Last August, in The Spectre of Inflation, I argued that the remarkable stability of prices in the past 25 years was due to central banks having operational independence and conducting monetary policy with a fixed inflation target of two per cent. While respondents and others put forward a variety of views, all recognised that a surprise increase in inflation would carry a real economic cost, create an arbitrary redistribution of income and be socially disruptive. In other words, inflation which takes off is bad and should be avoided.
For the immediate future, there is little prospect of serious inflation in the UK. Inflation is a dead issue. The implied inflation rate in financial markets in the UK, US and Euro area in 10 years time is less than two per cent. The policy priority is preventing a rise in unemployment.
While inflation may be dead in the short term, the prices of hedges against inflation, such as gold, silver, commodities, bitcoin, houses and art are high, some close to all-time highs. Despite recent setbacks, stockmarkets have risen remarkably throughout 2019. House prices in many countries have been rising. In Britain, partly aided by the stamp duty “holiday”, they are near an all-time high, in the US they are up by 5 per cent, in Germany 11 per cent.
This raises the question “Will Covid-19 kickstart inflation?” This is based on three concerns.
First, governments will find it challenging to finance their staggering deficits through a combination of greater borrowing and higher taxes.
Second, central banks will be under great pressure to keep interest rates low and continue with aggressive monetary easing, so allowing the monetary aggregates to expand excessively.
Third, there is concern that the institutional framework in which monetary policy is conducted may not be strong enough to weather the coming storms.
Balancing the books
For the past decade the coalition and Conservative governments have been severely criticised for pursuing a policy of austerity. They have targeted and succeeded in reducing the public sector deficit, as well as the borrowing requirement as a percent of GDP, year on year. Following the December 2019 election, austerity was discarded and the government committed to increase public expenditure on infrastructure, the NHS, schools, training and levelling up the North of England. As a result, in March the forecast for annual borrowing increased to £55 billion.
Covid has completely changed the story. During the first lockdown businesses were forced to close, output fell rapidly and with it tax revenue. The expensive furlough scheme to protect jobs was launched. According to the Office for Budget Responsibility, borrowing is expected to rise to a staggering £372 billion for the year, seven times greater than expected and way above the peak of £160 billion following the 2008 financial crisis. Far from being criticised for this, the Chancellor of the Exchequer, Rishi Sunak, has been applauded for an emergency, wartime and successful response to prevent mass unemployment.
The options now facing the government to balance the books and pay for extra spending are limited. It could rely on future growth providing increased tax revenue, but this is something over which it has little control. It could cut existing expenditure programmes, which it is unlikely to want to do because most are manifesto commitments. The options then left are raising taxes, borrowing more on the capital markets or allowing inflation to rise. The one unthinkable option would be to default on existing borrowing.
We know from history that serious inflations arise from the inability of governments to raise taxes or borrow to finance extra expenditure. This was true during the French Revolution, Germany in 1923, Hungary in 1946, Chile under Allende in 1973, Zimbabwe in 2008-9. We are nowhere near this and the chances of it happening are remote.
We also know that while a fiscal deficit is neither a necessary nor a sufficient condition for inflation to take off, the fiscal position is not irrelevant to a government’s ability to control inflation.
It is instructive to look at the evidence the last time that inflation took off in the UK in the early 1970s. A study by the Institute for Fiscal Studies shows that public sector net borrowing increased each year over the period, so that by 1973 the deficit was back to 1967 levels. In spite of the economic boom and the increased tax revenues it provided, public sector borrowing reached a post-war high in 1975 of 7.3 per cent of GDP (Figure 1).
Figure 1: Public sector net borrowing
The intention of the Heath government (1970-74) was to keep interest rates low in order to encourage business investment, extend home ownership and strengthen the economic recovery. While the government allowed public borrowing to increase year by year from minus 1.5 per cent to plus 6 per cent of GDP, the fact that interest rates were not raised was one significant factor accounting for the Bank of England’s failure to control money supply growth.
Because of the scale of the deficit the danger is that the public finances will spin out of control. Despite the operational independence of the Bank of England, including independent members of the Monetary Policy Committee (MPC), the money supply grew in the 12 months to August 2020 by £297 billion (12.5 per cent) of which the net contribution of the public sector was £244 per cent, namely 82 per cent. The leading independent economist, Peter Warburton’s conclusion is that this is monetary finance. “The convention has been to issue debt to the equivalent extent of the budget deficit but because this debt is being absorbed substantially by the Bank it has a monetary effect.” As a consequence I cannot see any fundamental difference between primary financing of government deficits, where the central bank prints money directly, and quantitative easing (QE), where it does it indirectly.
To get public spending under control is a formidable political challenge at a time when public expenditure will rise because of rising unemployment benefits, the uprating of pensions, further expenditure on health, social care and support for businesses to stave off insolvencies.
