Fears/Hopes of more Quantitative Easing lead to more fears about inflation in the US and UK

Yesterday saw a relatively quiet trading day in US equities with the Dow Jones Industrial Average falling by 19 points to 10948. I would imagine that minds were already turning towards todays non-farm payroll and unemployment numbers. For those who do not follow these matters non-farm payrolls and in particular the components of it are used as measures of the level of and indeed changes in US employment. Hence the numbers are used as a guide to the state of the US economy. In our current position where the recovery has so far earned itself the title of the “jobless recovery” one can see how the figures achieve some importance. I do however have a note of caution, as it is a shame that numbers which are often heavily revised are going to bear a weight of expectations that their accuracy and reliability simply does not justify. We could head off this afternoon on an expectations joyride today that if it were say corrected by a revision next month might be too late as the next FOMC meeting is on November 2nd and 3rd.

One place where there was more of an equity movement was Japan where the Nikkei 225 index fell by 95 points to 9588. This widened the spread between it and the Dow Jones to 1360 points indicating yet more underperformance by the Nikkei. This was in spite of the Japanese cabinet endorsing a new fiscal stimulus plan of some 5.1 trillion Yen which translates to 62 billion US dollars. Although this plan has yet to go through Parliament many may be wondering about Prime Minister Kan’s promise to make the fiscal deficit his first priority. Moving onto the Yen exchange rate at 82.42 versus the US dollar we have now been below the level of Japan’s initial intervention on the fifteenth of September for more than 24 hours. The rate against the stronger Euro has performed more weakly and is at 114.87.

Fears of More Monetary Easing or QE2 feed inflation fears

As the debate has progressed on whether the US Federal Reserve and other central banks including the Bank of England should undertake further monetary stimulus measures I would like us just to draw breath for a moment. In a somewhat febrile atmosphere I feel that many have forgotten that the Federal Reserve has its pedal quite close to the metal as it is with interest rates very near zero and the policy of QE-lite aimed at maintaining the size of its balance sheet at around 1.3 trillion dollars. So any further measures would be in addition to this and I have noticed recently that estimates of the size of QE2 are rising with some reaching around 6 trillion dollars. Also other types of stimulus are being mooted such as targeting a new higher inflation level or an even more expansionary policy which would target an absolute price level.

A likely effect of this is higher inflation expectations

If you think about all these proposed stimulus measures it may not be a surprise that there are starting to be increased fears of inflation in the United States. We do have one way of measuring this as there are what are called TIPS or Treasury Inflation Proofed Securities in the US. So if we take the 30 year version of TIPS and compare it with the conventional 30 year Treasury Bond we get an estimate of inflation over the next 30 years as that should be the difference between the too. This is currently 2.23% and has risen since late August from just under 1.9%, and this ties in virtually exactly with the rise in speculation over QE2. We can do the same for the ten-year maturities and we find that the estimated inflation rate has risen from 1.51% to 1.93%.

Now I counsel caution in using these numbers as an exact guide as I do not think that investors behaviour stands up to that in terms of accuracy but I think the trend which is clear and does coincide with a change in expectations on QE2 can be used as a guide. If anything one might expect these comparisons to under record what is happening as without getting too technical TIPS are not pure inflation instruments they do have a nominal element.

Somewhat surprisingly I see that Richard Fisher President of the Dallas Fed agrees with me as according to the Financial Times he said.

If the Fed is successful with QE, inflation breakevens should be higher

I could almost set a quiz question here,before this passage of time when did you ever here a central banker outside Japan say something like that?

Are there other possible signs of inflation?

I have reported often on the increases in commodity prices that have been evident this summer. The Commodity Research Bureau spot index dipped a little this week but has now recovered to 487.48 which represents a rise of 30% over the past year. Much of this has come from food prices but metals have been strong too.

Added to this has been a recent recovery in the price of crude oil. If we take West Texas Intermediate crude front month futures price as our measure then the price of a barrel of oil has risen from US $ 71.53 at the end of August to US $81 now for an increase of 13%. So there are upwards influences on the price level. For those who read the economics section of the BBC website these numbers may come as something of a surprise so please feel free to check them for yourselves which ironically in general terms you can for oil prices anyway on the same website. As I like to be even-handed I would like to point out that over the past two weeks the BBC has aired an excellent documentary on the Iraq war.


In some ways this is a return to the inflation/deflation debate however I wish to make a some more subtle points as the debate is far from simple and anyway it should be an inflation/disinflation debate. Also readers might like to take a look at my article of the 2nd of July which challenged US measurement of inflation.

1. If the US economy is slowing down but continuing to grow then extra stimulus measures could easily lead to higher inflation. I do not know the employment numbers as I type this but up to now the economic statistics do not justify QE2.

