Quantitative easing, inflation and the pound

After the Coaliton government formed and made clear its intention to cut the deficit further and faster, the pound has risen. This will start to cut the high inflation rate the old policy of devalue, print and borrow was bringing about. The main inflationary force was the falling pound.

It is true there remain two other inflationary forces at large. Rising taxes will add again to price rises when the new VAT rate comes in – but we did have the same effect this year which is already in the figures. There is also some inflation developing in manufacturing, as the world’s supply lines and capacities are already stretched a bit by the surge in Asian activity over the last year. It is now in many areas a global market.

I do not recommend any more quantitative easing as some of you seem to think I want. I criticsed the way they did that last time and forecast it would lead to a weaker pound and faster inflation. I do want functioning banks that lend to smaller borrowers on the High Street. The international regulators have started to back off, as I hoped. They do seem to be realising that demanding more cash and capital too soon will prevent decent recovery and impede the restoration of bank balance sheets as well.

Boom and bust are largely manufactured by governments and monetary authorities. The last boom was made from lax cash and capital rules and easy money policies. The last bust was made from too sharp a tightening of money markets and expecting too rapid an improvement of bank balance sheets after the excesses. Now we need to get it right to have the right pace of recovery. That requires the authorities to move on from austerity mode, but not to pump up more devaluation and inflation from simply printing public sector money and spending it on more quangos and CEOs.

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31 Comments

  1. Ian Jones
    Posted August 3, 2010 at 8:40 am | Permalink

    Headline this morning about highest inflation in wheat prices since 1973 not to mention other commodities. We are at the bottom and already have inflation, once the economy takes off the Bank of England will be struggling to suck out all the excess cash its created via QE. Whats the betting they get the timing wrong…..

    Real interest rates are currently -4%…….. boom and bust will be the way forward from now on.

  2. Alan Jutson
    Posted August 3, 2010 at 9:01 am | Permalink

    So the Banks balance sheets are getting stronger.

    What a surprise, since they have increased their margins by 300%.

    Any business which has no real competition, and can increase its margins by the amount the Banks have been able to do for the past 18 months, would surely be in the same position.

    The Banks balance sheets are stronger, because the savers and taxpayers have funded it,

    Time was when business could borrow at 2-3% above base rate, now its more like 8-9%.

  3. waramess
    Posted August 3, 2010 at 9:04 am | Permalink

    This economy is held together by low interest rates and money printing, both of which have to be reversed at some point.

    The greatest danger is of course interest rates which will need eventually to be raised, and then we will see whether the economy is robust enough to sustain the banking sector in particular.

    For the time being our banking sector is sustained no, thriving on, low interest rates and many of our large companies are held together by a combination of low interest rates and the effect of money printing. When that stops the recession will continue to its conclusion and the fallout in terms of the banking sector, the business sector and unemployment will be terrible.

    Keynesian madness will have delivered this to our door and will have magnified the original recession out of proportion to that which we might have expected.

    Inflation is not the thing to worry about at the moment, worry more about how we might escape from the deflationary mess brought about by the great and self appointed Saviour of the World who left us with so much debt we will have no choice next time but to let the banks go bust.

  4. Norman
    Posted August 3, 2010 at 9:23 am | Permalink

    A sensible position and let's hope the government will adopt this strategy.

    Banks are in business to make money, they will lend to whom will make money for them. HSBC announced great results as it has been investing heavily in Asia. If the government wants banks to lend to British businesses they must allow British businesses to be competitive so that banks see them as a viable return.

    Less regulation and taxation is definitely the road to go, government mandating to whom and how much banks should lend, based on 'bonus hysteria' is a recipe for disaster.

  5. Max Van Horn
    Posted August 3, 2010 at 9:27 am | Permalink

    John..watching the train wreck that masquerades as the European and US economys, I've been having serious doubts about the moral and economic legitimacy of fractional reserve banking.The creation of interest bearing virtual money times the money multiplier seems to have led us into this mess, especially when combined with highly leveraged investment strategies.Can you honestly put your hand on your heart and say that frb is really in the public interest.