In addition, the Bank of England and the Office of Budget Responsibility have recognised that interest rates may not remain at this ultra low level indefinitely. When interest rates start to rise, servicing the debt will become a significant item of public expenditure. Already this is £40 billion, greater than the defence budget.
The good news on the fiscal front is the commitment of the Chancellor of the Exchequer that the government has “a sacred responsibility to future generations” to leave the public finances strong and that through careful management the government “will always balance the books”.
Aggressive monetary easing
At present the world’s leading central banks – the Bank of England, US Federal Reserve (the Fed), European Central Bank (ECB), Bank of Japan – are all in the process of what they officially term “aggressive monetary easing”.
Official central bank interest rates have been reduced to an all-time low, in order to reduce the cost of borrowing, stimulate household spending and business expenditure on new capital investment. Having reached the lower limit through conventional open-market operations, central banks have implemented unorthodox monetary policies. All have bought government bonds through launching a QE programme, as well as purchasing corporate debt. The Bank of England’s Asset Purchase Facility, the vehicle through which QE is conducted, now owns about 40 per cent of the stock of conventional gilts. In the US, the Fed has extended such support to credit markets.
The Bank of England has relaxed capital requirements to allow banks to increase lending while the ECB has gone further and set negative interest rates. Central bankers have also made it very clear that the toolbox of unorthodox monetary policies is far from empty.
These policies have resulted in an increase in monetary aggregates. In the UK, the growth of the M4 money stock was 12 per cent to August 2020. In the US, the growth of M3 was 7.8 per cent in the month of April alone and, according to Tim Congdon, in the year ending June 2020 more than 26 per cent, greater than the highest numbers recorded in the inflationary 1970s.
Alongside imposing unorthodox monetary policies, central banks are giving themselves greater room to increase their inflation targets. Recently the Fed moved from a specific two per cent target to an average two per cent target, which would allow inflation to rise above two per cent for an unspecified period of time. The ECB, which has undershot its two per cent inflation ceiling for the past seven years, is conducting a review of monetary policy, with the prospect of targeting a more flexible rate of inflation, most probably similar to the Fed. The Bank of England has always made it clear that it reserves the right to allow inflation to rise temporarily above the two per cent target so as to prevent a sudden fall in GDP and employment. Andrew Bailey has now indicated his support for a more flexible approach to the Bank’s inflation target in order to cope with a world of much bigger shocks.
The real danger facing the UK is not rapidly rising prices of 20-30 per cent, as in the 1970s, but of inflation creep. If a two per cent inflation target is considered too restrictive, maybe four per cent could be tolerated. Then if the MPC misjudges the slack in the economy — which, following the accelerated pace of digitisation, decarbonisation and the scarring left by Covid, may be tricky to figure out — inflation could creep up to six, eight or even ten per cent. At the same time the velocity of circulation of money will increase, as its purchasing power is perceived as likely to fall. Expectations of future inflation will have no anchor and interest rates will have to be raised to whatever level is necessary as the brakes are slammed on to bring it under control.
Independence of the monetary regime
This third area of concern that inflation might take off is that central banks will not be sufficiently independent to resist politicians’ (and the public’s?) demand for greater public expenditure, leading to monetary finance and inflation.
Ben Broadbent, deputy governor (monetary policy) of the Bank of England, in a scholarly speech devoted to government debt and inflation (September 2, Bank of England) claimed that, regardless of the fiscal position, the most important factor guaranteeing low and stable inflation is a consistent monetary policy regime, which targets a nominal objective (such as inflation or money income), is operationally independent of political control, and is publicly accountable. When the Bank of England was granted operational independence in 1997 it was not given the right, as a body of unelected officials, to set the inflation target. This was reserved for the Treasury, whose ministers are accountable to the electorate.
In the last 200 years, the UK has had three significant periods of inflation: during the French Revolutionary and Napoleonic Wars (1792 –1815), in which prices increased by nearly 50 per cent leading to the UK suspending convertibility of the currency in 1797, leaving the gold standard and not returning until 1821; during the First World War, when in 1914 it moved off the gold standard again, inflation averaged 16 per cent annually during the war years but it did not return to the gold standard until 1925; and in the 1970s, following the collapse of the Bretton Woods international monetary system based on a gold-dollar exchange rate standard.
The lesson Broadbent draws from this evidence is that, regardless of fiscal excesses, the inherent strengths of the monetary regime will provide price stability. Certainly a monetary regime which limits the ability of governments to pursue discretionary monetary and credit policies is of value. However, the lesson I would draw from our history is that when the going gets really tough elected politicians might well produce reasons for dispensing with the monetary regime, as happened in each of these periods.
Monetary policy and the zombie economy
The great success story of monetary policy for the past few decades is that inflation has been under control. However, over recent years there has also been serious collateral damage.