2. Whilst the media and many economists seem to obsess on double-dip fears,what about a continuation of slow growth followed by QE2? That sounds like a recipe for stagflation to me. This may well be convenient for many sovereign nations who have high and increasing levels of nominal debts. If wage rises stay at low rates this may not be quite so convenient for individual debtors but they too may have some gain.

3. As estimates and projections for QE2 seem only to be rising one cannot avoid the thought that inflation at higher levels than that implied by stagflation could be triggered. This of course could coincide in a horrible policy mix.

So my thought is that economists should raise their noses from the grindstone of double-dip fears and consider other possible implications of what s happening. Indeed let me return to a theme of mine expressed in a question. As the existence of QE2 would clearly imply that QE1 failed, on what grounds can one reasonably expect QE2 to succeed?

The UK experience with inflation

This has been problematic to say the least. The UK Monetary Policy Committee does not have the leeway the Federal Reserve has to talk of raising inflation levels as our inflation is well above target. Indeed our previous measure of inflation RPI-X at 4.7% exceeds its previous target of 2.5% by some 2.2%. I would remind you that this has led a member of the Shadow Monetary Policy Committee to say this as I reported on the 5th October.

the Bank’s inflation target has no credibility to lose.

And with him being in favour of more monetary stimulus measures we got an estimate of the potential inflation which might result from it. 

There will be a modest inflationary price to pay on exit – perhaps annual CPI inflation will reach 6% and RPI inflation might reach 10%. But that is a problem for 2012 or 2013.

The last sentence is a rather literal version of “kicking the can down the road” to my mind. Why worry about the future?

Shop Prices and Producer Prices tell us a different story from the consensus

This week has given us some evidence on this front. The British Retail Consortium produced some estimates for the behaviour of shop prices in September.

Overall shop price inflation increased marginally in September to 1.9% from 1.7% in August, taking it to the highest rate for five months. Food inflation increased to 4.0% in September from 3.8% in August.

These are not entirely unfamiliar trends and yet again make me wonder about the Bank of England’s definition of the word temporary. Just to add to this we have received producer price numbers for the UK this morning and according to the Office for National Statistics we got the following.

Output price ‘factory gate’ annual inflation for all manufactured products rose 4.4 per cent in September.

Input price annual inflation rose 9.5 per cent in September compared to a rise of 8.7 per cent in August

As ever there is a mixture of information here but after noting that output inflation fell back from 4.7% there are again troubling developments here. The rate of increase in input prices is rising again after a dip making the dip look temporary rather than the other way round, and over time one would expect this to feed into output prices. Also there has been a lot of debate over the impact of indirect taxes on inflation so let me present the number for output price inflation excluding them 4.5%. Interestingly this now exceeds the headline rate.

For those interested in a breakdown of why input prices are rising we hear a familiar message.

Prices of imported materials as a whole (including crude oil) rose 0.9 per cent between August and September

I understand that I am pursuing a theme today which in many areas of economics is out of fashion. If you are a student of Phillips curve and output gap theory these trends I have discussed today should not be happening.However the actual evidence from our economy leaves one with a choice do you believe reality as best we can measure it or do you cling to a theory that not only is not explaining events today but has performed disappointingly since the credit crunch began?

With a slight touch of irony as many of those who cling to such theories are Keynesians I shall leave you today with a quote from the man himself.

When the facts change, I change my mind. What do you do, sir?


14 thoughts on “Fears/Hopes of more Quantitative Easing lead to more fears about inflation in the US and UK

  1. Hi Shaun and others,

    I’ve a question; “Why is inflation bad for UK?”

    Possible answers I anticipate are:
    1) Because pensioners who don’t have index-linked securities will suffer.
    2) Because it will go out of control (a la Weimar Republic) and will result in a societal breakdown.
    3) Because it will cause sneaky salary reductions and may cause strikes by unions
    4) It would put cashflow constraints on small businesses and general uncertainty for businesses.

    On the other hand, I understand there’s a ‘nominal debt’ problem in the UK, as it seems everyone owes everyone else too much, which is crippling the economic activity. This is fine as long as you’re borrowing against overvalued assets but doesn’t work if you want to re-align your economy as an ‘exporter’ nation as Mervyn King would
    like to have UK do.

    Admittedly I don’t have/understand the numbers behind these, and I’m just trying to grasp the situation by reading articles by people who appear to do, such as Mr. Richards here, or Mr. S. King below:

    And it appears to me, pumping up more money into the system will eventually jump-start economic activity or the prices (money theory). Both welcome changes in UK.

    Given problems 1-4 can be addressed by keeping a moderate inflation level and helping the pensioners by raising the state pension, am I missing something important here?

    • I suspect the problem is the ability to keep to a moderate inflation level once you remove any semblance of counter inflationary policy.

    • Hi Burak
      You pose some interesting questions and have already got some interesting answers. I have a thought or two and a couple of questions for you to consider.

