David Blanchflower: Woof! The deflation dog is barking loudly – but the Bank of England won’t do anything

There is a huge stock of assets remaining on the Federal Reserve’s balance sheet of $4 trillion

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The Independent Online

This Thursday the Bank of England will stand pat: its rate-setting Monetary Policy Committee will keep its asset purchase programme unchanged at £375bn and its rates on hold at 0.5 per cent, where they’ve been since March 2009. In contrast, other central banks have been doing something.

The Bank of England is the only major central bank in the world that has any of its members voting for rate rises. But the Japanese central bank, in a surprise move to avoid deflation, expanded its quantitative easing programme: Japan wants to weaken the yen to get inflation – currently at 1 per cent – back to the 2 per cent target. The oldest central bank in the world, the Swedish Riksbank, cut rates to zero in response to deflation. Its deposit rates for banks is in negative territory. That move vindicates their ex-deputy governor Lars Svensson, who had resigned when rates were raised to “lean against the wind” of an asset price bubble. He warned this was exactly the wrong thing to do and would cause price falls – and it has.

My old friend Sir Jon Cunliffe – now an MPC member at Threadneedle Street – made clear he is in the doves’ camp in a speech last week. “The softening in the pay and inflation data, together with the weaker external environment, for me implies that we can afford to maintain the current degree of monetary stimulus for a longer period than previously thought.” But the former external MPC member Andrew Sentance recently argued in a Bloomberg interview that deflation is “the dog that hasn’t barked”.

I disagree. That dog is howling loudly now as the deflation pandemic spreads. Oil prices continue to plummet, with Brent crude down to $85 from $115 earlier in the year. The price of a gallon of gas where I live has now dropped below $3 a gallon. Commodity prices across the board are also falling sharply. The Bloomberg Commodity Price Index is down around 16 per cent since May of this year.

On Friday, Eurostat announced that eurozone inflation had risen slightly to 0.4 per cent, but core inflation, stripping out volatile components like food and energy, had fallen to 0.7 per cent from 0.8 per cent. There are still 11 other European countries in outright deflation or very close to it – Bulgaria (minus 1.4 per cent), Greece (minus 1.1 per cent), Hungary (minus 0.5 per cent), Spain (minus 0.3 per cent), Poland (minus 0.2 per cent), Italy (minus 0.1 per cent), Slovakia (minus 0.1 per cent), Slovenia (minus 0.1 per cent), with Cyprus, Lithuania and Portugal all at zero. Woof. The eurozone unemployment rate held steady at 11.5 per cent although, most worryingly, the Italian rate jumped from 12.5 per cent to 12.6 per cent.

As a result, the European Central Bank – which raised rates twice in 2011 – continues to expand its asset purchase programme. This easing weakens their currencies against the pound, boosting their economies and slowing the UK economy. The MPC may yet have to respond.

Last week the Federal Reserve announced the end of its asset purchase programme: in contrast, the MPC ceased its purchase programme in June 2013. The tap controlling the flow of assets into the American QE tub has been switched off, but the plug is still in and there is a huge stock of assets remaining on the Fed’s balance sheet of over $4trn. There is lots of room though for plenty more where that came from if needs be. As the short-term assets mature the Fed will continue to use that money to purchase new, longer-duration assets to continue to impact interest rates further out on the yield curve. So the asset tub isn’t going to empty at all for the foreseeable future.

The decision to stop the Fed’s asset purchase programme was not unanimous. The vote was nine to one with Dr Narayana Kochalokota, president of the Minnesota Fed, dissenting because of his fears that inflation and inflation expectations are below target. The Fed’s statement was not as dovish on the state of the labour market than it had been in its previous statement in September. This seems to have been driven by the fall in the unemployment rate to 5.9 per cent. Despite the fact that there has been no increase in US wage growth, which still shows little sign of picking up. No matter which part of the Fed’s dual mandate you focus on, be it jobs or prices, the US data actually suggests that there should be more stimulus, not less.

In combination with interest rates remaining at the zero bound, this still means that both the US and UK economies are receiving considerable stimulus from the stock of assets and low rates. Ben Bernanke, the previous governor, argued that if the Fed hadn’t acted, the unemployment rate could well have reached levels seen in the Great Depression of as much as 25 per cent. Mr Bernanke was not predicting what was going to happen to unemployment, of course. My view continues to be that unemployment in the UK could have reached 5 or 6 million or more if the MPC hadn’t acted. Counterfactuals, of course, aren’t predictions.

The big question the markets are asking is: when will the next rate rise come, in both the UK and the US? It makes no sense for the MPC to go first. It also isn’t absolutely obvious that the next move by either central bank will be a rate rise. I wouldn’t rule out the possibility that the next move by both is to restart the QE programmes if economic headwinds start blowing hard again, just as has happened in Japan, Sweden and the eurozone. Raising rates too soon may well mean the next move is a cut followed by additional QE, as the Riksbank and the ECB have learnt to their cost. This baby still isn’t over.

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