A looming crisis

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John Maynard Keynes said that “not one man in a million” was able to understand the process of inflation. If we are to give credence to Keynes’ view, it appears that the Governor of the Bank of England Mervyn King is certainly no exception.

In January 2011 the inflation rate was above the Bank of England’s target range for the 13th month running, requiring King to write an open letter to Chancellor of the Exchequer George Osborne explaining why. As in his November 2010 letter to the Chancellor, King blamed a number of “temporary effects”, namely “the rise in VAT relative to a year ago, the continuing consequences of the fall in sterling in late 2007 and 2008, and recent increases in commodity prices, particularly energy prices”.

One could be forgiven for detecting a certain sense of déjà vu here. In November’s letter King blamed the failure of the Bank to meet its inflation target on “temporary influences” including “the restoration of the standard rate of VAT to 17.5% in January, past rises in oil prices and the continued pass through of higher import prices following the depreciation of sterling since mid-2007”. Indeed, looking back at his letters from August, February and May last year, we see VAT rises, oil prices and depreciation as the villains of the inflationary piece back then as well. We also find a similar reassurance that they will only have a “temporary impact” (August 2010), are a “short-run factor” (February 2010), or will be “temporary effects” (May 2010). Temporary seems to be a long time in King’s economic thinking.

The truth is that the monetary policy of the Bank of England is itself inflationary. Interest rates were slashed from 5% in September 2008 to an unprecedented 0.5% in March 2009. When you stop to think how this works it’s obvious that inflation will be the result.

The interest rate is the price of money. Like any price it is determined by supply and demand factors. If you want to reduce the price of something, in this case the interest rate, you supply more of it, in this case money. Via Open Market Operations central banks buy bonds from commercial banks and pay for them with newly printed (or digitally created) cash thus lowering interest rates. But, obviously, if the amount of money sloshing around in an economy increases at a greater rate than the amount of goods or services in it the prices of those goods and services will rise, creating higher inflation. Quantitative easing has simply poured more fuel on the smouldering inflationary fires.

This inflationary monetary policy risks torpedoing the coalition government’s economic strategy. The whole point about the austerity drive is to try and keep private sector borrowing costs down. Following the crowding out theory of government spending, there is held to be a fixed amount of money which can be borrowed at any one time. The more demand there is for this money then, like anything else, the higher the interest rate or, to repeat, its price. By restraining government spending, demand for these funds will be lessened and the price (interest rate) will fall.

This could be negated by the Bank’s monetary policy working via another economic mechanism, the Fisher Effect. If inflation is at 5% over a year then £100 lent to on January 1st will be paid back on December 31st with £100 but, crucially, it will only be able to buy the equivalent of £95 worth of goods today having lost 5% of its value. To compensate for this a lender charges 5% interest on the loan so that she is repaid £105 on December 31st which buys the same amount, £100 worth, of goods today.

If, however, inflation rises then so does the interest rate to protect the purchasing power of the loaned money. Thus, the important interest rate in an economy is not the nominal rate but the real rate which is the nominal rate minus expected inflation. From this we can see that the nominal rate is the real interest rate plus expected inflation. This is the Fisher Effect. A rise in expected inflation caused by the Bank of England’s loose monetary policy will lead to a higher nominal interest rate negating any effects of the coalition’s austerity drive.

Markets are already upping their inflation expectations and charging more to lend. In six months the yield on 10 year Treasury gilts has risen 1% to 3.87%. In so far as the Bank of England’s inflation erodes government debt George Osborne might be secretly grateful for these figures on the one hand. But, on the other, if inflation causes a spike in interest rates undoing the coalition’s work, the Treasury will be gunning for the Bank.

This article originally appeared at Global Politics

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