Ahead of the EEF Economists' shadow MPC debate on twitter we will be stating the case for each of the four different stances held by the MPC. The posts on the other policy stances will be available here.
Adam Posen has a point. Standing out on a limb might be lonely, but, hey, a dove’s got to do what a dove’s got to do.
The economy is weak. GDP contracted in the last quarter of 2010. Forecasts for growth in 2011 and 2012 are weak. Unless next Wednesday’s GDP data release is surprising enough to knock the dove off his perch, those forecasts aren’t going to change much.
And that’s because the fundamental prospects for growth remain pretty dim. Government spending – we know – will be cut. Consumer spending is unlikely to be strong: consumer confidence remains at levels associated with recession1 and 400,000 public sector job losses are forecast in the next five years2. The private sector should offset this, creating new jobs3, but we cannot take that for granted either.
The hope is that business investment and net exports will shore up demand but, as yet, the data has proved conflicting at best.
Low growth could well lead to below-target inflation. Shaky demand could increase the margin of spare capacity in the economy. And, let’s not forget, it is high already: unemployment is likely to average 8.2% this year4, compared with the pre-recession level of 5.2% . It is precisely this spare capacity that could cause inflation to fall below target in the medium term.
And monetary policy operates in the medium term5. Current short-term above-target inflation aside, there is a real risk that dismally slow growth causes below-target inflation in the medium term. Thus, the case for a rate rise, which would impact inflation in the medium term, looks weak. But I am not only arguing against a rate rise.
There is a strong case for increasing the amount of QE, based on the medium term risks to growth. Inflation forecasts6 already show inflation falling below target in May 2012. If growth is lower, inflation will be lower.
The concern is not necessarily that we see deflation. The Bank of England’s website clearly states that “Inflation below the target of 2% is judged to be just as bad as inflation above the target.” So, given the substantial risk of low growth causing below-target inflation, we should expand QE.
QE would offer the boost the economy needs. As “extraordinary monetary policy” QE does more than reducing rates would: even if it were a viable policy option.
The process of QE – where the Bank purchases government gilts with newly created money – means that as well as the usual economic stimulus which would come from reducing interest rates there are two important additional impacts. Purchasing more government gilts causes the interest rates on gilts to fall. This means that:
1) the rate of interest the government pays on its debt falls, which would thereby reduce some of the pressure of deficit reduction; and
2) other alternative (riskier) investments become more attractive
Both of these would support growth. Although the Bank is not explicitly allowed to purchase government gilts to reduce the cost of government borrowing7, expanding QE would have this effect.
But the second effect is crucial. One of the key factors holding back business investment is a lack of Access to Finance. EEF’s surveys show that there has been little improvement on this since the recession ended. As the return on government gilts falls investors will look to other assets, which could include buying shares, or providing loans to businesses.
Additionally, if more shares are bought this boosts their price, and has a wealth effect. People who own more shares feel better off, and may then spend more money elsewhere.
So QE could reduce pressure on the government, boost business investment and boost consumer spending. It is also likely that exporters would benefit from any additional weakening of sterling that expanding asset purchases caused.
Crucially, and this is the clinching point for me, some of the benefits of QE would remain even if interest rates went up in the near future.
I recently wrote that the reason the Monetary Policy Committee did not need to worry too much about inflation is that there was little evidence of a price/wage spiral developing8. I still hold this view, but I also see this as a key upside risk. Current inflation may be caused by temporary and external factors, but if wage rises start to quicken then high inflation could become permanent and domestically generated. In this situation interest rates would need to rise.
But monetary policy has to be made on the balance of risks. Currently there is little evidence that a price/wage spiral will develop. Evidence already shows that growth is struggling.
QE should be expanded now. QE should be expanded to boost access to finance. QE should be expanded to better enable businesses to invest and drive a strong economic recovery.
1The GfK-NOP consumer confidence index currently stands at -28
2Figures taken from the OBR
3The OBR forecasts 1.3million new private sector jobs in the next five years, meaning net job creation of 900,000.
Figures taken from the OBR
4ONS figure for February 2008
5The Bank of England’s website states that it takes 24 months for monetary policy to feed through
6Which admittedly factor in rate rises along the way, but also reflect the expected fall in inflation as temporary factors such as VAT subside.
7This is forbidden by the Maastricht treaty
8Additionally, the Bank of England Agents’ April report states that pay rises are around average pre-recession levels and even then reflect improved profitability and recognition of past wage restraint.