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A dissenting view on inflation

Has the Bank of England lost control of interest rates? You won’t hear that view from any official source, but it is worth listening to the economist Peter Warburton, the founder of the consultancy Economic Perspectives, whose often dissenting opinions have been more right than wrong over the past couple of decades. He argues differently in this contribution to the Shadow Monetary Policy Committee’s latest review of economic conditions, in which he warns about the incipient threat of price inflation. It is well worth reading: I suspect it will look very prescient when we look back in years to come.

It is becoming increasingly obvious that the Bank of England has lost control of UK retail borrowing costs. During the three years-plus that Bank Rate has been set at ½%, the average interest rate paid on banks’ and building societies’ notice deposit accounts has risen from a low of 0.17% in February 2009 to 1.83% in July 2012.

Admittedly, the quoted monthly rates have bounced around, but the average for 2012 is 1.41%. This is a measure of the average cost of retail funds to the banking sector; the marginal cost is closer to 3%. On the other side of the balance sheet, Santander UK has recently announced a 50 basis point increase in its standard variable mortgage rate, to 4.74% from October. Clearly, the level of Bank Rate has played no role in the evolution of market rates for the past three years. The MPC’s consideration of a cut in Bank Rate is perverse and farcical in this context. As and when the UK economic news flow permits, Bank Rate should be raised in order to reconnect it to the structure of market rates. However, with UK activity indicators currently erratic and weak, now is not a good time to do this.

It is important not to lose sight of the beneficial purpose of raising Bank Rate, at least to approximate a zero real rate, and preferably a modestly positive one. The UK is subject to mounting inflationary risks. Some of these risks are visible and obvious; others are as yet latent. Unconventional monetary policy is associated with a much wider range of inflation outcomes than conventional monetary policy because unconventional interventions tend to be poorly calibrated. As the official Bank of England and Debt Management Office holdings of conventional government bonds approach 50% of the total in issue, it is time to wonder where the tipping point for inflationary expectations lies.

The willingness of overseas investors to piggy-back on the Bank’s Asset Purchase Programme will one day evaporate and be replaced by a fearful rush for the exits because of Sterling depreciation risk. The loss of the sovereign’s coveted AAA-rated status cannot be far away now and this too could be a catalyst for overseas selling of UK government bonds.

Regardless of how soon this nightmare scenario arrives, there is plenty of inflationary concern that is already visible. Over the past five years, the UK has demonstrated a greater vulnerability to global inflation than other large European countries. Retail price inflation averaged 5.2% in 2011 and CPI inflation 4.5%. Inflation exceeded the year-ahead forecasts made by the Bank of England for the third year in succession.

Factors influencing the pass-through of foreign pricing to domestic pricing include the lack of indigenous competition to imports; an oligopolistic distribution system, especially in food retailing and domestic electricity and gas provision; and a dramatic upward revision to clothing and footwear price inflation. Sterling has been fairly stable in terms of its trade-weighted index over the past three years, but economic weakness poses a renewed threat to the ‘safe haven’ status of its fixed interest market. The flexibility of Sterling to depreciate means that global pricing pressures have the potential for magnification, given that the UK is an effective price-taker in many sectors. Long after the Sterling depreciation of 2008, import price inflation of 5% or so has persisted.

The sluggishness of the UK economic recovery has reopened the debate regarding the potential medium-term growth rate. The Bank of England and the OBR routinely assume that the medium-term growth rate of the economy lies in the region of 2% to 2.5% per year, but in a credit-constrained world, these growth rates may be no longer attainable. The shocking manner in which the economic recovery has petered out since the summer of 2010 underlines the centrality of the role of credit, in its broadest sense, in healthy economic development.

To the extent that cheap credit fostered the creation of excess capacity in the distributive and financial services sectors, for example, not only was their growth rate unsustainable but their peak level of activity was also artificial. Post-slump, the viable economic size of these industries may remain below their prior peaks for an indefinite period. This may already be reflected in stagnant productivity and rising unit labour cost inflation. After examining the behaviour of forty-four economic sub-categories, our conclusion is that the prevailing rate of sustainable economic growth may be as low as 1%. In these circumstances, economic stimulus whether monetary or fiscal, is liable to deliver an adverse mix of inflation and real activity.

The view of the Bank of England, reflected in the economic consensus (e.g., Barclays) is that an abatement of energy and commodity price inflation will allow the UK CPI to return to its target rate of 2% per annum and possibly fall beneath it during 2013. However, this has been the official view consistently and incorrectly for the past three years or so, regardless of the external realities. As ex-MPC member Andrew Sentance has pointed out, global inflationary pressures have strengthened since 2008 and 2009 and the UK is susceptible to them. Global goods deflation has been replaced by moderate inflation.

The improvement in the non-food and energy inflation rate in 2011 and 2012 has been associated with a particularly weak sequence of economic outturns. Supposing that there is some recovery reflex, aided by the various policy stimulus initiatives, the Bank of England cannot rely on a stagnant economy to deliver its inflation objective, any more than it can rely on a sequence of good harvests to deliver low food price inflation. For some years now, domestically generated private sector inflation has departed from its stable low trend during 1993 to 2008, and there is evidence of a return to an inflationary mentality, reflected in term inflation expectations of the general public.

Warburton’s conclusion is the most important point of all: “If the Bank of England was taking its inflation mandate seriously, it would have raised Bank Rate to 2% or more during the past three years. It has not and it now cannot”. I would add that this is an example of a more general truth, that in economic policymaking, as in most things, taking the easy option is usually more costly in the longer run than taking tougher medicine today.

Written by Jonathan Davis

September 4, 2012 at 9:41 AM