Andrew Lilico: Inflation may be up but Quantitative Easing prevented the UK from falling into Irish-style deflationary slump

Annual CPI inflation in December 2010 was up to 3.7%, RPI to 4.8%. The chart tracks inflation since 2000.

In August (repeating remarks from February 2009 and earlier), I suggested that CPI inflation might peak above 6% - a little higher than the 5.2% it reached in 2008 – and that if it manages to keep inflation down only to that level, whilst at the same time avoiding deflation, “I shall consider the Bank of England’s policy to have been a resounding and surprising success”.

At the time, queues of worthies formed to re-assure the public that my remarks were eccentric, saying that there was no realistic possibility of the Bank of England losing control of inflation that far.  Now, on the other hand, queues of different worthies have formed to condemn the Bank of England for allowing inflation to stay so high for so long.

Inflation is likely to have a passing peak in the early-ish part of this year (say, April or May) at above 4%, then drop back a little for a few months, before recommencing its upwards march in the final quarter of the year – unless we see some banks go under before then, dragging us into deflation (which remains much more possible, and a much more serious risk, than most commentary on inflation by politicians or political writers seems to acknowledge).  (Many things could cause this, but the most obvious is Eurozone problems.)

Sticking with the base case, by the second half of the year we should be through the slowdown (or even minor contraction) I still expect to see in Q1 and into the serious growth phase of the recovery – probably with quarterly growth in the 1-1.5% region (maybe higher).  As I’ve explained before, this growth will be largely investment driven (not exports or consumption).  If the banks haven’t gone bust by the time we are properly recovering, then (unless foolish regulation impedes them – which remains a real fear) they will start multiplying up the large increase in the monetary base created by quantitative easing, mainly lending to businesses.  Very loose monetary policy can generate huge investment growth (e.g. 1973Q1 had investment 25% higher than 1972Q1).

So I think there will be inflation – I hope no higher than CPI 6.0% / RPI 10%.  Does that mean I join with those condemning Mervyn King in general, or condemn quantitative easing in particular, or urge that monetary policy should be tightened at the earliest juncture?  No!  Most of the criticism of the MPC seems to me simply to fail to appreciate the delicate balance of risks involved here, and the challenges of policymaking in such a difficult environment.

Quantitative easing prevented the UK from falling into Irish-style deflationary slump.  I know that many commentators declare: “Where’s the deflation, then?”  But that’s a bit like someone said “If we don’t turn left here, we shall crash off a cliff”, we turned left, and someone else said: “But you haven’t fallen off a cliff, so you obviously didn’t need to turn left”!  It’s the quantitative easing that has prevented the deflation.  It worked!  Deflation (RPI) only reached 1.9% (in mid-2009, as you can see on the chart – just a few months after QE began) and wages never fell on an annual basis.  We scraped through (at least for now).  That doesn’t mean that QE was unnecessary – it means it was a success (so far)!

Ireland did not have command of its own currency, so was not able to use QE to prevent its money supply contracting aggressively (which it did), so it ended up with 6.6% deflation, the collapse of its banking sector, and effective sovereign default.  That’s where the deflation is – where they couldn’t do QE!
QE (at least, the British variety – the US version is another story) has worked very well in its prime task: preventing deflation from getting out of control.  But it was always going to be a blunt tool.  We never had any precise idea of exactly how much it was necessary to do, and it was always clear that we would prefer to err on the upside.

Furthermore, during the exit phase from the crisis, things were always going to get even more difficult.  One uses QE to offset a contraction in the money supply at a point in time when the total money supply is very unresponsive to expansions in the monetary base.  If it works, one of the symptoms of success would be that more normal relationships between the monetary base and broader money would re-assert themselves – so the additional QE we did to avoid the deflation would turn into too much money chasing too few goods and we would get inflation instead.

This much was always to be expected, and as an early advocate of QE (indeed, an advocate of money printing to deal with liquidity traps for many years even before the recession) I have always argued that a symptom of success would be a modest inflation problem on the exit path.

We aren’t there yet.  So far, we’ve only reached the stage of ending up with a tiny bit more inflation during the crisis period than we might have liked.  But the overshoot really is tiny.  We’ve had to quadruple the monetary base during the crisis.  Under normal circumstances that would generate 300% of inflation.  Having only a 1.7% over-shoot – and much of that associated with VAT changes – is the tiniest mis-calibration imaginable at this stage.

With QE2, oil prices have surged back into the sort of spike we saw in 2007-8.  An important element of that is dollar weakness.  Some reflects excessive money creation (absolutely deliberate, this time).  That might get worse in dollar terms, since the US continues to have problems and its hyper-loose policy stance has generated unsustainable booms across much of the developed world.  Dollar volatility is likely to continue for a while yet.

But neither of these is the real inflationary challenge.  That is sitting in the system, waiting.  Once the banks are no longer bust, the huge increase in monetary base will start to circulate more freely, multiplying out into larger and larger rises in broad money, and thence into more and more loans, more purchases, inflation.  I am now less confident than I was that the peak in inflation will be only 6.0% CPI / 10% RPI.  Households have not been panicking enough over the past six months.  Perhaps they will panic a little more when the slowdown or double dip comes – if so, that will be healthy.  For a key challenge for policymakers is that once recovery begins, we will need to be raising interest rates rapidly to above their 5.25% “neutral” level – probably to something like 7.5-8% if we want to keep inflation to only 6% CPI / 10% RPI.  But there is obviously no way to do that as matters stand.  The CML warns that even a 2% rise in mortgage rates would leave 3m people in significant financial distress.  Indeed, in the short term I still believe there is a strong case for loosening UK policy further (via more QE) to offset the fiscal consolidation now underway.

I see that those condemning the MPC for its laxity on inflation are terribly worried about the “morally deplorable” distortion to incentives to save and lend created by inflation, complaining about the negative impact of loose monetary policy and inflation on depositors.  But the truth is that matters have been enormously (unprecedently, outrageously, wickedly) distorted in favour of savers and lenders since 2007.  Banks should have gone bust.  Bondholders (and to a small extent depositors) should have lost some of their money.  Inflation now would not be improperly distorting incentives.  It would be partially reversing the mother of all distortions.  If depositors in banks that wouldn’t have gone bust don’t like it, they should have complained harder about the bailouts at the time.

That doesn’t mean I think we ought to deliberately engineer inflation.  But it does mean that I don’t believe the plight of savers or bondholders should be uppermost in our mind when considering the “evils of inflation”.  Bondholders and savers ought to have lost some of their money in 2007-11 when banks went bust.  The system has worked enormously in favour of the richest 20% (by financial assets) and to the detriment of everyone else in recent years.  They are the last people anyone should be worrying about now.