How will the Bank of England respond to zero inflation?

Yesterday’s inflation news poses quite a problem for the Bank of England. There are plenty of caveats in the inflation data as I discussed then but officially it finds itself in a position where it has to aim at an annual rate of CPI inflation of 2%. That is rather awkward when the actual level has fallen to 0% and should oil prices not rebound has a fair chance of going negative next month. Only a fortnight or so ago Bank of England Governor Mark Carney closed down a few options on himself.

Our job is to achieve a 2% rate of growth in CPI inflation……it’s a job given to us by the democratically elected representatives of the British people. We are mandated by Parliament to do that and we have an operational independence in order to accomplish that.

He had the opportunity to express the view that CPI was not the only measure of inflation, He could have pointed out about high house price inflation and the fact that the gap between the current targeted measure and our previous one RPIX (Retail Price Index less mortgage costs) has widened to 1%. This matters when the gap between the old and new target was set at 0.5%. As an aside I argued against it back in the day as I felt it was a policy loosening and if anything the situation is worsening. But returning to his speech an opportunity was missed if he wanted to avoid pressure for a policy easing.

What about the UK Price Level?

The reason I raise this is that we see a tsunami of economists emerge from their cubbyholes if inflation is below target for a period claiming we should catch-up. On the other side of the argument for intellectual and logical symmetry they should be arguing we need a period of below target inflation to slow down to where we should be. You have not heard it? Well nor have I! There is a clear inbuilt bias in the system.

In reality if we go back to the levels of 2008 and calculate where the CPI should be if we had hit our inflation target then it should be at 121. As it is instead at 127.4 then the deflation mania in the media should move from obsessing from monthly and annual changes to the bigger picture. In fact it would be good for all sorts of measures in the UK if we undershot our inflation target for a while. For example it would be much easier for us to establish a consistent pattern of real wage growth if inflation was low or even negative for a bit. Lower prices and costs would help our exporters at a time when we do have serious issues with our balance of payments so we could find ourselves in something of a win-win situation and I will leave it to others to explain why they reject this.

Just to be clear there is the possibility of a deflation/depression scenario but there are many other alternatives especially if we consider that we are where we are because oil and commodity prices have had a sharp reverse. Unless they fall forever that effect will fade and we will then return to an economy which left to its own devices does have inflationary pressure.

The CPI all services index annual rate is 2.4%, unchanged from last month.

Dr Shafik Speaks

One of the group of Carney’s cronies that has been appointed to the Monetary Policy Committee has given an interview to the Kent Business Newspaper. What insight does she offer?

Dr Shafik said the “central expectation” of the Bank of England’s monetary policy committee, which sets interests rates, is that the next move will be up…….The monetary policy committee has rightly said we shouldn’t change interest rates in response to something that is temporary……..we have the option to lower rates.

So interest-rates might go up or they might stay the same or they might go down. That about covers it! Still she did say something unlikely to come out of the mouth of the other Carney Crony Kristin Forbes.

Kent is interesting

You see Ms Forbes has not bothered much with coming to the UK leading me to wonder if she knows where Kent is? Still as a music fan let me air the possibility that she resides in Massachusetts because she is a fan of the Bee Gees.

Let me make it clear I am attacking these women as Carney’s Cronies because of their background and not their sex. There are plenty of British female economists that could and indeed should feel slighted by what has happened here. Why wasn’t one of them appointed?

UK Monetary Policy Has Tightened

Real Interest-Rates

We now have a Base Rate which is higher than current inflation as 0.5% is of course more than 0% so we have a unique situation for the UK in the credit crunch era which is a real interest-rate. In spite of the fact that Gilt yields have been falling some of them have a real interest-rate too now. For example the five-year yield at 1.11% will have one at least for a while and even longer-dated Gilts will have one. Of course for the latter the strict definition is over the life of the bond but lets face it this is a period of time where any such longer-term calculations are a fantasy.

The Pound £

This has risen overall since its nadir of March 2013 and has been tightening UK monetary policy ever since. More recently the rise has been shrouded in mist due to the strength of the US Dollar forcing the UK Pound lower against it but overall it has been strong. Back in March 2013 the trade-weighted index fell at one point to 77.9 as opposed to the 89.2 of yesterday. Over the past year the rally has been equivalent to a 1% rise in UK Base Rates.

Funding for Lending Has Faded

From its inception the Funding for (Mortgage) Lending Scheme or FLS gave quite a boost to the UK housing sector and prices via the downwards pressure it applied to mortgage interest-rates which approached 1%. This has now ended so let us look at how it is helping businesses.

Net lending by FLS Extension participants to all businesses was -6.9bn in the fourth quarter of 2014.

So it continues to be a complete failure which is my financial lexicon definition for a counterfactual success which no doubt it will be claimed to be.

However one area did benefit from the FLS in the last quarter of 2014.

Of these, 14 participants made drawdowns of £8.5bn in total.

Remember when we were promised that the banks would only get cheap liquidity if they increased lending. Well up is the new down yet again!


There are a lot of factors at play here but regular readers will be aware that I have been warning about the dangers of an interest-rate cut from the Bank of England since December 2013. In my opinion the protestations about an interest-rate rise are like the boy (girl) who cried wolf for the majority of the Monetary Policy Committee to establish their credentials and mean little if anything. As I have described above there are several grounds for arguing that UK monetary policy has tightened.

