THE governor of the Bank of England (BoE) has just sent his ninth letter to the chancellor explaining why he and his impressive team on the Monetary Policy Committee (MPC) have failed to meet the two per cent inflation target for yet another quarter. The chancellor will no doubt reply that the contents of the letter have been noted and he is sure they are right.
On Wednesday, Mervyn King announced that inflation, which last month stood at five per cent, “is judged more likely to be below than above the two per cent target at the forecast horizon” (i.e. by the end of 2012). However, if we lift a corner of the duvet on the comfortable, mutually reinforcing exchange of letters, we might ask ourselves what will happen if they are wrong?
If things do turn out different to expectations it will have profound implications for the economy, one of which has been largely overlooked. When King came before the Treasury Select Committee last month, I asked him about the possibility of quantitative easing (QE) not being rent-free – when the time comes to unwind QE and interest rates finally rise quite dramatically, is there not a chance that the BoE could make significant losses on its gilt purchases, selling into a market where bond prices are falling, costing taxpayers dearly? King denied that there could be a loss, telling me: “That, of course, will be exactly offset by the mark-to-market profit or loss that the government has earned on issuing those liabilities, because this is not the public sector issuing a security to the private sector, where there is a gain and loss between the two sectors. This is entirely within the public sector.”
Yet this does not look like a matter of simple book-keeping, with assets and liabilities being swapped between the BoE and the Treasury, because the gilts have been purchased in the market and are therefore subject to market forces. It is clear from talking to other people close to the BoE that there is a division of opinion between those who agree with King and those who share my concern. The BoE needs to address this as a matter of urgency. What is the potential financial impact on the taxpayer of unwinding QE? Answers on a postcard please.
Also, the longer-term merits of QE are far from clear. It is an odd thing that while the Eurozone finds itself in existential crisis, the Germans cannot bring themselves to encourage the European Central Bank (ECB) to print money. No doubt they are mindful of the lesson of the Weimar Republic, which raised 50 per cent of government spending that way and saw the mark become worth a trillionth of its 1914 value in 1923.
So why do we appear to take it for granted that QE is a “free option” that will not have an inflationary effect on Britain’s economy? King acknowledged to the select committee that “any monetary policy easing is going to have the effect of expanding demand, output and ultimately inflation.”
Whether things really would have been worse without QE can be classified, in Rumsfeldian terms, as a known unknown. What worries me is an apparent lack of assessment of the possibility that taxpayers could lose money when QE unwinds and the fact that we do not know just how big that loss, or how big the longer-term impact on our economy, could be.
Andrea Leadsom is MP for South Northamptonshire and a member of the Treasury Select Committee.