Readers of this site will know I have long been advocating that the Bank of England cuts interest rates and concentrates on fighting recession. Inflation will fall next year anyway. This has proved contentious with some of my readers. I ask them, how much more evidence do you need of slowdown, how much bigger a fall in property prices, how much more of a squeeze on incomes and lending before you accept that conditions are disinflationary, even recessionary?
Yesterday I was delighted and amazed to read the words of David Blanchflower, Monetary Policy Committee member. He delivered an extraordinary broadside against his own Committee. He accused the Bank of relying on â€œwishful thinkingâ€ in its forecasts, and condemned the whole monetary policy as â€œmisguidedâ€. He agrees that next year inflation will fall, and states â€œ18 months down the road and inflation is going to plummet like a rockâ€. In a now famous remark he said â€œ To sit and worry about inflation expectations and what is going to happen to those, rather than worry about the fact that the economy is going to go into recession seems to be misguidedâ€.
Of course, under the requirements set down by the government to the MPC, they are required just to worry about inflation expectations. Their remit prevents them from considering the impact of their actions on the real economy, unless that has an impact on inflation. For years we have been fed the soundbite that the UK has an independent Central Bank and that is a guarantee of economic stability. The truth is we do not have an independent Bank, and the actions of the MPC have helped destabilise the economy. They kept money too loose allowing a credit binge, and they are now keeping money too tight, assisting a Credit Crunch. They have been aided in this by pro cyclical regulation of the banks â€“ too loose on the way up, too tight on the way down â€“ and by a government which does not seem to understand money markets.
We will now see many of those who have spent the last few years praising the mythical independent Bank demanding a change in its government remit. The truth is that in a democracy if any institution or group of actors gets things wrong and inflicts economic misery on the public, their roles, jobs and remit will be debated and changed. No quango or Bank stays â€œindependentâ€ for long if its actions do not please. The politicians have to respond to the popular anger about failure or mistakes. The government will have to look at adding a requirement to the MPC to consider its impact on the real economy, just as the Fed has to in the USA. In the last quarter the USA produced annualised growth of 3.3% (where are all those pundits who told us the US is in recession now?) whilst the UK slowed to a standstill and Euroland fell. The USA has a Central Bank that has to work with the government to influence the level of economic activity as well as prices. Euroland and the UK have central banks which just concentrate on inflation, and manage to get that wrong.
Perhaps the most important thing David Blanchflower said was â€œWe need to actually get ahead of the game and it appears that we are now behindâ€. Exactly. It is as if all those clever economists have forgotten one of the basic things they teach their students â€“ there are leads and lags in economic policy. Changing interest rates has a delayed effect, as it takes time for all rates to adjust and for banks and borrowers to adjust their behaviours to the new levels. Many people have protection from higher mortgage rates for a period. Larger companies can use interest rate futures to protect themselves for months ahead. Many people and companies have a bit of money for a rainy day, but not enough for a rainy year.
The present high inflation reflects mistakes of the MPC and others a year or two ago. There is nothing the MPC can do in the short term about that. The issue is what are conditions going to be like a year or two ahead? Most commentators agree they will reflect the current squeeze. It is difficult to see inflation staying high against such a background, and strange to see a government and a Bank so keen to intensify the squeeze by most of their actions. The rest of the MPC need to join David Blanchflower, by trying to project themselves into the future. Most of them seem to be at best living in the present, if not stuck in the past. Applying a second load of bolts to the stable door after the horse has bolted wonâ€™t bring it back. The issue is how we get a new horse into the stable in times of slowdown or worse.
I remain strongly of the view that the US has got its policy response right to the Credit Crunch, and the UK is still getting it wrong. It will not be easy for the US authorities to chart a successful course, given the magnitude of the mistakes made on the way up. They still have to contend with a very weak banking sector, with more bad news still to come, and with a very weak property market, which adds to the banking weakness. So much lending is secured against property, so falling property prices undermines old loans and puts people off making new ones. The Fedâ€™s slashing of interest rates helped, but it cannot get all the market rates down in line with its rates, because the banks are short of cash and reluctant to lend. There will be some excitement about a change of President, and the two main candidates seem to be lining up to continue fiscal stimulus to assist low interest rates, with the emphasis on tax cuts to alleviate the squeeze on personal incomes. All that means the US is better placed than Europe.
Meanwhile Euroland remains mesmerised by inflation despite the obvious evidence that the slowdown has now hit Germany as well as Italy and Iberia. Destocking is adding to the woes of companies, as they fight to become more liquid against a backdrop of declining turnover. The UK is going for a huge fiscal stimulus based on increased public spending with revenues falling from the downturn. The fact that the government sector is as overborrowed as the private sector before entering the downturn leaves it in a weak position, at the mercy of the markets. The pound is now falling against the dollar, having devalued against the Euro, increasing the cut in living standards.
(Previous blogs on this topic on www.johnredwood.com include
“Halve interest rates and cut wasteful spending” 18.7.8
“The lies about the EU economy” 14.8.8
“The Bank of England is fighting the wrong dragon ” 9.8.8
“An inflationary or inflammatory letter?” 17.6.8
“Why have the government and the Bank of England failed us on inflation?” 17.5.8)