, February 06, 2023

We need to get into people’s heads, says Bank of England Governor

  •   5 min reads
We need to get into people’s heads, says Bank of England Governor

The Bank of England Governor says the bank needs to get into people’s heads and that to defeat climate change we may need to invest more in gas. Maybe he is right.

Immediately after World War 2, the West experienced high inflation. In 1947 in the US, inflation went close to 20 per cent. (19.67 per cent in March 1947.) By 1949, inflation was negative. Average, US inflation in the 1940s, was 4.8 per cent — which followed average inflation in the 1930s of minus 1.8 per cent and was followed by average inflation in the 1950s of 1.82 per cent.

So why did inflation follow such a strange trajectory in that decade? It was partly caused by one-off issues related to the war and partly a reaction to the 1930s.

Post-2008, it was a similar story but less exaggerated. First, prices surged a year or two after the crash; then, inflation fell sharply.

The Bank of England reacted to the 2008 crisis by cutting interest rates and introducing quantitative easing. There is a good TV show on BBCi Player called: ‘The decade the rich one.’ Don’t be put off by the title, which feels a bit YouTubeish and click batey; it is an excellent presentation featuring interviews with the people who really did shape the economic response of that time.

But when, post-2008, the Bank of England announced QE, inflation hawks swooped down from their lofty perches to proclaim doom. Writing in the Telegraph, Liam Halligan warned of hyperinflation virtually every week.

In Germany, Bundesbank president Jens Weidmann likened QE to a Faustian pact with the devil.

But did we get inflation? Sure, prices rose for a couple of years, but then deflation became a bigger fear. QE was about as inflationary as a damp squib in the rain during floods.

Now, the very same people who warned about inflation post-2008 are warning again. Well, a stopped watch is right twice a day; maybe they will get it right someday.

Is it different this time? Or are recent price rises more like the one-off rises we saw post WW2 and 2008?

The issue here is the money supply. Milton Friedman says inflation is always and everywhere a monetary phenomenon. If the money supply grows faster than our ability to produce more goods and services, we get inflation. (Note, if the money supply grows slower than our ability to produce goods and services, we get deflation, which is what happened in the 1930s).

Central banks worldwide reacted to Covid by slashing interest rates and more QE. Ergo, say some economists, we will get a rising money supply and then inflation.

They look at the current surge in prices as evidence they are right, but then post-2008 inflation hawks looked at rising prices as evidence they were right, and we can now say, with the benefit of hindsight, that they were wrong.

But are they right this time?

UK real wages fall will this spark-off inflation?
Real wages fell in the final quarter of 2021, official data shows, thanks to rising inflation. But does this mean inflation will rise further? It depends on inflation expectations, and it depends on technology.

Balance sheets

It may boil down to balance sheets.

The 2008 crash and subsequent recession were all about balance sheets — bank balance sheets became awful, house prices fell, which meant household balance sheets looked pretty ropey too.

The main purpose of central bank activities post-2008 was to get asset prices up, improve balance sheets, and get borrowing going again. It took a long time for the policy to work, but it was pretty clear that by 2021 asset prices had reached extraordinarily high levels.

These high asset prices boost balance sheets, making consumers feel flushed and encouraging borrowing.

How many people have discovered their property has doubled in value, so they top up their mortgage at incredibly low interest rates, maybe to fund retirement?

Such activities can indeed be inflationary.

When banks lend money via fractional reserve banking, they create money. This is how the money supply usually grows. The Bank of England confirmed this in a frequently cited paper.

Beware the CAPE — US equities look dangerously poised for a crash
Beware the CAPE. The cynically adjusted price-earnings ratio looks dangerously high. Are we getting close to a market crash?

What next?

What happens next is important.

Central banks are increasing rates. If this makes people feel poorer or less flushed, they may spend less, decreasing the velocity of money, and that will put brakes on inflation.

If higher interest rates lead to lower asset prices, banks may cut back on lending, possibly leading to a contraction in the money supply.

If instead, wages rise and people don’t feel any worse off, they may well continue spending, and inflation may continue.

In a recent TV interview, when asked whether the Bank of England was trying to get into people’s heads, Bank of England governor Andrew Bailey said, “in a way, yes.”

And so we have this clash.

Prices go up; people demand higher wages. So the bank ups interest rates, but real rates (inflation minus interest rate) are much lower than before Covid. So if real wages increase faster than real rates go up, then they may lead to more inflation.

However, the big danger is that asset prices look so extraordinarily high that it won’t take much to cause a crash. If they crash, the mood will turn bleak, a recession may well follow, and inflation will turn to deflation.


But new technologies can change all.

Andrew Bailey also said we might need to invest in gas during the transition to renewables. He may be right, but such investment will be short term.

The renewable revolution continues to astonish.

Automation technologies continue to advance.

Autonomous cars could change the economy in the most profound way.

As such technologies advance, central banks may well have to create money to stop a chronic shortage of demand creating a 1930s style depression.

The most significant danger is that a backlash against QE and central banks today may damage their credibility or make them scared to apply QE later this decade, when we may desperately need it.

Untangling the inflation quagmire and cognitive dissonance over interest rates
What’s the truth behind the inflation story of 2021, and do interest rates need to go shooting up to nip inflation in the bud?

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