  6. Tim Carpenter
    Posted August 3, 2010 at 10:10 am | Permalink

    As you say, boom and bust are manufactured by governments and monetary authorities. The way to avoid that is, then, to take away the monopoly over legal tender, so enabling other organisations to compete with their own currencies.

    The State, BoE and the Pound would still exist, but the monopoly would be gone, so exposing the Pound to market forces, making any attempts to devalue (i.e. defraud savers) rapidly felt as individuals go elsewhere. Newcomers would also have to be scrupulous in managing their money supplies lest people abandon their currencies too.

    I know the State will hate the idea of losing the ability to impose stealth taxation via the printing of money, but, tough, frankly.

  7. Huw Clayton
    Posted August 3, 2010 at 10:32 am | Permalink

    There is a third inflationary force. International harvests are likely to be poor this year – ours will probably be truly dire due to the dry weather we've had – and that will see food prices increase. In fact, they have already started edging up.

    It's more likely to badly affect people on low or fixed incomes (e.g. me) who spend the majority of their income on food, than most of your readers, but they will probably notice a gradual increase in their household expenditure over the winter as shortages make themselves felt. To what extent this fuels inflation depends a little on how bad the shortages become, but it may be a factor.

  8. Jonathan
    Posted August 3, 2010 at 11:42 am | Permalink

    Mr Redwood,

    As I understand it, QE is a form of monetarism that seeks to achieve a negative interest rate and therefore is in theory in line with Conservative thinking on economics.

    If fiscal tightening and a strengthening pound lead to inflation undershooting the target, would QE in a different form than that previously carried out be worthwhile? eg. QE money being distributed direct to individuals and companies rather than the banks, who would then have to compete to get this new money.

    • StevenL
      Posted August 4, 2010 at 8:16 pm | Permalink

      Milton Friedman advocated what we now call QE as the solution that would have stopped the 1929 crash becoming the Great Depression. Japan listened to him after their bust, they didn;t have a Great Depression, just a 'lost' decade and a half of zero interest rates, debt deflation, zombie banks and money printing.

      If you print money and give it to individuals, they will either spend it or save it, someone somewhere down the line will save it or buy assets with it. If they save it as a bank deposit then the bank has a new liability and needs to do something with this money (i.e. lend it out).

      Money printing of this nature will increase people's inflationary expectations, so more than likely people will want to borrow it to buy houses, gold, stocks and just cause another asset price bubble. When it bursts the banks will have to write all the loans down etc again and we're back to square one aren't we?

  9. Disco Biscuit
    Posted August 3, 2010 at 12:56 pm | Permalink

    Is it possible that we haven't yet seen the inflationary effect of quantitive easing, John? I'd have thought the lag in money-supply inflation would mean we haven't… Meaning we've yet to see the worst of Brown's economic catastrophy.

    • Steve
      Posted August 4, 2010 at 2:21 pm | Permalink

      Yes, that's right, it's all to do with a somewhat obscure economic concept called the velocity of money. Please everyone, read all about what a disaster we are facing if the BoE doesn't start unwinding it's massive expansion of the money supply.

      Read this: http://www.telegraph.co.uk/finance/comment/ambros

      • Sally C.
        Posted August 5, 2010 at 9:48 am | Permalink

        Thanks for that link. 'Japan was the world’s biggest external creditor when the Nikkei bubble burst twenty years ago. It had a private savings rate of 15pc of GDP. The Japanese people have gradually cut this rate to 2pc, cushioning the effects of the long slump. The Anglo-Saxons have no such cushion.' Quite right. Gradual erosion of savings will be the inevitable outcome of keeping interest rates so low for a long time. The other side of the same coin is the temptation to take on more debt. The coalition government is now complicit with the B of E in encouraging people to take on debt by keeping Base Rate too low.

  10. Steve
    Posted August 3, 2010 at 1:25 pm | Permalink

    Spot on, John, but has Mervyn King understood this? He's recklessly mouthed off far too many times as soon as the pound has shown any signs of recovery. And what is he doing still in his position, as the biggest failure in the BoE's history? Please talk to Mr. Osborne about replacing him with somebody who actually knows what he's doing. King has been a disaster, Andrew Sentance appears to be the only MPC member who has any grip on what is happening. Surely it's high time to get rid of NuLab's docile pro-inflation placemen on the MPC?

