yet, as Ben Broadbent and Kevin Daly, of Goldman Sachs, argue, although these worries are real enough, the recession has left huge amounts of slack in the economy in the form of spare capacity ready to be brought back into use.
The scale of this, which Goldman estimates as equivalent to up to 8 per cent of GDP, should overwhelm the effect of any capacity lost in the slump. Equally crucial, growth is unlikely to climb to levels that would test even the economy’s diminished speed limit at any time soon. With consumers facing soaring unemployment, a continuing squeeze on incomes, an overhang of debt and severe damage to their wealth from crashes in house and share prices, growth will be well below par and will struggle to pick up any steam until at least 2011.
The remaining perceived inflationary peril — unease that governments might deliberately stoke inflation to erode the real value of now enormous public debts — can also be largely dismissed. To achieve this, governments would have to wholly undermine the independence of central banks. This is rendered impracticable since markets would inevitably punish any country that attempted this by driving up market interest rates on that country’s bonds, making the move self-defeating.
Taken together, all of this makes the inflation bogeyman being conjured up by some City scribblers no more than a phantom menace. Yet the climate of fear that this threatens to create could carry real perils. Should it lead a wary central bank to fret over its credibility and move too far, too fast to retighten the screws on the economy, through withdrawing QE or raising base rates, recovery could be scuppered. Imagined dangers can be as pernicious as real ones.’
Growth will struggle to pick up any steam until at least 2011.