Opinion: Inflation the biggest threat to economic growth

Economic commentators and politicians searching for that most elusive of phenomena – economic growth appear to be operating a back to basics approach. The Bank of England takes the traditional neo-classical approach to its role as arbiter of monetary policy – Quantitative Easing and liquidity schemes to expand the money supply and make borrowing cheaper to incentivise businesses to expand. The government are taking a much more Keynesian route to growth, announcing house building schemes and other infrastructure initiatives in order that the state injects the demand into the economy which the private sector is unable to create.

I have previously written about the ineffectiveness of QE as an engine of growth. The government’s infrastructure initiatives are more welcome, especially as they retain the existing framework of spending cuts, thus trying to manage market confidence and demand at the same time in a way which few governments in the UK have been cogent enough to do over the term of an economic cycle.

But while the Bank of England’s policies and the government’s policies are complementary of each other, one seeking to increase the demand for money-the other for goods-the combined policy approach also manages to both ignore and exacerbate the biggest internal threat to UK growth – that of inflation. Inflation has been consistently above the Bank of England’s own target of 2% for many years – and while it showed some signs of declining earlier this year – inflation rose again in August to 2.6%.

Quantitative Easing from the Bank of England is an upward driver of supply side inflation, while the government’s initiatives as outlined above will add upward pressure to demand side inflation.

These inflationary pressures would be a risk worth taking if the overall drivers of inflation at home and abroad were for a reduction – but the opposite is in fact true. Increases in energy prices in the UK combined with the rise in food prices caused by the current drought in parts of the United States means that inflation is likely to be on an upward curve for some considerable time.

Economic growth at a sustained and significant level, is, I would argue, impossible to achieve if inflation is persistently high. The Bank of England can print as much cheap money as it wants – but if the purchasing power of that money is continually reduced then the central bank are simply throwing good money after bad, no matter how cheap the money is – businesses won’t want to expand if demand is being reduced because the purchasing power of their customers is eroded by inflation.

Persistent inflation may also mean that the funds allocated by the government for its housing and infrastructure projects don’t stretch quite as far as intended, while the second phase of the government’s plan, that the revenues generated for the private sector from the public building programme facilitates demand from the private sector – will be less likely to happen if inflation erodes the worth of the revenues generated by the government’s infrastructure projects.

* David Thorpe was the Liberal Democrat Prospective Parliamentary Candidate for East Ham in the 2015 General Election

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  • David – won’t inflation have a beneficial effect on the debt problem, much as those who bought houses in the 70s are now laughing all the way to the bank? Interested in your thoughts.

  • Bill le Breton 14th Sep '12 - 10:45am

    I suppose that is why the Federal Reserve yesterday announced QE3 as an openend operation, why the S&P500 has risen 2 or 3% on the rumour and a further 2% on the news. An indication that the markets believe as a result of this real GDP will increase. Why they also announced that interest rates will remain low until at least 2015 so that money GDP will rise (also confirmed by the increase in long term rates following the announcement) and reassuring that if firms start investing, if builders startr building they won’t be stung in a couple of months time by interest rate increases.

    Whilst you inflation hawks strangle the UK economy and condemn it to years of stagnation, a Republican Chairman of the Fed has made the re-election of a Democrat President more likely because he believes that deflation is the problem not inflation. It is a funny world.

    So, although the ECB has done it and the Fed has done it … we Liberal Democrats seem still to be siding with the hawks.

  • david thorpe 14th Sep '12 - 12:13pm

    @ Bill

    The markets rise because short term demnad for the assets they hold will rise-they arent interested in the bigger picture-just that asset prices rise because of QE3-not necessarily real growth-mario draghi has acknowledged previously that QE is not a driver of grwoth

  • David Pollard 14th Sep '12 - 1:10pm

    I agree completely with the headline. For a couple of years, wages have been going up less than inflation so people do not have money to spend. Also, the data shows that people are being sensible and paying off debt. As the economy is so dependent on retail sales, there will be no upturn until inflation moderates. Commentators on Bloomberg News are saying that QE just puts up the prices of basic goods like food and oil. If the BOE wants to print money they should hand it straight over to housing associations and/or invest directly in infrastructure projects.