One effect of aggressive monetary easing driving down interest rates to zero has been to create asset price inflation. Asset prices, by contrast to those of goods and services, have risen and have been a major factor increasing inequality in wealth between those who own physical assets, such as houses, or shares in them (equities), and those who either rent rather than own property and have few investments. Since Covid the wealth of billionaires has increased in all major economies (source UBS). The more asset prices increase, the greater will be the demand for wealth taxes or their effective equivalent.
Another effect of this policy has been to create a zombie economy. Ultra low interest rates enable zombie companies to survive. These are companies which have sufficient revenue to pay interest on their debt but are unable to pay down the debt itself. It makes sense for the Treasury to support firms which have a long-term future but are shackled because demand is temporarily weak due to lockdown. However, identifying those companies at a time of rapidly changing consumer behaviour and digitisation is far from straightforward.
Ultra low and negative interest rates discourage zombie companies from restructuring and becoming profitable, thereby tying up capital and labour which could be used to support growing firms. For certain companies direct financial support is justified, but keeping interest rates across the board at ultra low levels is not the appropriate way to proceed. Even in difficult economic circumstances, the government accepts that not every job can be saved and not every business can be rescued. Hence it must simultaneously prepare the ground for future growth through providing incentives for enterprise, growth and higher productivity.
I believe it would be a tragedy for the UK to embark on negative interest rates. I am sceptical that negative (by contrast to ultra-low) interest rates have any impact on increasing aggregate demand. For central banks to introduce negative rates is a sign of desperation, not confidence in the future. The key to confidence is an overall government policy of how we live in a sustainable way with Covid, a public expenditure programme which can be financed without inflation and incentives for new and growing companies. The Bank for International Settlements (the central bankers’ bank) has said that the main purpose of negative rates has been to drive down the exchange rate, as in the case of Denmark, Switzerland and Japan.
In countries in which negative rates have been introduced, they have had an adverse impact on commercial bank profitability, with UK commercial bankers making it clear that even if it was desirable they are not yet prepared for such a move. In addition, a move to negative interest rates will be a psychological shock to retail bank customers, who will view it as the end of “free” banking. According to Sir Dave Ramsden, deputy governor (markets and banking) of the Bank of England, the experience of other countries is that cutting interest rates below zero may be passed on to corporate depositors, but interest rates on household deposits are unlikely to fall below zero. Negative interest rates will also hit companies that have final salary pension schemes, which will be forced to increase their cash contribution to their schemes rather than use it for productive purposes.
The experience of the Swedish central bank, the Riksbank, is also instructive. Negative interest rates were introduced in 2015 and abandoned in 2019. The bank governor subsequently described it as an “experiment”. It was successful at first: demand increased, inflation rose, the exchange rate weakened but then inflation fell. Although inflation rose at first, because Sweden is closely integrated with the Euro area, its inflation rate is highly correlated with Euro-area unemployment. As Euro-area unemployment fell over this period, isolating the impact of negative rates is difficult. However, when first implemented they also led to a rapid increase in house prices and household debt. The public struggled to understand the policy, and savers and companies began to hoard cash. It was finally abandoned because of the distortions it created in credit markets, the failure of prices to act as signalling devices thereby misallocating resources and the collateral damage to banks, pension funds and insurance companies.
Current monetary policy has the unintended consequence of not only driving inequality in the distribution of wealth and creating a zombie economy, but low interest rates are also a disincentive to save. The irony is that in the very short term since Covid, saving has been at an all time high of 29 per cent and funds have poured into National Savings and Investments (NSI), mainly from older people, to such an extent that NSI have cut the interest paid and may even close the fund. Although people will have very different reasons to save and in what form, the expected rate of return is certainly one of them. Ultra low interest rates create a huge disincentive to save. In TheArticle Andrei Rogobete (20 August 2020) has pointed to the bleak picture presented by Legal & General’s estimates that more than 30 per cent of people in Britain have less than £1500 in savings, while 15 per cent have no savings at all, a number which rises to over one half of those aged between 22-29.
Since the 1970s the real return on saving has fallen. Currently the kind of monetary and credit policy we are pursuing is the least attractive aspect of 21st-century neo-Keynesianism. At its root it has a very short-term perspective. We live in retirement off accumulated savings, unless we are forced to become wholly dependent on the state, which is clearly not the intention of policy. As a result, alongside rock bottom interest rates, governments have had to provide special tax incentives to encourage saving, such as tax relief of pension contributions, ISAs and Help to Save. A free society and a vibrant democracy requires households with a secure economic base and in that context savings are important, as is the incentive to save.
