Hamish McRae: We need tighter policy if the Bank is to dig itself out of this debt trap
The Treasury is worried that policy is too loose. Expect this to spread more widely
Sunday 04 March 2012
Where is the exit for the central banks? It is very easy for a central bank to pump out the billions, as we saw last week with the European Central Bank's €530bn (£443bn) of loans to the commercial banks. But eventually those loans will have to be paid back, just as the pile of gilts bought by the Bank of England will have to be sold on to firm owners.
In an emergency, central banks have to flood the markets with cash. That is the classic textbook response to a liquidity crisis, tried and tested over the past 200 years. Whatever you think of the long-term outlook for the eurozone, you can defend the ECB as meeting a crisis situation (for indeed it was that) with the appropriate crisis response.
Here in Britain, it is getting harder to justify what our own central bank has been doing. Its first bout of quantitative easing did indeed help ease financial market conditions and, insofar as we know its medium-term effects, it may well have helped turn round the real economy too. But there is a bigger question mark over its subsequent efforts, including the bout of QE approved at last month's monetary committee meeting. There is evidence that the larger the dose of the drug, the less effective it becomes, and the artificially low yields on gilts are not cost free.
Aside from the still-unquantifiable impact on inflation, anyone who retires now with a specific pension pot gets a much smaller pension than he or she would have done from the same-sized pot three years ago.
Indeed, and this is something the Bank's monetary committee should be pondering as it meets this week, it may well be that monetary policy is now too loose. As is widely appreciated the Bank has had an easy-money bias and has repeatedly overshot the inflation target, but more recently the outlook has improved and it is plausible that inflation may actually come below the 2 per cent central point later this year. So is there really a case for tightening?
Have a look at the graph on the left. This shows different components of the CPI on a three-month-on-three-month basis. The CPI overall is nearly 3 per cent, while only three of the components of it are below 2 per cent. Everything else is above that, in some cases shockingly so. Petrol is higher than its previous peak, with the sterling price of oil at an all-time high. Barclays, in noting this overshoot, pointed out that MPC member Martin Weale recently made a speech saying he did not think there would be a case for more QE once the present programme was finished and that the first rise in interest rates might come earlier than the present market forecast for mid-2014. His views are interesting, because he was until recently head of the National Institute and showed a good intuitive feel for the way the economy was moving.
So there are voices on the MPC worrying about this, and that is encouraging. The Treasury is worried that policy is too loose. So expect this concern to spread more widely in the months ahead, especially were the CPI not to come down to the target range by the autumn. Meanwhile, expect there to be more and more focus, not on whether there should or should not be another bout of QE, but how on earth is the Bank going to claw things back. The stronger the economic numbers – and the Treasury and the Bank think the economy is growing faster than the reported GDP figures would suggest – the earlier everyone will have to think about digging ourselves out of the debt trap.
The issue came up last week, when Bank Governor Sir Mervyn King was questioned about this at the Treasury Select Committee. This is what he said in reply: "Well, I think actually unwinding this is one of the more straightforward aspects. Either we would sell the gilts we had purchased back on to the market or if we felt that [we were] putting too many gilts on the market at the same time, or in a short period, we could issue short-term securities, Bank of England bills, and sell those. So actually mopping up the liquidity is a relatively straightforward aspect of this process."
So, it is all right then? I am not so sure. Royal Bank of Canada notes that previously Paul Fisher, the Bank's executive director for markets, had said its plan would be to wait until interest rates started to rise, then it would announce a programme of asset sales. It would say how much it was doing and over what period so the market would have some certainty.
The problem, however, is so huge I am not sure how easy it will be for the markets to absorb the supply, particularly since the gilts will have to be sold on a falling market: if yields are rising, prices are falling. The proposition you buy the gilts off the Bank and lose money on them does not seem attractive. As for the scale, have a look at the right-hand graph.
The white vertical line shows where we are now, the black chunk is the debt held by the market (pension funds, insurance companies, foreign owners, etc) and the red chunk is the stuff held by the Bank of England. The projection, done by Capital Economics, shows where we might be in a year's time, assuming some more QE beyond the present programme. Now we will probably not get there, but it is plausible that a year or so from now the Bank will still be financing a deficit of £100bn a year, plus trying to get rid of up to £400bn of its own holdings of debt.
These are unspeakably large numbers. They are large not just in absolute terms but relative to the size of the economy, the flow of real UK savings, the availability of global savings and the willingness of foreign investors to lend us the money. Technically Mervyn King is quite right. If the market won't take the long-term debt we can issue short-term debt instead. But that would carry inflationary risks: short-term debt is near-money and that feeds into asset prices.
There is no simple answer, but the key point is that the earlier the Bank tightens monetary policy, the more chance it has of reducing inflationary risks when it has to unwind QE.
All this pre-Budget lobbying isn't helping at all – especially on the 50p top tax rate
One of the depressing aspects of this run-up to the Budget is the wall of submissions to Chancellor George Osborne, right. They are depressing for at least three reasons.
One is that they are predictable: the job of a lobby group is to lobby, so each submission will push for something that would help (or damage less) the group that pays it to make that submission. Lobbying can be useful and actually helpful to government, when it is at a detailed level, for it enables tax and regulation to be framed in such a way as to achieve its objectives and cause the least collateral damage. But the pre-Budget stuff is not.
The second is that the submissions ignore the fundamental mathematics facing the Government. It has to cut costs and it has to get in revenue.
Jeremy Browne, the LibDem minister at the Foreign Office, pointed out at a Reform conference last week that the Government still had to borrow 20 per cent of its outgoings – and, incidentally, Foreign Office costs were equivalent to a weekend's worth of borrowing. Calls for tax cuts have to be seen in that context.
But most depressing of all is the fixation on the 50 per cent top tax rate. Business wants to get rid of it; the popular view is to keep it. But the entire discussion is predicated on the idea that it brings in extra revenue. We will see what the Revenue & Customs think, but if they take into account the dynamics, they will surely conclude it loses revenue.
My quick calculation suggests that the loss may be upwards of £3bn a year. That is the real argument against keeping it.
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