  • @David
    “I have previously written about the ineffectiveness of QE as an engine of growth.”

    Yes, and the balance of the debate in that thread appeared to conclude that while this may be true QE has been effective as a deliverer of increased stability.

    While you balance demand-side and supply-side concerns about inflation, I’m concerned that an approach which doesn’t balance growth with stability simply repeats the events of recent years leading up to the crisis when growth was combined with volatility.

    Is the correct conclusion therefore that the proper response to address underlying volatility caused by misapplied financial regulation is to accept lower levels of trend growth? And if so doesn’t this mean we should be more flexible about inflation targets?

  • Dave,

    Adam Posen’s recent interview on BBC hardtalk included this exchange:

    Stephen Sackur: It seems to me there is a fundamental problem. That is, growth forecasts, inflation forecasts, the gritty data you need to rely on has been consistently wrong over the last three to four years.

    Adam Posen: It has been worse on the growth than the inflation. On the inflation, I and some of the others, have kept focussing on core inflation, which is not the short term noise about this month’s train fare increases or last month’s oil price falls. If we tried to follow that all the time we would just jerk around the UK economy to no good avail. The inflation forecasts we have gotten broadly right frankly. The growth forecasts have been disappointing. That was in part I think because people, not just in the United Kingdom, underestimated how much of a drag austerity was going to be. I have said that from a long time ago. I said from a while ago, whatever its long term merits, austerity was always going to be more painful short term than people expected. And I think that’s a big part of it. And then also obviously the eurozone getting worse and worse and has been a big part of that.

    Stephen Sackur: Now you have already introduced the idea that you were battling some others inside the Monetary Policy Committee particularly on the issue, particularly on how much to loosen monetary policy and in particular on how much to use quantitative easing (QE). Pouring new money into buying government debt. You were on the side of employing it very dramatically and indulging in quantitative easing. Others opposed you. Would it have made a difference if you had won the argument earlier and been more extreme in your QE policies?

    Adam Posen: I do not think they opposed me. They were worried about things that turned out not to be legitimate worries or turned out ex post not to be major worries, like inflation expectations getting out of control. Wages going up too fast. Us getting into credibility problems. All of which proved to be nonsense.

    Stephen Sackur: Well, no they didn’t because inflation went up beyond 5 percent a year ago.

    Adam Posen: Twice it’s got up to 5 percent and come down immediately once the oil price has moved or once the exchange rate has moved. That’s the definition of a good monetary anchor. So when you get buffeted by the storms, you do not move the fundamental economy, you just have a short term buffeting. So the Bank of England and the MPC delivered what it was supposed to on inflation. But when you talk about would it have made a difference if we had moved earlier, I think it would have. I don’t think it would have solved all of our problems by any means. I think unemployment would have been lower. Investment would have been higher. And in particular I would like to think consumption would have been higher over the last couple of years.

  • Richard Dean 14th Sep '12 - 1:56pm

    My impression is that infaltion is actually NECESSARY for growth.

    I don’t know why. But I do notice that, when you look at historical records of an economy that is growing, you often find that the growth is accompanied by significant inflation.

    One reason might be that inflation eats away at savings, so it encourages savers to find and invest in industries that beat inflation.

    Velocity and hystereis might have some bearing there too?

  • Bill le Breton 14th Sep '12 - 3:06pm

    Richard; “One reason might be that inflation eats away at savings, so it encourages savers to find and invest in industries that beat inflation. ” Or just ‘buy it now before it goes up’.

    One hot potato, two hot potato, three: the hot potato effect.

    And Joe helpfully provides the Posen quote, “But when you talk about would it have made a difference if we had moved earlier, I think it would have. I don’t think it would have solved all of our problems by any means. I think unemployment would have been lower. Investment would have been higher. And in particular I would like to think consumption would have been higher over the last couple of years.”

    What Posen might be concluding is that with NGDP back around 5% in mid 2010, had the new Coaltiion team sent a different message to King and the MPC we might have retained that 5% NGDP growth,

    If in year one that had been 1.5% real and 3.5% inflation and then 2.5% and 2.5% we would have had a great deal more tax revenues and a great deal more progress on the defict. Our manifesto position would have worked.