      Firstly when I started this blog,some of my earlier posts were around what is a price? How does one identify a price? and so on. The point that I was trying to make was that many recent changes in the way we shop and industries operate make it difficult in many instances to determine what a price is. For example supermarkets manipulate prices with all sorts of effects. In the UK right now there is a price war for milk making 4 pints of it cheap, yet dairy farmers are going out of business saying 22p a litre is not enough. If you buy a loaf of bread the price varies nearly every week. If one moves onto energy or mobile phone tariffs they can be almost incomparable and impenetrable..

      Therefore in some respects the conventional theory of inflation has been overtaken by events as I would argue the price level is often unclear. In some ways I think that it makes inflation more of a problem as what we actually have is a lot of different rates of inflation going on at the same time. So the issue is more complex.

      However I did say I had some questions for you.

      1. Official bodies are treating disinflation as being pro rata a lot more serious problem than inflation why do you think that is? Do you think that this is true?

      2. Who benefits from inflation? I ask this because the debate is usually about the losers and the way the world has gone I think the list of winners is at least as relevant.

    • Hi Shaun,

      Thanks for your reply. Here are my thoughts on your questions:

      1) I suspect disinflation is seen as a problem because of the settling of the economy below its previously higher capacity levels. I know how you’re not fond of output gap theory, but I think this is also to be seen in terms of high unemployment levels.

      Also, with the high-levels of debt and inflated asset prices inflation is probably seen as a natural way to reduce debt in the long term.

      It may be that, they are afraid of deflation taking hold if disinflation is allowed, and I suspect that’d be a quite a horrid scenario bringing back scenes of the 30s.

      Finally, from the point of comparison of disinflation vs. inflation, I think inflation is seen as a lesser evil because deficit countries such as US and UK are trying to close those deficits by currency devaluation against current exporters. Inflation is a natural outcome of that (although the effect would be seen to be temporary in this case as it’s not the core inflation). I think, closing the deficit, and re-aligning the economy is seen as a more pressing issue than running the economy more efficiently (a la low inflation).

      2) I think the easy answer to that would be debtors.

      But I’ve read here and there that some amount of inflation is good for the economy to grease some of the nominal changes which are otherwise hard to achieve.

      Again, following from the previous question, if inflation is seen as a devaluation, it’d benefit the exporters I suppose.

      I feel the inflation/disinflation/devaluation question is about judging what’s better for the country, and a very though one.

      • Hi Burak

        I asked the question deliberately because I already had some thoughts on it. At this time disinflation is being represented as a type of Agent Smith to use one of your analogies. My point is that it may not be as bad as everyone thinks. Japan has had its lost decade but then in another part of the world so has Portugal and it has not had disinflation. So I feel that the problems of disinflation are being inflated if you will forgive the pun and it is happening too often to be a coincidence. There are problems and 2% disinflation is worse than 2% inflation but is it worse than 4 or 5% inflation I do not think so.

        You are right about debtors but our political class and bureacracies benefit from inflation too….. inflating away national debt, fiscal drag etc. Just to add one more there were examples today of inflation raising nominal GDP being used to improve numbers. As if by magic the issues they were talking about were improved. Alchemy not improvement

      • Hi Shaun,

        Thanks for your replies. I get a feeling QE is being used more as a tool for international trade these days; devaluation rather than inflation so to say. On a separate note, indeed I’m curious to find the Agent Smith of Credit Crunch…

  2. Burak

    If people’s pay fails to rise with inflation (which is possible at the moment) then their purchasing power diminishes. Take this to the extreme of 10% inflatoin but no payrises, and quite quickly large swathes of society will be impoverished.

    Similarly, as savers are punished for providing for their future the implication is that they should not make provision. Thus placing more burden on the country in generations to come.

    More dangerously, if savers feel that they can’t generate a positive return on their money in the medium term then the risk is that they will ultimately remove their money from the banks, thereby causing another banking crisis. Economics tells us that the time value of money has to be greater than the value today to encourage people to defer their expenditure. That is possible in some countries, but currently not this one.

    Hopefully this shows that this is a dangerous line to tread. There is a saying that you can’t inflate your way out of a problem. Just ask Zimbabwe.

    • Hi Russ,

      I see your point with the people being impoverished. On the other hand it makes me think, in Smithian invisible efficient hand of the market point of view, in a way without inflation the market can’t do its job because (nominal) income drops are very hard to achieve, and instead companies shut down. Assuming markets are efficient, wouldn’t it be more simpler to have inflation?

      I understand the motivation behind reducing the gain from risk-free income (deposits and gilts) is to move the money to riskier ones to motivate economical activity. If the money goes from the banking system to abroad the value of sterling drops, which is good for exporters. If it goes to riskier assets, it is good for business I suppose. If it goes to gold then I can see how that may be problematic, but really central banks have demonstrated that they’ll act in a liquidity crisis.