    • The Squeeze
      Posted August 4, 2010 at 8:19 pm | Permalink

      I don't understand how King has got off scot free either.

  11. Bernard JUBY
    Posted August 3, 2010 at 2:12 pm | Permalink

    Who on earth coined the phrase "quantitative easing" when all that it meant was a euphemism to print money and thus create a further twist to the inflationary spiral? Just like the phrase the spin-meister who coined it should be shot!

  12. Michael Lewis
    Posted August 3, 2010 at 3:12 pm | Permalink

    One of the reasons why I accepted a job offer overseas was because of the way the MPC in this country has wilfully avoided tackling inflation. Quantiative Easing is simply theft: savers are taxed and the money given directly to borrowers. It will create more inflation. The MPC -will- engage in more QE. All to keep asset prices – mainly houses up. Nominally they will succeed. The value of Sterling will plummet. The chancellor's response to Mervyn King was limp at best. The UK has been way over inflation target for months – trying to inflate the debt away, to the cost of UK savers, pensioners.
    The coalition government is complicit in this theft if it does not require the MPC to stick to its target. If inflation is over target for months, they should raise rates. The excuses will wear thin for many people….

    • The Squeeze
      Posted August 4, 2010 at 8:21 pm | Permalink

      But what could possibly be more important than making house prices rise against sterling?

  13. Demetrius
    Posted August 3, 2010 at 4:54 pm | Permalink

    The whole situation is now so delicately balanced that it will not take much to provoke a major reaction. Large amounts of QE could now do this.

  14. Mark
    Posted August 3, 2010 at 5:46 pm | Permalink

    Debate is slowly moulding opinion. I note that even Peston has finally been converted to the idea of principles based regulation, as used to be practised by the Bank of England before Brown interfered. However, the new EU bank regulator and the Basel III committee clearly have other ideas: more power ceded leaving Osborne in the role of Canute, as you recently pointed out. Footnote: it is fatuous to see RBS fined for failure to follow the money laundering regulations despite no evidence of money being laundered being presented, while ignoring the many other failings of that institution that should have seen their banking licence revoked or at least curtailed several years ago.

    Mere discussion of the possibility of more QE in the USA has seen the dollar crash towards 1.60 $/£. That should be warning enough that the policy should continue to be avoided here. It was encouraging to see that now two MPC members are minded to vote for a rise in base rates – a step towards better solutions that will encourage markets to consider the possibility that bailouts are not forever.

    The main problem for UK banking remains its reliance on bubble property prices for profitability. This is not sustainable, and is costing taxpayers a huge fortune in the subsidies that are being used to delay the inevitable. Banks need to address this problem by using their excess capital to write down loans and let the bubble deflate. At present they are able to generate about 3% of assets per year as excess capital, as the recent BoE stability report revealed – in line with the subsidy between the 0.5% bank rate at which they are presently able to fund mortgages and the 5% they charge the typical mortgage customer.

    The more realistic their loan books become, the greater the chance they will be able to secure funding to replace the Credit Guarantee Scheme and Special Liquidity Scheme, and to roll over commercial wholesale funding. That would also enhance their ability to lend to small business and industry too. The sums likely to be required are minuscule alongside mortgage borrowing, or even the annual government deficit. But there is little point in pushing on a string, and trying to ram borrowing down the gullets of those who do not see that borrowing will generate a good return. That requires creating the right conditions in terms of lower burdens of tax and regulation and lower energy costs that will help to make British businesses internationally competitive, whether for import substitution or exports.

  15. DBC Reed
    Posted August 4, 2010 at 7:42 am | Permalink

    Another reading of the data is that the international markets (why are we governed by them?) have not been spooked by Quantitative Easing which has in part re-capitalised the banks.Now the condition of the banks is non-terminal there is no reason whatsoever not to use QE to finance the public sector: teachers and nurses ,not quangos which as I remember was a Conservative wheeze to "lend the public sector private sector expertise".