    As it is we are presently setting monetary policy to deliver 1.5% inflation in two years time and 1.8 in three years time. And yippee that gives 0 growth this year and …

    It is not inflation that is suppressing demand it is lack of confidence in the face of still too tight monetary policy and scary austerity talk. Result, the increasing deficit. Repeating the mistakes of the 1930s.

  • david thorpe 14th Sep '12 - 3:26pm

    @ joe

    thanks foer typing all,l of that out…posen is a big fan of QE-and hes right that their estimates of core inflaiton have been nearer the mark.
    There are those who would argue that core inflation is a good measure of discretionary demand-and since core inflaiton has been quite high-its interesting that Posen wishes to continue with more QE
    @ Bill
    The current fashion fior QE was inspired by the doctoral thesis of ben bernanke-who wrote that if more QE had been applied in the 30s the outcome would have been different-so not repeating the nmistakes of the thirties at all.

  • Richard Dean 14th Sep '12 - 4:22pm

    Inspired by a doctoral thesis? Do you know how BAD some doctoral theses are? Particularly ones in economics!

  • Richard Dean 14th Sep '12 - 4:25pm

    No, Bill. “Buy it before it goes up” does not explain why growth over or one two decades is accompanied by inflation over those decades that is in a more-or-less fixed ratio to the real growth.

  • Bill le Breton 14th Sep '12 - 4:33pm

    David, I wrote that Not doing QE is (a la Bernake) repeating the mistates of Japan and the Thirties. It is. And the LIb Dem economic team is complicit.

    What I find interesting is that now I find myself on the same side as 11 out of 12 voters on the Fed and, at long last the ECB, yet there does not seem to be a single member of the LDV following Liberal Democrats who shares my views.

    As Sumner has just posted: It is What it is (in the US):

    * Twelve basis points on the 5 year TIPS spread

    * Two hundred points on the Dow.

    * and the Fed lowers its 2014 unemployment estimates by 0.3% or 0.4%

    That is serious market support. Do the economic Liberals here believe in markets or not?

  • Bill le Breton 14th Sep '12 - 4:44pm

    Richard, when aggregate demand is stuck you need the expectation of inflation to get things moving. Hence the good news above that in the US the 5 year TIPs spread has risen 12 basis points on the QE3 news.

    Just remember what happened to the purchase of stamps when the Post Office gave notice well in advance of its recent price rise. It brought forward demand. If that happens generally (or people expect it to happen) then firms start anticipating it and increasing stocks and bringing forward new projects.

    Fighting inflation the way the Bank of England is (to the extent that it is actually getting the two year forecast under its target) does not encourage anyone to believe that demand will pick up anytime soon. If you want zero inflation you can have it. But you won’t get any growth and you will get increasing debt levels … Japan.

  • Richard Dean 14th Sep '12 - 4:57pm

    Bringing forward demand may work for one-off things like stamps, but does it work for ten or twenty year periods? There’s only a certain number of stamps you can usefully hoard.

    Is inflation really a driver? Rather, perhaps, growth is driven by something else and causes some inflation, so that if you block the inflation you end up blocking the growth?

    Maybe the Professon Ha-Joon Chang can help with some explanations? I read a chapter of his book in an airport shop recently, but didn’t want to carry the weight to the job.

  • Bill le Breton 14th Sep '12 - 5:15pm

    Does it have to work for more than a few months? If money national income is expected to rise it changes everones attitudes; consumers, firms, bankers. The resulting activity becomes a self-fulfilling expectation.

    Expectation in UK at the moment: subdued growth, weak demand. Resulting behaviour: caution, hoarding cash, risk aversion, fear, paralysis.

  • Bill,

    monetary and fiscal stimulus are tools designed principally to correct temporary imbalances in the macroeconomy resulting from supply-side shocks and/or lack of demand in the economy.

    If the current economic malaise is due to lack of confidence to invest/spend than stimulus may be effective in resetting the economy on its trend growth path.