The template has been provided by the Riksbank in Sweden which on the day of the UK Budget Statement cut interest-rates to -0.25%. Yet according to it the state of play is as below.

GDP growth is relatively good, the labour market is strengthening gradually and there are signs that inflation has bottomed out, although it is still low

If interest-rate cuts are the new fashion for central bankers replacing forward guidance well we know from the comments section that Governor Mark Carney is this.

They seek him here, they seek him there,
His clothes are loud, but never square.
It will make or break him so he’s got to buy the best,
‘Cause he’s a dedicated follower of fashion.


15 thoughts on “How will the Bank of England respond to zero inflation?

  1. Hi, Shaun.
    Interest rates are where they are because lenders can increase their margins far wider, the lower they are.
    Since all economic policy is geared towards banks’ balance sheets, and bugger the rest, and since more and more people will be buying homes they have no chance of affording at non-“emergency” rates, then not only will ZIRP, or even MIRP continue, but self-preservation means that it will have growing support in the home-owner populace.

    Make the banks’ needs the people’s needs, and soon you can claim to be serving the people.

    • Yes, you are correct, it is about homes, house prices and maintaining the banking strangle-hold. So over-powering is this single asset class and wealth-creating system that there is virtually no room for any other economic agenda, or they must all play second fiddle to this lead violin.
      Any policy must be seen through this filter, to pass this test first of all. I reckon this obsession is a flaw in its own right and can only build up an ever more precarious artifice. I do wonder when or how the foundations will crack? Paul

    • I see Robert Peston has a different view ….
      “This matters because the nearer Bank Rate approaches zero, the bigger the squeeze on the profits banks earn from borrowing and lending.
      Think of it this way. Competition between banks should bring down the interest rate on loans when Bank Rate is cut towards zero. But savings rates would be kept by competition above zero.
      So the gap between the interest rate paid and received by banks would narrow: the profits on this most basic of banking activities would fall.”
      I laugh out loud at the theory that banks are competing for my savings.

      • As if on cue I had a letter from my savings bank today informing me that the interest I receive will be dropping from 1.0% to 0.5% in June. No justification, no drop in loan rates just a wider margin for the bank.

      • Hi Dr R and welcome to my corner of the blogosphere

        Back in the day when the Bank of England cut interest-rates to 0.5% in 2009 it was terrified of the impact of lower interest-rates on the banking system. In my opinion that is why it did not go lower as the “precious” must be protected! There were also fears about whether banking systems would blow up sub-zero as they were and indeed are so antiquated.

        If we step forwards to today I suggested this on Twitter earlier.

        “With a UK establishment insider like @Peston of the BBC discussing possible #BoE Base Rate cuts are we being warmed up for them?”

        Maybe they think that in the subsequent 6 years the banks have got ready. If so it was hardly at express speed was it?

    • Hi therrawbuzzin

      I remember a pre credit crunch conversation with a friend and ex-colleague who had done a survey on the people he knew and how they would respond to higher interest-rates. Apochryphal I know but there was a clue in the number who would struggle with a 1% rise. Sadly in spite of the much lower interest-rate numbers I would not expect a major difference now would you?

      • For many, a 1% change in interest rates, equates to 20-25% of their interest payment, and the number who buy houses, only just within their reach at today’s cost, increases every day.

        Increase their payments by that much, and the banks have a large number more of non-performing loans, as many just couldn’t cope, and are praying desperately that wage inflation comes well before interest rate rises.

  2. When we lost Sushil Wadhwani from BoE Policy committee we probably lost the last person who actually believed that asset price bubbles were the major cause of inflation. I had the opportunity to chat with him back in 2006 and he expressed the belief that the Bank of England should clamp down on rises house prices as this was going to drive inflation. Instead they just left it out of the measure.

    One of the reasons that I don’t believe in the London living wage is that I know that as soon as it is passed all the landlords will just put rent up and the money will just flow up to the rich land lords. What we need is council houses to drive down the cost of rent and house prices. If people are going to give over 60 per cent of their pay to someone it might as well be the local council. Housing and transport and by far the highest costs and yet public transport is allowed to increase above the rate of inflation despite the fact that more people than ever are using it so it should be getting more money anyway.

    • Hi Bootsy

      You are far from the first person I have come across who speaks positively about Sushil Wadhwani. Mostly those I have met were helped by him when they were studying but he emerges with respect, although he did of course spend some time at the Vampire Squid. Still none of us are perfect!

      Actually Mervyn King had his concerns about asset price bubble but he did nothing about it….

      We need to end the rentier society don’t we ? However it will be something of a struggle as its tentacles are throughout our establishment.

    • Hi Pavlaki

      They should and indeed later today Kristin Forbes said that she would in an article in tonights London Evening Standard. However I think that all the protestations were critiqued by William Shakespeare in Hamlet.

      The lady doth protest too much, methinks.”.

  3. Hi Shaun,

    I’m sure the BOE will have the same relaxed attitude to under target inflation as it did when it was consistently over target for 4 years or however long it was!

    • Hi Zummerzetman

      On the day of the last Prime Ministers Questions before the General Election it seems appropriate to give the answer I gave some moments ago to Pavlaki!

      “They should and indeed later today Kristin Forbes said that she would in an article in tonights London Evening Standard. However I think that all the protestations were critiqued by William Shakespeare in Hamlet.

      The lady doth protest too much, methinks.”.

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