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The Bank of England will lose control of inflation and 1980s mass unemployment will return
Since Bank of England governor Mark Carney issued his “forward guidance”, bond markets have reacted by bringing forward the date at which they implicitly expect interest rates to rise. Bank officials appear mystified by this reaction. But that just indicates how out of touch they are with how the Bank is perceived.
The Bank of England, led by Mark Carney, will have neither the will nor the tools to control inflation fully Photo: Bloomberg News
By Andrew Lilico
5:02PM BST 27 Aug 2013
32 Comments
Forward guidance appears to have been based on the assumption that markets believed the Bank likely to be an “anti-inflation nutter”, seeking any excuse to raise interest rates, even if that meant snuffing out recovery or driving up unemployment. In fact, most people regarded the Bank as having demonstrated, comprehensively since 2007, that it didn’t care at all about meeting the inflation target and would not have the slightest interest in raising interest rates until the recovery was well under way.
So when forward guidance came with various caveats or “knockout” clauses – including in particular a “trigger” for raising interest rates if inflation was expected to be above 2.5pc - the key message the markets drew was that, contrary to expectations, the Bank might in fact care about inflation and might be willing to raise rates to counter it.
There is much confusion about “credibility”. Many commentators appear to believe that, just because market expectations imply inflation being only moderately above target for a while, the Bank therefore has credibility. But actually that merely means financial markets agree, broadly, with the Bank’s inflation forecast, even if its own forecasting record has been poor since 2006. Agreeing with a forecast isn’t credibility.
The inflation target would be credible if economic agents believed the Bank would stick to it, even if doing so might lead to recession or unemployment. But few people believed that before forward guidance was issued.
Now it seems like there may be rising inflation scenarios that would trigger interest rate rises, and so markets think the average “expected” rate of inflation is now higher.
And so they should, for recent economic data suggest recovery is now well under way and the medium-term policy risk is that the Bank will raise rates too little too late, not that it will raise rates too soon.
Related Articles
Near-zero interest rates and quantitative easing (QE) were originally introduced to prevent a catastrophic collapse in the money stock, casting the economy into deflationary slump. Well, the past couple of years have seen a steady pick-up in monetary growth.
Whereas towards the end of 2011, the Bank of England’s standard measure of broad money was growing well below 2pc annually, in the latest June 2013 data that annual growth rate is around 5pc, where it has been throughout 2013. That is still perhaps below the 6pc to 8pc that would be compatible with CPI inflation of 2pc to 2.5pc real GDP growth rate over the long term.
But because the sustainable growth rate for UK GDP is about a percentage point slower than normal at present (around 1pc to 1.5pc), the amount of money needed likewise grows about a percentage point less, so 5pc monetary growth is about appropriate.
Recent months have seen a distinctly rosier picture for the UK macroeconomy. GDP is estimated to have grown at 0.7pc in the second three months of 2013, and since then most survey data have suggested a further pick-up. Quarterly growth numbers pushing 1pc seem plausible for the second half of 2013 in a way that few commentators would have dreamed only six months ago.
The detail of the GDP growth figures implies a broad-based pick-up, including accelerations in investment and net trade rather than just consumption. Unless something bad happens internationally (a possibility touched on below), there should be further scope for an expansion of non-oil net trade, especially if the situation in the eurozone stabilises.
Business investment may finally be responding to a combination of intrinsic pressure from projects long delayed and the desire to shift from financial into real assets to gain greater protection from inflation – which has been well above target over recent years and risks accelerating further over the next couple.
However, international events in Syria, and the possibility of their spilling over into a wider conflict, constitute a threat both to international trading conditions and to oil prices. An oil price spike could have implications for inflation down the line, though for now it is appropriate for monetary policymakers to await events.
The more straightforward risk of inflation comes from the likelihood of a large further acceleration in broad money growth as the large boost QE has created in what economists call the “monetary base” (the narrower form of money that is just notes and coin and money banks hold at the Bank of England) eventually becomes multiplied up into much larger amounts of broad money as the economy recovers and the banking sector becomes less distressed. Interest rates “doves” believe the UK can grow rapidly without inflation because there is still room to close an “output gap” before we return to trend GDP growth.
But a return merely to trend growth would see QE turn into rapid monetary growth – we don’t need to overheat for that. The extended nature of the 2011-12 “double blip” soft patch in growth has not fundamentally changed the dynamics of the inflationary impact of QE on exit from recession; it has merely delayed it.