      I must also add to my previous points I think inflation is bad because of the implicit moral hazards it introduces. On the other hand, one has to judge the overall good I suppose, I mean which one would be better for the country as a whole? Disinflation with a crippled economy, or inflation?

      Anyhow sorry if I was rambling, thanks for your reply.

  3. Hi Burak,

    I think you are omitting one salient factor concerning inflation, as well as a number of other relevant factors. Keynes himself stated that Lenin had been correct; inflation is the most effective method of destroying advanced civilisations and societies, and for re-distributing wealth. It takes wealth from the industrious and provident and redistributes it to the improvident and indolent. That is why it is always a key factor in Socialism. But worse it takes capital value from the real wealth generating process and impoverishes and ultimately destroys that process.

    Without getting into a detailed explanation, in a modern advanced economy it’s worse feature is that it harms or even destroys the real wealth generating capacity and process. There are a number of reasons for this, but the principal one is that inflation erodes the capital operating bases of enterprises (most of all those which are capital-intensive enterprises), and forces them into technical over-trading and then usually ultimate collapse due to insolvency. In a Capitalist economy enterprise is of course the principal vehicle of real wealth generation. Once that is injured or destroyed in the modern world, it is impossible to restore, and an economy will slip back into an impoverished and technologically backward condition in global terms. Such an economy will become like that of a backward or emergent nation, where it no longer has the sufficient capital to re-invest in real wealth generation at the high technological level required in the modern world. It’s only enterprise then can be growing bananas or similar agricultural activity, if the climate is suitable; if not…..! In other words it will then become what we know as a “Banana Republic”, a very primitive society!

    If you look for example at the UK and the economic deterioration which it has experienced since the last World War, with many real wealth generating enterprises and processes destroyed, then you can get some idea of what the logical outcome on such an increased gradient trend line would or will be. So far the UK economy has been partly preserved during this deterioration by the discovery of North Sea oil and gas, but production of these is now in decline. The expansion of Financial Services and debt over the last decade or so has also obscured the reality of the real trend line for this period.

    • Hi Drf,

      Thanks for your reply. I will look further into what you’re saying, also from a historical perspective as you suggest. In the meanwhile, you may know the following website on an economist:


      The counterside in a way is that, with too high nominals aren’t the same enterprises being crippled? According to a white paper on that website, the natural way forward are mass bankruptcies of firms. Admittedly, probably to be followed by a strong growth, but after the harm has already been done?

  4. I would still like to understand what happens when inflation catches and those holding gilts realise they are holding crap and sell. The banks have been buying tens of billions as they were told to do by the authorities and to hold it as “capital”. The price falls will decimate their capital and we will have another crisis.

    The central banks no longer seem to be bothered about hiding their true actions which is to inflate the general price level to get rid of the debt.
    Hopefully we get a real inquiry into what went wrong so it can never happen again, blaming the banks isnt going to fix it!

    • Hi Ian,

      Surely that was supposed to have been the concept and purpose of making Central banks independent of political governments, so that independent Central banks, like the original Bundesbank, would prevent debasement of their currency independently from democratic politicians (who try to get re-elected by deceit and trickery)? The Germans had not forgotten the lessons learned at the end of the Wiemar Republic. The difficulty has been that as in the USA and UK since that, left-wing oriented, semi-neo Keynesiansts have been deliberately selected and appointed by politicians to control their Central bank policies so as to avoid real independence and real neutrality. Escalating inflation is now resulting and because of the Socialist perspective which these proponents have it will get out of control.

  5. ‘As the existence of QE2 would clearly imply that QE1 failed, on what grounds can one reasonably expect QE2 to succeed?’

    I know that sincere people are doing their best in this, but it does look increasingly to me that QE is a ‘kicking the can down the road’ exercise designed to postpone grappling with problems until a politically more convenient moment.

    Seen against that background, maybe QE1 was not a failure, and QE2 could mean that a politically convenient moment has not arrived?

    Otherwise I agree with you Shaun, it really does not look worth the trouble. And it has some serious side effects.

  6. Drf has already described the UK position. North Sea oil and gas was used to supplement what would have been poor economic performance and falling living standards. Instead of ‘banking’ this windfall like the Norwegians, the UK had to use it to pay for today. Then the financial industry hid the trend by creating a credit bubble, now its burst. QE1 was used to pay for continuing government expenditure , but the bad loans still exist on banks balance sheets. QE2 will allow the government to take the toxic loans thus releasing the banks to renew some sort of credit-backed growth.
    The result of all this is to continue to mask the reduction in UK living standards for as long as possible. Governments can always ‘create’ more money in the future to meet increased debt, but at the cost of ever decreasing value.
    Unfortunately in a ‘world economy’ living standards will equalise, some up , some down. This is a managed decline, not pleasant for 99% of us.

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