Huge Risks If Bank Cannot Get It Right on Inflation; ECONOMICS ANALYSIS

The Evening Standard (London, England), May 19, 2009 | Go to article overview
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Huge Risks If Bank Cannot Get It Right on Inflation; ECONOMICS ANALYSIS


Byline: Hugo Duncan

THE question facing the Bank of England this year is: how much money should it print under the quantitative easing scheme, and when should it stop?

Governor Mervyn King and the monetary policy committee are desperate to reverse the economic slump, and prevent a dangerous bout of deflation that could cripple the UK for years.

Figures today showed inflation fell again in April, from its 12-month low of 2.9% in March, and it is expected to head towards zero or even into negative territory this summer, having peaked at 5.2% last September.

In anticipation of this, the Bank has slashed interest rates to record lows and started printing money in a drastic bid to stimulate growth and return inflation to the 2% target.

The actions are unprecedented in their scale but there is no guarantee of success and, if they do not work, it could spell disaster for the UK as well as the reputation of the Bank and its Governor.

On the one hand, too little stimulus could result in a prolonged recession and period of deflation, wage cuts and spiralling debt like that which blighted Japan during its "lost decade" in the 1990s. On the other hand, too much stimulus could see inflation return with a vengeance and force the Bank to raise interest rates at a time when the real economy is still in recession, or only just beginning to recover.

It is a risky balancing act, and one the Bank must get right if it is not to aggravate the downturn or stifle the recovery.

The Bank kicked off quantitative easing in March after rates hit a 315-year low of 0.5% and effectively had no fur-theto fall. It pledged to pump [pounds sterling]75 billion into the economy over three months by buying up assets such as gilts and corporate bonds and this month extended the scheme by [pounds sterling]50 billion to [pounds sterling]125 billion over the next three months.

The timing of the extension surprised many in the City but it should not have done, coming as it did in the same month as the quarterly Inflation Report when the Bank published its latest (grim) forecasts for the economy.

Tellingly, the Bank completes the [pounds sterling]125 billion of asset purchases announced so far in August, the month of the next Inflation Report, so the City would be wise to expect the next significant update to come then, whatever the decision.

There is every chance that the scheme will be extended again to stave off deflation and the Chancellor may even be asked to lift the current limit of [pounds sterling]150 billion, which is by no means set in stone.

But while the Bank and many others in the City do not see inflation as a threat in the near term, printing money inevitably leads to uncontrolled rising prices if it goes unchecked.

The Bank must also be wary of the rebound in the oil price (up from $35 a barrel towards $60 since December), the reversal of the cut in VAT, and higher duties on alcohol, tobacco and petrol.

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