  16. Mark
    Posted August 4, 2010 at 1:48 pm | Permalink

    I find it deeply worrying that Cameron is reported to have instructed Mervyn King to inflate the housing bubble again by encouraging more mortgage lending. Doesn't he understand that the housing bubble is the source of our problems?

    • StevenL
      Posted August 4, 2010 at 8:26 pm | Permalink

      Ah, but MP's are mainly mulitple property owners. They tend to have interest only mortgages (because that's all their expenses cover) so need capital growth to get rich.

      • Mark
        Posted August 5, 2010 at 11:37 pm | Permalink

        Leaving aside those with a BTL portfolio such as Chris Huhne, the rules have now been complicated like this:
        http://www.ipsa-home.org.uk/cgt.html

        MPs have until September 2012 to convert their second homes into rented properties. It is unclear from the provided examples whether IPSA will compensate them for a capital loss, although the logic of calculation suggests that it could be possible.

        More salient is the fact that many MPs (including most of Labour) consider that rising house prices are "good news": indeed, Brown and Darling constructed a mini house price boom timed for the election. I'd call that papering over the cracks: the rot will soon show through, and be worse the longer it is left untreated.

  17. EJT
    Posted August 4, 2010 at 2:15 pm | Permalink

    Does anyone know what % of the UK's QE has been the purchasing of commercial paper, and what % government bonds ? The latter is government effectively printing money, but saying we're not printing money, we've loaned it to ourselves (ex-nihil) ?

    • Mark
      Posted August 4, 2010 at 9:09 pm | Permalink

      It's almost exclusively gilts. The reports here are helpful:
      http://www.bankofengland.co.uk/publications/other

      • EJT
        Posted August 6, 2010 at 12:37 pm | Permalink

        Many thanks, Mark. I suspected this, not did not know it. IMHO, this is not a fact that can be left out of a discussion of QE.

  18. christina sarginson
    Posted August 5, 2010 at 8:31 am | Permalink

    I have been around a long time and although economics is not my forte I have seen the results of the boom and bust situations. I dont want that to happen and just hope all the powers in the Government know what they are doing, I will watch with interest

  19. Kevin Peat
    Posted August 5, 2010 at 7:17 pm | Permalink

    Dear Ms Sarginson

    I meant to give you a negative mark on your EU comment but gave you a positive by mistake.

    I like your comment here but have given you a negative mark to restore the Cosmic balance. You seem reasonable enough to understand why I feel compelled to do this.

  20. Tom K
    Posted August 6, 2010 at 12:08 pm | Permalink

    I don't read the word 'savers' anywhere here. The profligate – be it bankers or those who overextended themselves with silly mortgages or who re-mortgaged to fund an extravigant lifestyle – are being bailed out by these low interest rates and debt-eroding inflation, where prudent savers are made to suffer negative returns.

    Interest rates should go up as soon as possible. With inflation sitting between 3 and 5 per cent (depending it's counted) for months on end, it's a scandal that it hasn't already.

    We didn't elect a Tory government for it to sit on its hands and do nothing but that's exactly what is going on.

  21. Lindsay McDougall
    Posted August 8, 2010 at 10:49 pm | Permalink

    If a government wants to reduce its debts, it pays to create an inflationary boom and pay off debt in clipped coinage. How do I know? Because there were two years in the late eighties when the PSBR was replaced by a PSDR (public sector debt repayment). This was done by a Conservative government and Nigel Lawson knew exactly what was going on. Perhaps, though, the world is a little wiser and we would not get away with it again.

  22. John Cardy
    Posted August 28, 2010 at 12:06 pm | Permalink

    John, you are the first commentor I have seen who can see that Inflation is directly caused by the policy of devaluing the pound.

    The claimed reason for the policy was to help Exporters, but I dont think the BOE really understand the extent of interconnectivity in todays world, as so much even of Uk produced products are sourced from the Far East as components.

    Eventually the BOE will realise that interest rates have to go up.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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