Quantitative easing: playing with fire

Anyone that has lived and worked in the UK in the past few years will have noticed that prices have been rising and that, owing to the sluggish economy conditions, wages and job prospects have not quite followed suit.

When the economy is booming, people earn more, consume more and, typically, prices rise. The reverse is also true when the economy is cooling. That is, if people are out of work and consume less, shops will need to lower prices to sell their stock.

The Bank of England’s primary remit is that of price stability. Its job is to rein the economy in when we all get carried away with our credit cards, and to encourage us to spend and invest when the high streets are deserted. It does this by adjusting interest rates.

By increasing interest rates in the good times, we are encouraged to save more and borrow less, and our mortgage payments also increase thus leaving us with less disposable income to spend. Thus, demand for goods and services will fall as will investment (due to cost of borrowing increasing). This will result is negative pressure on prices. In the bad times, interest rates are lowered thus having a positive pressure on prices.

In 1997, the Bank of England was granted independence from the Government. This was a historic occasion marking the end of political influence on interest rate policy. No longer would a chancellor be able to artificially boost the economy prior to an election to get re-elected. And no longer could a chancellor allow inflation to creep up to reduce the real value of Government debt. That is, if the Government owed £100 million and prices were doubling every year, tax revenues would be doubling, but the amount the government owed would be fixed nominally at £100 million. Hence, the government would have a much easier time paying off its debt at the expense of price instability.

Quantitative Easing

Quantitative Easing - Picture: Telegraph

This week Mervyn King, the governor of the Bank of England, said that inflation is expected to go above 5% in September. To put this into context, prices will be rising at more than twice the Bank of England’s 2% target. King also believes that in the medium term, inflation is likely to fall to below the 2% target.

Given that interest rate policy decisions take time to take effect on the market, the Bank of England must be forward looking in setting policy. King argues that the current sluggish economic environment will eventually cause inflation to fall dramatically. Hence he believes that we should act now to stem the decline in prices and boost the economy.

Given that interest rates are already at 0.5%, King does not have much room for cutting rates further. Hence, he has decided to print £75 billion and inject it into the economy (quantitative easing, or QE) to boost cash in circulation and, in theory, encourage investment, borrowing, and spending.

Crucially, King’s QE stimulus will only be effective if people buy into the idea that in the medium term we are facing a sharp drop in inflation. If, instead, the latest round of QE is seen as a way of supporting economic growth with little or no regard for the 2% inflation target, QE will only result in higher inflation. This is because individuals will ‘price in’ the additional money in the economy and raise their price expectations.

For example, when it comes to renegotiating your wage, or setting prices on the high street, people will no longer assume that inflation will be roughly 2%. Instead, price and wages will be pushed up as shop keepers and employees strive to protect their real earning and spending power from price increases. This is why once inflation gets out of control it is very hard to bring back to a stable level.

Alan Ruskin, a leading currency strategist at Deutsche Bank, said that King’s statement that inflation is likely to undershoot 2% in the medium term was asking a lot of the market to believe. Nida Ali, of the Ernst & Young ITEM Club, said she was sceptical about the effectiveness of the QE stimulus boosting growth. If they are right, inflation could spiral upwards and the credibility of the Bank of England could be at stake.

Another important factor to consider is the growing demand for commodities in China, India and other developing countries. This could put further upwards pressure on prices as we compete in greater numbers for oil, metal, food and other resources.

Naturally, George Osborne was very pleased with King’s announcement of £75 billion QE. I’m sure he will be even more pleased with Andrew Posen, another member of the Bank of England, stating that we should push QE policy even further.

We would like to think that Osborne’s happiness is as a result of the Bank of England’s responsible policy stance in looking to counter the anticipated sharp decline in prices. The more skeptical commentators amongst us would argue that the Bank of England has abandoned its primary remit of price stability in favour of supporting the Government’s efforts to boost economic growth.

Whilst this may seem perfectly sensible, inflation has a habit of sticking around. In a worst case scenario, should inflation get out of control, we only need to look at the Zimbabwe of today or pre-WW2 Germany to see how damaging this could be.

If inflation begins to drop by early next year, King will have been vindicated and will have saved this country from plummeting prices and the horrors of deflation. That is, a vicious downward spiral in trade driven by a ‘buy tomorrow as it will be cheaper’ mentality.

If, instead, we see inflation rise further in the next six months, we could be sleepwalking towards spiralling inflation. This could cause a huge reduction in living standards and could push political sentiment to the limit.

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About Mark Birri

Corporate finance professional with six years experience in M&A. Interested in the UK economy, the political impacts of monetary and fiscal policy and free market versus interventionist theory.

Posted on October 7, 2011, in Coalition Government, Comment, General and tagged , , , , , . Bookmark the permalink. 3 Comments.

  1. Some great points Mark,

    However I should note, historically, before the advent of fiat (or loosely fiat) currencies anyway, prices fell in the wake of economic growth thanks to increased productivity.

    A good analogy is the PC market; despite gains in technology and more bang for your buck, prices have steadily dropped over the past 40 years thanks to technological advancements, economies of scale and reduced human capital. The price rises we witness today are artificial to an extent that central banks release arbitrary amounts of credit into the system ad hoc.

  2. This is a great read Mark.

    However, please allow me to take you up on one point.

    Looking at Germany in the 1920s and Zimbabwe is not appropriate. The form of quantitative easing seen in the UK is different because money is being printed, as part of monetary policy, to prevent deflation. This is vastly different from the examples above as both are representative of countries printing money to help finance government defecit.

  3. Zoe,

    I would say the BoE and Fed are going beyond just preventing deflation.

    We are financing fiscal stimulus through money printing. Despite Bernanke’s and Kings rhetoric QE2 UK and QE3 US real goals are to kick start the economy and reduce unemployment.

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