most recent Monetary Policy Committee (MPC) minutes suggested that the Committee may be moving towards injecting more stimulus into the UK economy by restarting its policy of Quantitative Easing (QE). This would be a big mistake. It would confirm what many are beginning to suspect – that price stability and the 2 per cent inflation target are no longer the key objectives of UK monetary policy. And it would do little to support growth when the squeeze on consumers from high inflation is itself one of the biggest impediments to the progress of the UK economy in the short-term.
The case for injecting more stimulus into the UK economy rests on relatively disappointing GDP figures over the past year, which has reignited worries about future growth. This partly reflects a softening in the global growth trend – though the latest IMF forecast still suggests that the world economy will grow by 4 per cent this year and next, after expanding by over 5 per cent in 2010.
At home, the main factor holding back economic growth is the squeeze on consumer spending from rising prices – with consumer price inflation now at 4.5 per cent and set to rise further in the months ahead. The latest retail spending figures show this very clearly. In money terms, retail spending is up a respectable 4.5 per cent over the past year, and with inflation around 2 per cent this would have been associated with healthy increases in sales volumes. But all of this increase in money spending is now being swallowed up by price rises. This leaves consumers no scope to increase their spending in real terms and support the growth of the economy. In other words, high inflation and slow growth are inextricably linked.
The MPC believes that this rise in inflation is temporary. But if that is the case, there is no need to provide extra stimulus to the economy, as a fall-back in inflation next year will allow the growth of consumer spending to resume.
Worryingly, there are signs that relatively high inflation may persist into next year and beyond. Services sector inflation – which accounts for about half of the consumer basket – has been stubbornly high in the UK since the late 1990s, and continues to run above 4 per cent. In addition, the weakness of the pound against the dollar and the euro is pushing up the cost of goods imported into the UK – much more so than in other countries. Unless the pound begins to recover, particularly against the euro, we are likely to continue to experience high imported inflation.
MAKING THINGS WORSE
The injection of more stimulus through QE is likely to make this problem worse by further weakening the pound. It would reinforce the expectation that the MPC has a very dovish stance and will be reluctant to raise interest rates for some time. And the direct effect of more money creation in the UK is likely to depress sterling by boosting the demand for foreign assets as investors rebalance their portfolios.
In the short-term, the impact of QE on the value of the currency would therefore simply prolong the pattern we are now seeing – of high imported inflation squeezing consumer spending growth. There is likely to be little offsetting benefit to the manufacturing sector, which is already highly competitive at the present value of sterling and where capacity pressures are already beginning to emerge.
In addition, there are two longer-term dangers of a policy of injecting more stimulus in the current environment. The first is that the experience of high inflation continues to push up wage increases – which are now running at over 3 per cent in the private sector. Against the current background of weak productivity growth, a further drift upwards in pay growth to 4-5 per cent would not be consistent with 2 per cent inflation in the medium-term.
The second risk is to the credibility of the MPC itself. The purpose of having an independent central bank is that it is prepared to take tough decisions in defence of its core mandate – price stability. There has been little evidence recently that the MPC is prepared to do that. In the second half of last year and early this year, the Governor and other senior Bank officials resisted a rise in interest rates to head off the current surge in inflation.
A further round of QE in the current circumstances would provide fairly clear confirmation that the MPC has an inflationary bias, and is much more prepared to tolerate inflation above the target than below it. This would be a bitter blow for all those on fixed money incomes – especially pensioners living off their savings – who had put their trust in the price stability mandate of the Bank of England.
This autumn, there is an opportunity for the MPC to give a clear signal that they are not sliding down the slippery slope to a high-inflation future. The Committee should turn its back on the siren calls for more stimulus and focus on its core remit of price stability.
Dr Andrew Sentance is a former member of the Bank of England Monetary Policy Committee. His website is www.sentance.com.