Unless some further international disaster (such another flare-up in the eurozone crisis, a hard landing in China, full-blown war in Syria) derails British recovery, things should be expected to play out as follows. The huge six- or seven-fold increase we have seen in the monetary base should translate into rapid broad money growth and thus inflation down the line. Anticipating that inflation, investors and companies will exit from cash and financial assets into real assets in a distinct spike in business investment.
That spike in business investment will be associated with a rapid pick-up in GDP growth over a few quarters. That in turn will make the balance sheets of banks appear (temporarily) much improved. That will facilitate a rapid pick-up in lending. (In the economic jargon, the “velocity of circulation” will rise.)
Once this scenario is in play, the Bank of England will have neither the will nor the tools to control it fully. It will lack the will because the measures required to cap such rapid monetary growth will entail driving the economy back into recession, and the Bank will not be willing to do that until it feels we have comprehensively escaped the previous recession. The consequence will, by around 2015, be even higher inflation than the UK experienced in 2008 or 2011 – perhaps much higher.
When that inflation comes, workers will seek to protect their real wages by seeking rapid pay rises. When the Bank of England is, at last, willing to cap inflation, workers will not believe its promises and the consequence will be many workers stranded on excessively high wages who then become unemployed. The key problem with losing credibility on inflation is not the inflation itself – the inflation comes from the broad money growth, not the expectations. The key problem with losing credibility on inflation is the mass unemployment that will be the consequence, as it was in the 1980s.
The key near-term issue liable to derail the scenario above is, as it was in 2011, the eurozone crisis, and that is by no means resolved yet, though considerable political progress has been made.
Eurozone policymakers are finally acknowledging what has been obvious for some time: that the eurozone will only work as a transfer union, without debt pooling but with annual payments made from richer to poorer regions of the eurozone via a greatly expanded version of the EU’s current structural funds arrangement. A transfer union of that sort can only be delivered in combination with political union – the establishment of the EU Federation. The euro was always going to imply the creation of a Single European State.
For Britain that EU Federation will have political and economic consequences within just a few short years, but for now, for monetary policy-makers, managing the great volatility likely to be associated with exit from the current recession is the priority. Markets do not need guidance on when the Bank will not raise rates. The guidance we need is on when it will.
Andrew Lilico is the chairman of Europe Economics
The Bank of England will lose control of inflation and 1980s mass unemployment will return
Since Bank of England governor Mark Carney issued his “forward guidance”, bond markets have reacted by bringing forward the date at which they implicitly expect interest rates to rise. Bank officials appear mystified by this reaction. But that just indicates how out of touch they are with how the Bank is perceived.
The Bank of England, led by Mark Carney, will have neither the will nor the tools to control inflation fully Photo: Bloomberg NewsBy Andrew Lilico
5:02PM BST 27 Aug 2013
32 Comments Forward guidance appears to have been based on the assumption that markets believed the Bank likely to be an “anti-inflation nutter”, seeking any excuse to raise interest rates, even if that meant snuffing out recovery or driving up unemployment. In fact, most people regarded the Bank as having demonstrated, comprehensively since 2007, that it didn’t care at all about meeting the inflation target and would not have the slightest interest in raising interest rates until the recovery was well under way.
So when forward guidance came with various caveats or “knockout” clauses – including in particular a “trigger” for raising interest rates if inflation was expected to be above 2.5pc - the key message the markets drew was that, contrary to expectations, the Bank might in fact care about inflation and might be willing to raise rates to counter it.
There is much confusion about “credibility”. Many commentators appear to believe that, just because market expectations imply inflation being only moderately above target for a while, the Bank therefore has credibility. But actually that merely means financial markets agree, broadly, with the Bank’s inflation forecast, even if its own forecasting record has been poor since 2006. Agreeing with a forecast isn’t credibility.
The inflation target would be credible if economic agents believed the Bank would stick to it, even if doing so might lead to recession or unemployment. But few people believed that before forward guidance was issued.
Now it seems like there may be rising inflation scenarios that would trigger interest rate rises, and so markets think the average “expected” rate of inflation is now higher.
And so they should, for recent economic data suggest recovery is now well under way and the medium-term policy risk is that the Bank will raise rates too little too late, not that it will raise rates too soon.
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Near-zero interest rates and quantitative easing (QE) were originally introduced to prevent a catastrophic collapse in the money stock, casting the economy into deflationary slump. Well, the past couple of years have seen a steady pick-up in monetary growth.
