Thursday, August 13, 2009

Pumped-Up On Experimental Drugs

At least he tested it on himself

As regular readers will know, we are very concerned that the Bank of England is overdosing us with monetary stimulants. We're especially concerned at the Quantitative Easing (QE) programme - or printing money as we old-timers still call it.

Last week, against all expectations, the Bank announced a further dose of QE, taking the total from £125bn to £175bn. Which has worried us even more. Because as others have said, QE is an untested drug, and we've already swallowed a very large dose. Common sense surely tells us it might be best to wait a while before taking yet more.

Yesterday the Bank of England tried to explain their thinking. They said that without the additional dose of QE, CPI inflation would remain well below their mandated target of 2% for the next two years and beyond. Here's their fan chart showing just that:

As we can see, with QE (aka asset purchases) limited to £125bn, inflation is expected to fall well below 2% - although not, please note, into deflation territory. And two years out (the vertical dotted line) it's still expected to be below 2%. Or rather, there is only around a c 20% chance it will be at 2% or above (the bands on the fan chart are supposed to denote probabilities).

So to address this, the Bank is deliberately stoking up inflation by pumping in a further £50bn of QE. Here's what that does to their outlook:

As we can see, the extra dose does the trick and inflation over the next two years is lifted much closer to the 2% pa target.

Job done.

Er, yeeesssss... except...

For one thing, there are increasing signs that world growth is already through the worst, and turning up. Chinese growth is moving forward again (currently 8% pa), the US is widely expected to bounce back to 2% next year, and just this morning we've had news that GDP grew in both France and Germany during Q2. The massive reflation medication worldwide is feeding through.

Which means that world inflation is no longer out for the count. Commodity prices, including oil, are now well off the bottom - over the last month alone, the Economist Commodity Index (in dollars) is up 10%.

Given Britain's chronic long-term problems with inflation, and the potential for weak sterling to import a lot of inflation very quickly, this is not a world in which we should be taking risks. This is a world in which we need to be very careful indeed.

And as for the Bank's highly impressive fan charts, we just need to remember one simple fact: no matter how glossy the presentation may be, the underlying forecasts are no better than the flip of a coin. Nobody has the faintest idea whether inflation in two years time will turn out to be 1%, 2%, or 5%.

Because that's just the way economic forecasts work. You can employ the best brains, and construct the most sophisticated and detailed models available to humanity. But all those known unknowns and unknown unknowns make it impossible to have much confidence in your projections.

The Bank certainly can't claim any particular record of forecasting success. Here's their inflation fan from last August - just 12 months ago:

Pretty different, huh?

And in fairness to the Bank, they admit their record is not that brilliant. They say (page 48 here)that over the last decade their one-year forecasts of inflation have turned out within their 50% probability range (the dark red bit of the fan) only four times out of ten (ie a supposed 50% probability range has turned out to be closer to 40%). Moreover, their past forecasts have been biased down (ie inflation has turned out higher than forecast two to three times more often than turning out lower).

So we can't have a lot of confidence in the doctor's judgement here. In the past, he has not been particularly accurate in his diagnosis, and has tended to underplay the risk of inflationary fever.

And now he's administering huge doses of untested drugs.


Feel lucky?

PS Of course, as we've blogged before, inflation won't be bad for everyone. Debtors - including the government - will benefit as the real value of their debt gets eroded away. But savers, widows and orphans will be punished most savagely. Just like they were back in the 70s and the Weimar Republic. Meanwhile, the banks are coining it in, as the Bank of England shovels in cheap cash for them, while home owners and small business get racked by higher borrowing rates. Ah, it's a cruel cruel world.

1 comment:

  1. Mental imagery is good, drugs and beta blockers are probably not.