Let’s recap the way it is supposed to work. The Bank of England (BoE) attempts to control economic activity through interest rates – a cut in interest rates makes spending more attractive than savings and can increase aggregate demand.
But the nominal rate cannot fall below zero. When standard monetary policy hits the zero lower bound central banks can switch from focusing on the price of credit (the interest rate) to the quantity. Since the current rate is 0.5 per cent there is little scope for further cuts, and this is what the Bank has done, with substantial injections of new money in the guise of quantitative easing (QE). Since growth in the money supply is a critical determinant of the general price level, a substantial injection of money will raise inflation expectations. After all, central banks can use their influence on inflation to hit whatever level of aggregate demand they wish.
But although the BoE has begun using QE as a monetary policy tool, it is attempting to do so within the existing regime of inflation targeting.
Inflation targeting goes beyond simply trying to target low inflation. Any central bank can target low inflation. Rather, inflation targeting also involves a focus on transparency and accountability – on providing information to help the public form inflation expectations that are in line with the target. Over a decade of delivering close to 2 per cent inflation has helped keep inflation expectations anchored, and there is evidence to suggest that shocks to the price level have less impact on the economy when that anchor is strong.
The BoE is learning that the work that went into creating that anchor is now hampering its attempts to use QE to move the economy.
QE can only work if inflation expectations are allowed to rise. And guess what: even though inflation is above 5 per cent, the BoE is still committed to hitting 2 per cent inflation and still forecasts that it will return to this level soon. To quote the standard macroeconomic textbook by David Romer, “agents may reasonably believe that the central bank will largely undo the increase in the money stock as soon as it starts to have an important effect on aggregate demand. As a result, expected inflation may not rise, and the open-market purchase may have little effect”. He is talking about Japan, but with Citi reporting that the UK public’s inflation expectations have hit a five month low the basic point is apt – above target inflation makes little difference if expectations remain anchored.
We now have the odd situation where those warning of impending hyperinflation – the sternest critics of QE – provide the intellectual prerequisites for it to work. By contrast, in pandering to those concerns, its proponents ensure that it will not. I would not recommend it, but for QE to work the BoE needs to up anchor and credibly commit to reckless and rampant inflation.
Anthony J. Evans is Associate Professor of Economics at London’s ESCP Europe Business School, and Fulbright Scholar-in-Residence at San Jose State University.
His website is www.anthonyjevans.com.