Whereas towards the end of 2011, the Bank of England’s standard measure of broad money was growing well below 2pc annually, in the latest June 2013 data that annual growth rate is around 5pc, where it has been throughout 2013. That is still perhaps below the 6pc to 8pc that would be compatible with CPI inflation of 2pc to 2.5pc real GDP growth rate over the long term.
But because the sustainable growth rate for UK GDP is about a percentage point slower than normal at present (around 1pc to 1.5pc), the amount of money needed likewise grows about a percentage point less, so 5pc monetary growth is about appropriate.
Recent months have seen a distinctly rosier picture for the UK macroeconomy. GDP is estimated to have grown at 0.7pc in the second three months of 2013, and since then most survey data have suggested a further pick-up. Quarterly growth numbers pushing 1pc seem plausible for the second half of 2013 in a way that few commentators would have dreamed only six months ago.
The detail of the GDP growth figures implies a broad-based pick-up, including accelerations in investment and net trade rather than just consumption. Unless something bad happens internationally (a possibility touched on below), there should be further scope for an expansion of non-oil net trade, especially if the situation in the eurozone stabilises.
Business investment may finally be responding to a combination of intrinsic pressure from projects long delayed and the desire to shift from financial into real assets to gain greater protection from inflation – which has been well above target over recent years and risks accelerating further over the next couple.
However, international events in Syria, and the possibility of their spilling over into a wider conflict, constitute a threat both to international trading conditions and to oil prices. An oil price spike could have implications for inflation down the line, though for now it is appropriate for monetary policymakers to await events.
The more straightforward risk of inflation comes from the likelihood of a large further acceleration in broad money growth as the large boost QE has created in what economists call the “monetary base” (the narrower form of money that is just notes and coin and money banks hold at the Bank of England) eventually becomes multiplied up into much larger amounts of broad money as the economy recovers and the banking sector becomes less distressed. Interest rates “doves” believe the UK can grow rapidly without inflation because there is still room to close an “output gap” before we return to trend GDP growth.
But a return merely to trend growth would see QE turn into rapid monetary growth – we don’t need to overheat for that. The extended nature of the 2011-12 “double blip” soft patch in growth has not fundamentally changed the dynamics of the inflationary impact of QE on exit from recession; it has merely delayed it.
Unless some further international disaster (such another flare-up in the eurozone crisis, a hard landing in China, full-blown war in Syria) derails British recovery, things should be expected to play out as follows. The huge six- or seven-fold increase we have seen in the monetary base should translate into rapid broad money growth and thus inflation down the line. Anticipating that inflation, investors and companies will exit from cash and financial assets into real assets in a distinct spike in business investment.
That spike in business investment will be associated with a rapid pick-up in GDP growth over a few quarters. That in turn will make the balance sheets of banks appear (temporarily) much improved. That will facilitate a rapid pick-up in lending. (In the economic jargon, the “velocity of circulation” will rise.)
Once this scenario is in play, the Bank of England will have neither the will nor the tools to control it fully. It will lack the will because the measures required to cap such rapid monetary growth will entail driving the economy back into recession, and the Bank will not be willing to do that until it feels we have comprehensively escaped the previous recession. The consequence will, by around 2015, be even higher inflation than the UK experienced in 2008 or 2011 – perhaps much higher.
When that inflation comes, workers will seek to protect their real wages by seeking rapid pay rises. When the Bank of England is, at last, willing to cap inflation, workers will not believe its promises and the consequence will be many workers stranded on excessively high wages who then become unemployed. The key problem with losing credibility on inflation is not the inflation itself – the inflation comes from the broad money growth, not the expectations. The key problem with losing credibility on inflation is the mass unemployment that will be the consequence, as it was in the 1980s.
The key near-term issue liable to derail the scenario above is, as it was in 2011, the eurozone crisis, and that is by no means resolved yet, though considerable political progress has been made.
Eurozone policymakers are finally acknowledging what has been obvious for some time: that the eurozone will only work as a transfer union, without debt pooling but with annual payments made from richer to poorer regions of the eurozone via a greatly expanded version of the EU’s current structural funds arrangement. A transfer union of that sort can only be delivered in combination with political union – the establishment of the EU Federation. The euro was always going to imply the creation of a Single European State.
For Britain that EU Federation will have political and economic consequences within just a few short years, but for now, for monetary policy-makers, managing the great volatility likely to be associated with exit from the current recession is the priority. Markets do not need guidance on when the Bank will not raise rates. The guidance we need is on when it will.
Andrew Lilico is the chairman of Europe Economics