Chasing inflationary ghosts?January 15, 2010
Andrew Sentance, of what his former Monetary Policy Committee colleague Danny Blanchflower rather cruelly referred to as the ‘feeble six’ of MPC members, appears to have learned very little from the last 18 months:
A Bank of England policy maker has said that Threadneedle Street has done enough to lift Britain out of its deepest post-war slump and will need to consider raising interest rates this year if a recovering economy poses a threat to inflation.
…he warned that while the early stages of the recovery would feel “fragile and uncertain”, the MPC needed to be vigilant about the risks of igniting inflation.
“There will be quite a lot of spare capacity and slack to take up [as the economy recovers] but that is not the only influence on inflation. There are global influences such as oil and commodity prices and the impact of the exchange rate which can lead to speed limits for the rate of growth. The inflation outlook is not entirely driven by the level of the output gap.”
Formally, he is correct: the ‘inflation outlook’ is not entirely driven by the amount of spare capacity in the economy. It can be imported through a falling value of the pound, pushing up the price of imports. Or it could come in through rising prices of raw materials, like gas, oil and steel.
This is all true. But it severely understates three factors: first, the truly colossal, global scale of the deflationary pressures unleashed by the credit crunch. The losses for the banks were so huge that, even with the eye-watering dimensions of the government bailouts offered, they couldn’t have anything other than a major depressive effect on the economy. It is simply too optimistic to assume that this drag on the economy has now been overcome; banks are still essentially sitting on their bailouts, with US lending depressed and liable to choke off further in the UK.
Second, whilst there has been much hurrahing of late about an improvement in UK manufacturing orders from their depressed level, and some return, in some places, to growth in the housing market, the services sector – accounting for over 80 per cent of UK employment – remains depressed. The picture, at best, is too murky to make chirpy pronouncements like Sentance’s.
Third, and perhaps most fundamentally, the characteristic monetary feature of the last decade has been – away from asset prices, like the housing market, and some raw materials – not inflationary pressures on economies, but deflationary, as a transport and communications costs slumped, and the price of manufactured goods crashed through the floor. Central bankers, like Sentance, have persistently underestimated this, chasing inflationary chimeras – until, as in Sentance’s case, the debacle was upon them.
Inflation may yet return: we are in uncharted economic waters; the twin effects (amongst others) of quantitative easing and the appearance of China as an economic superpower are deeply uncertain. But a rerun of the bad old days, of central banks paranoiacally lurching after the ghosts of past inflation, will do little to help.