Tricky. This week the first estimates for GDP growth for the final three months of 2010 should be out. Though industrial output should be up (from a very low base), services may well be down (especially given that retail sales suffered their sharpest fall on record in December, and services were already contracting by October anyway). Overall growth probably won’t be negative for the quarter, but there is likely to be a significant slowdown, and growth may slow further or even contract slightly in the first three months of 2011. Expect Ed Balls and David Blanchflower to be all over the news proclaiming that this is the slowdown they warned would result from the Coalition’s deficit-cutting programme. (Others of us, of course, have long warned that there was likely to be a slowdown about now that would be unrelated to the cutting programme, and make early cuts more important, not less.)
So GDP growth is slowing. Well, we know what to do about that, don’t we? We loosen monetary policy – print more money, do more “quantitative easing” (more QE). That’s always the recommended strategy, anyway, when engaging in a major deficit-cutting programme (and what many of us urging cuts to the deficit had urged should be its companion). Broad money growth has been weak in recent months (just 1.4% in the year to November 2010), implying underlying deflationary/recessionary forces, so expanding monetary growth would be justified even in its own terms, without the GDP data.
And yet… inflation is well above target, and has been so for a very long time. So long, in fact, that many people are now questioning the Bank of England’s credibility (a bit late, guys – some of us have been pointing out that the Bank of England has lost its policy target credibility for about four years, but feel free to join the party anyway). Indeed, Citi is now forecasting CPI inflation reaching 5% later in the year. I guess my warning that keeping CPI inflation to even a 6% peak would be a challenge might not seem like “complete rubbish” now, eh?
Current consensus forecasts are that after reaching its 4-5% peak, CPI inflation will drop back rapidly. I certainly agree that it will fall back a little, initially, as certain “base effects”, such as the short-term effects on inflation of raising VAT, drop out of the calculation. But will it fall back in any sustained way?
That’s definitely possible. The scenario under which that occurs is one in which either the international economy suffers a significant downturn (e.g. a blow-out in the US or China), dragging down import prices (and probably dragging the UK economy back into recession) or/and a UK bank goes bust (either because it’s dragged down by a crisis in the Eurozone, or perhaps because of good old-fashioned bad lending decisions in the UK on mortgages, as house prices plummet again through 2011), leading to a precipitous contraction in the UK money supply. Each of these is a genuine danger – I’d put something north of 15% on that scenario occurring over the next 18 months, unless we do sufficient additional QE to ensure rapid nominal growth. That is a genuine danger, and I think it imprudent to run that danger at the same time as engaging in a major fiscal consolidation, without providing the safety net of additional QE.
But it isn’t the base case. The base case continues to be that, after a sticky patch in the six months from October 2010 to March 2011, the economy starts to boom again. I think that by the final quarter of the year we will be looking at quarterly growth rates of 1-1.5%. If this scenario does come through, inflation isn’t going to drop back for any sustained period with interest rates remotely close to their current level (0.5%). Instead, after a brief respite as the base effects drop out, it will resume its upward path through 2012.
Why would inflation peak if there is GDP growth of 1-1.5% per quarter, negative real interest rates, QE2 still working its magic on international commodity prices, and a quadrupling of the monetary base still sitting in the system?
To get inflation to fall, we will need either (a) depression; (b) monetary tightening through banking sector collapse; (b) monetary tightening through huge regulatory-driven increases in capital requirements; (d) monetary tightening through significant appreciation in the value of sterling; or (e) monetary tightening through positive real interest rates or quantitative easing-reversal (or some combination of the above). Otherwise, once GDP growth gets going, inflation is only going one way. As matters stand, we can only do it through (b) and thence (a) – we'd get banking sector collapse long before we had positive real interest rates. What policymakers must hope is that we can get as far as (e) with only a little bit of (a) as a consequence. Otherwise we might end up with inflation of 20%+ in which case relying upon (a), early 1980s-style, is our only real option left. If we do get the 20%+ scenarios, then QE will have been a mistake, as the cure will have been worse than the disease. But I remain hopeful we can contain it to an early-1990s-style scenario.
This is all deeply politically important. The slowdown in growth will be politically significant. CPI inflation reaching 5% will be politically significant. Inflation accelerating again in 2012 will be significant. And then we will either have interest rates rising at levels that aren’t remotely priced in at the moment, or we will see inflation spiral up to disastrous levels. And all through this, the government will also face rising unemployment (unemployment almost always rises during deficit-cutting programmes, even if growth doesn’t fall) and falling house prices (house prices are still some 10-15% above a sustainable level).
What’s to be done? For now, more QE. Policymakers should have taken the opportunity from mid- to late-2010 to raise interest rates up to around 1.5% at the same time as doing more QE (not in order to tighten monetary policy – interest rate rises to 1.5% would not have been tightening; they would merely have been returning rates to “zero” and removing some of the subsidies to the banks created by the high margins rates so low create). But they didn’t. They also should have taken the opportunity to involve themselves in the international QE2 effort from November. But they didn’t – yet. If a Eurozone bank or sovereign (or both) goes down, and Britain gets sucked in to the crisis that would then ensue, the failure of the UK to do more QE will be extensively and rightly criticised by economic historians as a key moment in the crisis.
But after the next six months, assuming we get through to the inflationary growth phase – what then? Well, obviously we want to be in a situation where we could raise interest rates to achieve positive rates to bear down on inflation. The neutral rate for the UK is about 5-5.5%, so we’d really like to be able to go a couple of percentage points above that – 7.5-8% – some time in 2012 or early 2013. But there’s just no way we could get anywhere near that at the moment. Even a 2% rise in mortgage rates is apparently likely to put about 3m people into significant financial distress with their mortgages.
So the key thing – the thing that will make the difference between CPI peaking at 6% and 15-20% – is whether households use the period between now and early-2012 to reduce their indebtedness. Policymakers should be screaming at every opportunity that interest rates will definitely rise, and may rise very fast, and households should be preparing themselves by reducing their debts and preferably building up some savings. Policymakers should also be moving, at the earliest possible opportunity, to give us better protection against the deflationary scenarios, also, by introducing credible mechanisms for dealing with distressed banks in special administration that don’t involve government recapitalisations. It is absolutely extraordinary that, three and a half years into the financial crisis, we still have no proper bank resolution mechanisms.
It is also extraordinary the passive way in which electorates remain content to see their governments chuck another few tens of billions at the banks every few months (although we now call the banking sector bailouts “sovereign bailouts”, a skunk by any other name will smell as foul – as Shakespeare didn’t quite say). Bear Stearns, Fannie Mae and Freddie Mac, All of them (October 2008), The British ones again (February 2009), all the American ones (via the US form of QE, which involved buying out the banks’ mortgage assets at inflation prices), the European ones (via the Greek bailout), the Irish ones (the ECB buying up almost the entire distressed assets of the Irish banking system), the European ones again (the Irish bailout), the Spanish one (this week). The way in which people seem content to sit idly by and watch this, and the way that governments don’t seem to care about even trying to get any credible resolution mechanisms in place, are, to me, absolutely extraordinary.
The only explanation appears to be that it has gone on so long, and the amounts involved are so vast, that we’ve become desensitised to the whole thing. We think that where we are is the new normal, and have begun to imagine that it can continue this way – interest rates 0.5%, a few more tens of billions chucked at the banks every few months, but the rest of life broadly ticking along as before – all-but indefinitely.
It can’t. The next steps are either (a) we sort ourselves out; (b) deflationary Armageddon; (c) inflationary Armageddon. I want to see more panic. There are times to panic. Now is one of them.