There are different views across the pond over how best to deal with inflation, warns Eric Stoclet, CEO of Crown Mortgage Management
As CPI inflation rises to double the target rate and GDP slips into negative territory in the final quarter of 2010, it’s easy to see the economic quandary faced by the MPC. Is it best to maintain growth or to control spiralling prices?
But the MPC aren’t the only ones faced with this dilemma. The problem is broadly similar in the States. Although the Federal Open Market Committee (FOMC) doesn’t have to worry about excessive inflation – US inflation is currently running at 1.6% – interest rate hawks are concerned QE and low rates still pose a severe long-term danger.
Nevertheless, 9% unemployment has led the FOMC to inject $600 billion to the US economy and leave rates at a similarly ultra-low level to that in the UK and this has worried those who believe quick-fixes often have dire side-effects.
Thomas Hoenig, a member of the 2010 FOMC, has been consistent in his condemnation of the growth-first approach. His advocacy for higher rates and restricted QE is based on a belief that an excess of money in an economy is the root cause of the asset bubbles and, ultimately, recession. He cites spiralling fuel and agricultural property prices as evidence that an unsustainable prices boom is underway which will create just the kind of bubble from which the last recession emerged.
This argument is based on fundamental principles of economics. When large amounts of money are pumped into the system, they have to go somewhere. With interest rates at historically low levels, very little of this money will go into savings. It will instead begin to chase assets with higher yields. Currently these are commodities and to a lesser extent, stocks. The argument goes that as long as interest rates do nothing to incentivise saving, excess money in the system will continue to push up asset prices until they become excessive and ultimately tumble. Boom and bust.
In the most recent minutes document issued by the MPC it was made clear the decision to stall a rate rise was based on a belief that the current rate of inflation is a result of excessively high commodity prices. This is certainly true. But the Bank, like the FOMC is staking its reputation on the analysis that this price spike is the result of uncontrollable temporary external factors, like the poor wheat harvest and latterly the civil war and regime change in North Africa and the Middle East. These events certainly have a major impact on prices, but hawks such as Hoenig would point out that there are a growing number of analysts who put down the rise in commodity prices directly to quantitative easing.
It’s all very well to insist growth and low unemployment are the most important goals. But it’s also easy to overstate how much of an impact interest rates can have on employment and growth in the short term. There is a real threat that the effective dismissal (in the short-term at least) of the inflation target by the MPC will push up inflation expectations and potentially saddle the UK with an ongoing inflation problem that will require decisive and dramatic rate rises in the future.
Hoenig’s hawkish message would surely be dismissed by the MPC’s doves as it was by the FOMC last year. His views are certainly not those of the majority. But we all know being in the majority doesn’t always make you right. If the MPC is worried about the dangers of a long-term price spiral, it would do well to consider some prescient words from across the pond.