The Chancellor has said he cannot save every job and every business and clearly the present is not the time to allow swathes of firms across the board to fail. Given the impact of the Covid-19 crisis, fiscal support for business is justified. What is not justified is moving to negative interest rates. This is a blanket approach which undermines confidence, kneecaps the banks and is unable to distinguish between those firms that deserve help and those which do not.
The way forward
To sum up so far, inflation is unlikely to take off in the immediate future but is a serious concern beyond that. Public spending is now growing at such a pace that it poses a serious challenge of how it can be financed without inflation. The ratio of public debt to GDP is over 100 per cent, the highest for 60 years. Interest rates are at their lowest level ever and a monetary policy of aggressive easing is accommodating a growing fiscal imbalance. Central banks are actively seeking to have a more flexible (i.e. higher) inflation target. Output has fallen dramatically, largely because of lockdown but also social distancing, broken supply chains in international trade and in the future some possible disruption following Brexit. The recovery is decidedly not V-shaped.
Because of these factors and the second wave of the Covid pandemic, the government is in an extremely difficult position and will be criticised whichever way it moves. I believe there are three priorities.
One is the need for an overall fiscal and monetary plan, which is underpinned by a sustainable policy for everyday living with Covid, so that business can thrive in a “new normal”. Fighting Covid is like fighting a war in which the Treasury is on the economic front line. The Treasury has cancelled the Autumn Budget and the three year spending review, announced three job packages in the last six weeks, and that the expensive furlough programme will be continued during November. Last week it was extended to the end of March. The reason given is “100 per cent Covid”, mainly because of the difficulty of forecasting future GDP growth, tax revenue and uprating benefit payments.
We can sympathise with the Treasury’s predicament. Nevertheless, the decision to move house or spend money on housing improvements requires some indication of future tax liability. Similarly business capital investment on restructuring and adapting to new technology requires some assurance of the government’s future commitments. This is particularly true for those businesses directly affected by government capital spending, such as defence and construction. The Treasury may not be able to set out a budget for more than one year ahead, but it still needs to provide greater guidance to business on its aspirations and best estimates for the longer term.
A second area which needs a major reset is monetary policy and in this I have been greatly influenced by a former academic colleague, Peter Warburton. Warburton is an economist and the author of Debt and Delusion: Central Banks Follies that Threaten Economic Disaster (Penguin, 1999), which argued with great prescience that there was an unexploded bomb in the financial system — which indeed blew up in 2008.
There is no justification at present for increasing QE yet again by £150 billion to a new total of £875 billion. Keeping interest rates at 0.1 per cent, or even signalling through extra QE the possibility of negative interest, does not begin to address the reasons for a lack of investment by households and business. UK business is facing the digitalisation and decarbonisation of the global economy. Covid has accelerated these changes, so increasing the different outcomes between winners and losers. For a business to adjust is to decide that its existing business model is not sustainable and needs restructuring. This requires confidence in government strategy and probably a tax incentive as well, not simply keeping interest rates low.
To move to negative interest rates would damage commercial banks, extend the zombie economy, penalise savings and increase asset price inflation creating greater inequality in the distribution of wealth. Increased investment depends on confidence in the government’s management of the economy. Moving to negative interest rates will not inspire confidence, just the opposite.
Current monetary, credit and regulatory policy is drifting into creating a state-regulated monetary, banking and financial system. It is already clear that commercial banks are too important to fail, so they need strong capital controls. Because the government deficit must be financed, banks, money market funds, hedge funds, pension funds and insurance companies will need to be made to hold increasing quantities of government debt. Hence the prospect of new prescribed ratios of public sector debt for these institutions.
The one area on which there is common ground is the importance of training, with more short courses responding to digitalisation and upgrading the content and status of jobs where there is increasing demand, such as social care. Not that long ago nursing provided limited training. Today nursing has developed with undergraduate courses and post-graduate qualifications. Similar changes are needed in social care as people live longer, require assisted accommodation and professionally trained carers. This is just one area, but many others have similar potential.
Inflation is dead in the very short term, but beyond that it is far from dead. The government’s humane, if stuttered and erratic, response to Covid has meant that excessive public expenditure and the public finances are arguably of greater concern than at any other period in peacetime. Aggressive monetary easing, coupled with a more flexible interpretation of the two per cent inflation target, is enabling a growth of monetary aggregates inconsistent with low and stable inflation. By keeping interest rates ultra-low and considering negative rates central banks are damaging commercial banks, penalising savings, creating zombie economies and fuelling asset price inflation, while having little impact in creating the confidence necessary to increase aggregate demand.
The next move for interest rates should be up, accompanied by the removal of unnecessary credit restrictions imposed on the banking system. The Treasury is justifiably reluctant to present a Budget for more than one year ahead, but restoring confidence in fiscal policy requires it to set out indicative medium term expenditure intentions, especially regarding investment.
This was first published in The Article.
Lord Griffiths is the Chairman of CEME. For more information please click here.