    If however, the problems are principally of a deeper structural nature, then stimulus can only mitigate the effects of a downtum not reverse the trend. We have seen this consistently in the post-war economy as the efects of successive devaluations and reflations have been short;-lived.

    I think Dave’s proposition that persistently high inflation will be a drag on growth is accurate in the second scenario i.e. where our economic problems stem from long term structural flaws. This will be particularly so when you condider RPI inflation (including housing costs) V CPI.

    It is on this basis that I would argue for very substantial investment in housing and economic infastructure projects coupled with the kind of industrial strategy outlined by Vince Cable this week as the appropriate response. This involves both a reorientation of public spending from current spending to capital costs and an intial expansion in QE or public borrowing .

    The paper ‘ Decent Homes for All’ to be debated at conference presents two credible proposals for kick-starting investment in housing:

    “While substantially increasing public sector investment in the present climate may look very difficult, two measures look able to deliver a big impact without damaging control of public borrowing:
    · Adopting public borrowing accounting rules commonly used in Europe so that Local Authority borrowing against the Housing Revenue Account does not add to government borrowing figures – potentially releasing some £50bn investment in affordable housing over time.
    · The Bank of England extending the scope of the Quantitative Easing programme to include purchase of social housing-issued bonds.”

  • Tony Greaves 14th Sep '12 - 9:06pm

    Well I for one agree with Bill le Breton except that I don’t think that QW is the most efficient way of putitn gmore money into the economy which is what is needed. Indeed I don’t think it is an efficient way as practised in this country – all that is happening is that it’s going into the banks’ virtual vaults.

    I asked the government where the extra money from QW was ending up and got a hopeless load of waffle in response which leads me to think they don’t know (or find it too embarrassing to say).

    Tony Greaves

  • The reason for continued inflation and lack of effective consumer spending power in the economy is the fact that, this time round, we are competing not just with Western countries for key resources like oil, metals and food, but also with the BRICS and other emerging economies. Previously, when the west stopped consuming, commodity prices went down, buying power went up and the economy restarted.

    Not this time. The structure of the world economy has changed – painfully for Western countries – and we can no longer expect inexorable rises in living standards like we did in the past. Add to that the need to repay our debts and we are in, in technical macroeconomic terms, a “right old pickle”.

  • Richard Dean 15th Sep '12 - 3:46pm

    All assets deteriorate over time. Physical assets degrade or become obsolete. Inflation makes financial assets deteriorate over time, too. So, an increase in inflation is likely to move money out of financial assets and into physical ones as invstors/savers seek to maximize their returns.

    Which is what Vince seems to have realised is what is wanted.

  • Richard Dean 15th Sep '12 - 3:54pm

    QE is surely an absolute scandal. Initiatives like the Bristol pound show that the country can survive even if the financial system crashes (http://bristolpound.org/). So why should we suport that system to the apparent detrimnent of everyone else?

  • Richard Dean 15th Sep '12 - 4:14pm

    I agree that expectations are important and that we are presently in a self-sustaining slump. Low demand shifts investors’ interests towards buying financial assets, and leads to low tax revenues and a need for governments to borrow more – to sell financial assets. So one thing supports another.

    But if you knock a pendulum sideways, the pendulum will return to its original piosition after the knock ends. Likewise, a short-term financial stimulus will not not necessarily move a stable system out of slump – the system will simply fall back to its equilibrium positon once the stimulus ends.

    To move the pendumul permanantly, the who thing has to be re-oriented relative to earth’s gravity, which baiscally means a fundamental re-design of something. Likewise for the financial system. But what to break and what to keep? There’s a question!

  • Bill le Breton 16th Sep '12 - 5:21pm

    Richard, I find with my beloved tic-tac clock that a little nudge gets the pendulum swinging happily again. http://www.clockwatch.de/index.html?html/tec/hem/rol.htm But it does need that nudge from time to time.

  • Richard Dean 16th Sep '12 - 5:52pm

    But Bill, your clock is ticking slow. Some of the cogs will soon have to be made redundant, others are becoming visibly corroded with lack of use, the central battery will have to expend more energy to keep them turning over, and the while thing will soon collapse like a pack of cards!

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