QE is not likely to lead to hyperinflation, or merely 1970s type inflation any time soon. Interest rates are likely to stay close to zero for some time. But that does not mean it will always be thus, and I can see developments in the pipeline that will change this.
The thing about the bonds bought by QE is that they sit there for years. The potential money creating effects of QE percolate around the system. Right now, I think it is unlikely to lead to severe inflation, but that does not mean it won’t in the future.
There is more than one reason why I don’t expect inflation to rise sharply for some time. Reason number one is Japan. There are parallels between the UK and much of the Eurozone now and Japan 20 years ago. Japan has seen interest rates stay close to zero for a very long time. Deflation rather than inflation has been its concern.
Reason number two: it’s all about demand and supply. If demand is greater than supply prices go up and demand falls. This is not inflation, merely one-off price rises. If conditions are in place which mean that demand is always greater than supply, we get inflation. So, let’s say there is a shortage of oil. Price rises, pushing down demand. But if workers say: “We can’t afford petrol at these prices. We want a pay rise,” which they then get and demand for oil rises as a result, we are getting into inflation territory.
Add to the equation broad money supply. When she was Prime Minister, Mrs Thatcher argued that if the money supply is unable to rise, it will simply be an impossibility to have inflation. One of the flaws with her idea of using monetary policy to fight inflation is that actually her government found it quite hard to stop the money supply from rising. The theory may or may not have been right, but the practice was devilishly difficult to implement.
In the modern era we have what’s called fiat money. The broad money supply increases with debt. The more we borrow, the more broad money rises. The broad money supply is more closely associated with inflation than narrow money supply.
In the West we have had modest inflation in recent years because consumer demand has seen such tiny growth. Indebted households don’t want to borrow, no matter how low interest rates are. Baby boomers fretting about their retirement want to save more. Furthermore, thanks to the fact that labour markets are more flexible these days, we have seen wage increases lag behind consumer inflation.
In such circumstances, it is difficult to see how inflation can be pushed upwards by demand, or how the money supply can grow thanks to expanding credit. That is why despite £375 billion worth of QE, growth in broad money supply in recent years has been tiny, and often negative.
But there is another factor at play. Changes in the global economy, such as the rise of India and China, have led to rises in global demand for oil and food, and this has created inflationary pressure.
So in the UK we have seen minimal internal inflationary pressure, but more significant external factors. There is very little the UK government or central bank can do about inflation caused by the rise of emerging markets.
QE may have led to some inflation because it pushed down on sterling. It is possible that by pushing up asset prices, QE also encouraged some speculators to buy oil. In as much as QE may have prevented a global depression it is possible that it contributed to growing demand for oil and food from the emerging countries. But I don’t think anyone can say for sure whether QE has indeed stopped a global depression taking place. As for the UK, I think it is possible that if we had not had QE, the UK economy would have been in depression, and demand would have been strangled so tightly that we would have had deflation. No one can say for sure.
The danger with QE is what will happen when things go into reverse. Supposing demand starts to rise; all that bond buying implemented by the Bank of England may then lead to inflation. At that point, the bank will need to reverse QE, and that will be a very controversial thing to do.
However, for as long as households are in debt and the baby boomers worried about their retirement, I don’t think inflation is a major worry. Yes, it will happen. Yes, it may be above the Bank of England’s target but, relative to the 1970s, it will be modest.
But what worries me is what will happen once most of the baby boomers are retired, and start drawing down savings. At that point growth in demand may outstrip growth in supply.
What will happen once China passes the Lewis turning point, and runs out of workers?
What will happen if China does what the US keeps asking it to do and lets the yuan rise? At that point the cost of products imported from China will rise. We may see inflation in manufactured goods.
If China stops buying US bonds to maintain a cheap yuan, while at the same time the savings ratio in Japan continues to fall, we may see a shortage of money flowing into the West.
If these things happen, not only might we see more dangerous levels of inflation, but interest rates will also rise. And by that I mean not merely that nominal rates will rise, but real rates too.
These are the dangers that I think are more serious.
These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees