Does Britain have a problem with inflation? Last week, the Office for National Statistics (ONS) announced consumer price index (CPI) inflation remained at 3.1% in September, once again above the Bank of England’s target.
However, most central bankers and economists are not recommending interest rate rises. A common view is that inflation will fall as government cuts kick in, private sector growth remains weak and value added tax (VAT) stabilises after its recent rise.
Given the deleveraging still facing Britain, economists such as Neil Williams at Hermes Fund Managers and James Dowey at Neptune Investment Management say the dangers of excessively low inflation persist. They say debt deflation, where real servicing costs rise as deflation takes hold, could be ruinous. Any increase in money supply growth from low levels – 1%, according to a key measure used by Pimco – would help inflation overcome longer-term headwinds.
”Economists who advocate a strict control over the money supply warn quantitative easing is hard to control”
To fight these perceived deflationary pressures, Britain and America are likely to embark on a second round of quantitative easing, or QE2, which will entail printing money and giving it to institutions in return for financial instruments. Theoretically, this boosts demand for financial assets and helps their owners and issuers with their balance sheets. The new money can then be diverted into the real economy.
Economists who advocate a strict control over the money supply warn quantitative easing is hard to control. Printing money has, in many cases, produced catastrophic long-term inflationary effects as it increases the supply of a currency and reduces its value and buying power.
Advocates of quantitative easing, however, argue the money can be withdrawn from the system later by selling assets for cash, relieving any inflationary pressures if easing overshoots.
Although neither Williams nor Dowey expect QE2 to create an inflationary problem in Britain owing to the difficult domestic outlook, Dowey fears it could create an inflation problem elsewhere, which could have an indirect effect on the British economy. (article continues below)
Institutions with billions of new pounds or dollars on their balance sheets are less likely to lend them out to the developed world, which Dowey says has poor growth prospects and is deleveraging. One play is to inject them into emerging economies, where demand for credit is rising and growth is strong.
Inflation, however, is already high in parts of the emerging world, such as India. Strong GDP growth and wage growth in key regions such as China make developing markets particularly susceptible to massive capital inflows. On its own, Britain’s quantitative easing may have little effect in the emerging world but, with massive American QE2, it could cause problems.
The most immediate difficulty is commodity inflation. Commodity markets are global, and inflationary demand from the emerging world would push up prices everywhere, including in advanced economies.
However, as Dowey and Williams both point out, this could hurt British retailers or corporate consumers of those commodities, rather than push up inflation. Retailers may be forced to buy the commodities at high prices and sell goods and services at low margins because wage growth is sluggish and customers cannot afford higher prices.
Perversely, Dowey says, the effect could be disinflationary because retailers would be forced to cut costs and shed jobs. However, the latest official figures show that prices of selected commodities, such as meat and fruit, still rose in September despite a poor economic outlook, although others, such as fuel prices, fell.
The second problem for Britain relates to bonds. If the country avoids excessive inflation, British investors may be relatively happy holding and refinancing domestic state debt, most of which pays out a coupon that does not rise with inflation.
The argument for government debt has become increasingly convincing as the private sector offers only limited opportunities and the British government is reducing its deficit. If overseas investors experience high inflation, however, the case for holding British government debt at low yields diminishes, as they would deliver a negative return when adjusted for inflation. As international investors meet a significant part of Britain’s financing needs, overseas inflation could hamper the outlook for the British government and hence for the economy. Dowey points out that cuts in the British deficit mean Britain is less dependent on foreign creditors. But the risk of a state debt sell-off persists.
The risk is potentially most pronounced with the government debt of America, still a key component of the world economy and hence a vital driver of Britain’s.
Economists such as Paul Krugman, an American Nobel laureate, see quantitative easing not just as a means of stimulating money supply in America, but of forcing down the value of the dollar, which the Chinese government has kept artificially low against the renminbi by selling its own currency and buying America’s.
Holding down the dollar would make American exports more competitive, but it could dent areas of the domestic economy such as retailing, which rely partly on cheap goods manufactured in emerging markets such as China.
Where inflation is concerned, however, the effect is clearer. Commodity futures are denominated in dollars, meaning nominal prices are likely to rise if the value of the dollar falls. Although rising currencies in the emerging world could help mitigate inflation in local currency terms, they failed to prevent it when inflation last rose rapidly, during 2005-08.
Inflation could also make it less financially attractive for emerging world investors to add to and refinance their enormous stock of American government debt, which is sitting on extremely low yields.
The International Monetary Fund has warned repeatedly of the damaging macroeconomic impact of these “currency wars”. But as key central banks such as Britain’s have solely domestic remits, discouraging them may prove difficult, especially if their home countries do not directly experience any immediate impact from extraordinary policies such as QE2.
Although inflation may yet remain low in Britain, the effects of overseas inflation could prove severe.