Policymakers have been taken by surprise by the persistence of high inflation, now that the initial spike triggered by a combination of supply chain disruptions and Russia’s invasion of Ukraine has passed.
They were hoping for something more transitory. For me, this hints strongly at an underlying cause that is in part monetary.
We cannot blame where we are today purely on a sequence of unfortunate real economic shocks, as Bank of England deputy governor Ben Broadbent has tried to do. But after a decade and a half of money printing through the BoE’s quantitative easing programme, why should this happen now?
Inflation is a fall in the value of money, which leads most economists to accept that it is monetary in nature. But I do not feel this definition gets us very far. Neither does the view that inflation is the result of “too much money chasing too few goods” — how much money is too much? These are empty statements.
Below I set out why the consequences of the latest round of QE were so dramatically different from earlier ones. Hint: it is to do with how quickly the newly created money gets into the hands of consumers.
There is a school of thought — not so fashionable these days — that puts a lot of weight on the usefulness of the quantity of money as a predictor of the level of prices. Its adherents must have been somewhat alarmed when the BoE decided to begin QE in early 2009.
Newly created money
In the UK, QE involves the BoE’s Monetary Policy Committee voting to purchase assets from the private sector — almost exclusively UK government bonds, or gilts — using newly created central bank money, sometimes called base money or high-powered money.
In the first year, the stock of central bank money more than doubled. But what happened to prices? As it turned out in that instance, not a great deal.
The conventional wisdom is that QE works by raising the prices of the assets that the central bank is acquiring, and those of close substitutes, thereby depressing yields and making it cheaper for companies and households to borrow.
OECD economists Nobukazu Ono and Álvaro Pina estimate that QE purchases up to the value of 1 per cent of gross domestic product might cut long-term yields by 5 to 10 basis points.
There is a school of thought that puts a lot of weight on the usefulness of the quantity of money as a predictor of the level of prices
If they are right, the first tranche of QE, from March 2009 to January 2010, should have lowered long-term gilt yields by between 0.5 and 1 percentage points, while the whole 2009-19 programme would have lowered yields by 0.9 to 1.8 percentage points.
Yet, despite the rapid increase in high-powered money during this 10-year period, UK consumer price index inflation remained comparatively stable, fluctuating within a percentage point or two of the target.
But the response of inflation to the round of asset purchases that began in March 2020 as the UK entered lockdown has been very different. During 2020, UK economic output fell by 11 per cent — reportedly the most severe economic contraction to hit the UK since the Great Frost of 1709.
And yet, as the chart below shows, factor incomes — the sums paid to workers as reward for their labour and companies as reward for their capital — were largely unaffected. How so?
The answer lies in a little-known component of the accounts known as the “factor cost adjustment”, which represents the difference between the sum of money received by companies and workers for their part in producing UK economic output, and the sum of money spent by UK and overseas residents on buying that economic output.
It is the balance between government taxes levied on products and production, and government subsidies. In normal times, it is worth 12 per cent of GDP and fluctuates almost not at all. In the second quarter of 2020, it turned negative.
The UK government funded lockdowns through the widespread payment of subsidies, ensuring that companies and workers continued to receive near-normal levels of income, despite large parts of the economy being shut down.
Where did this money come from? Not from the government selling bonds to private investors, which is the normal form of deficit finance — well, strictly it did, but only once the MPC announced that it would immediately take those bonds out of the hands of private investors by making purchases in the secondary market.
As the second chart shows, the BoE’s Asset Purchase Facility mopped up almost the entire additional issuance of debt stemming from the pandemic. Simply put, we saw the government order whole industries to stop producing, and by way of compensation hand both companies and workers newly created central bank money on condition that they did not work.
It turns out that this is a recipe for inflation — and when repeated on differing scales across the world, it is a recipe for global inflation. This was effectively monetary financing of the deficit: ultra-loose monetary policy combined with ultra-loose fiscal policy to deliver something that looked very much like former US Federal Reserve chair Ben Bernanke’s proposals for “helicopter money” as a last resort in the fight against deflation.
Could we have avoided the inflationary consequences? Probably not entirely, though it might have helped if the BoE had paid greater attention to the part its own actions were playing from the off.
Today’s inflation is the result of decisions taken during the pandemic, in an emergency, and therefore hard to criticise — up to a point.
Fiscal policymakers might have got on top of the situation early on if they had taxed away a good portion of the pandemic savings that had built up during periods of lockdown — hardly a vote winner, of course, but there are no easy answers here.
But they did not, leaving the task to the BoE. So far the central bank has not managed it well.
Andrew Brigden is chief economist at Fathom Financial Consulting
