Economics: Paper tiger – no hard and fast rule to keeping inflation at bay

Nobody can accuse the authorities of standing idly by while recession bites deep into the fabric of the economy. The Monetary Policy Committee has slashed interest rates from 4.5% to 1%, the lowest ever in the Bank of England’s 315-year history, inside four months. At the same time, Chancellor Alistair Darling loosened fiscal policy to the extent that even on his typically optimistic forecast, borrowing in the coming tax year (2009-10) will reach a record £118bn. On top of this, sterling slipped to its lowest-ever rate against the euro. All the key levers have been pulled decisively and early into the downturn.

If conventional economic policy means anything, this will be a relatively short-lived and shallow downturn.

Unfortunately, recession is not the only problem. While the credit crunch neither caused nor was caused by recession, collateral damage from the turmoil in financial services will have a major impact on the pace and strength of a recovery.

Trying to get the banking system on an even keel is taking at least as much government time, and certainly more money, than kick-starting the economy. This is not because the authorities like the banks particularly, or have any sympathy for what in many cases is a self-inflicted plight. Rather, policymakers recognise that most businesses and many households depend on a regular flow of credit for normal day-to-day business.

Companies have to produce goods or supply services before they are paid, while the housing market depends on a flow of mortgage finance. Without it, any recovery could be very weak and patchy.

Even though the price of money is at historic lows, it is not helping unblock the plumbing of our banking system. As Bank Rate falls, savings rates offered by banks become less attractive and so, as the retail deposit base shrinks, banks have to use the wholesale or interbank market for additional funds. This is the crux of the problem: the interbank market has dried up and those funds that remain available are more expensive than Bank Rate, reflecting the lack of liquidity and confidence among banks.

In spite of the steps the government has already taken, and the much-publicised government investment in RBS and HBOS, credit still seems in short supply. Because balance sheets need rebuilding, the money was used to recapitalise the banks rather than for new lending. Other steps taken by the government involve insurance-type schemes aiming to reduce the risk to the banks of lending to businesses.

These are sensible ideas but will take time to have an effect. Meanwhile, confidence continues to drain away from companies and consumers, leading to active consideration of the ‘nuclear option’. Known technically as ‘quantitative easing’, it amounts to increasing the money supply, thus ensuring adequate flow of credit from the banking system at attractive rates. The Japanese tried it, the Americans are using it now, and the UK will probably be next. There are various ways of going about it and while it is a last resort carrying inherent risks, it should, in conjunction with the other measures, have the desired effect.

Quantitative easing is the modern way of printing money. The aim is to get money moving around the economy when the normal process of cutting interest rates is not working and they cannot be cut any lower.

The most likely method is for the central bank to buy assets from the banks for cash, assets such as government debt, mortgage-backed securities or even equities. The money is created by increasing the size of the banks’ accounts at the central bank, leading to a build up of excess reserves which then become available for lending.

This is uncharted territory for UK policymakers and there are very few comparable modern precedents elsewhere. The Japanese attempt a few years ago was later on in the recessional cycle and the results were mixed, perhaps because the Japanese attitude to spending and saving is quite different from the British. The US is only just underway and it is too soon to judge its effectiveness.

Of course, there are risks. By buying up assets that are hard to price and perhaps of dubious quality, the authorities could be landing future taxpayers with an even larger bill for failure. There is also an obvious danger that the currency is effectively being debased, which could have implications for both the exchange rate and inflation. But, in the current climate, in which there are genuine concerns about deflation, a little bit of inflation would be welcome. In many ways, the mindset associated with an environment of falling prices is more insidious and harder to counter than the usual inflationary psychology.

But how the Treasury and the MPC ensure we only have a little bit of inflation is the crucial issue. Inflation develops its own momentum and recognising the signs early and taking the appropriate interest rate action is a very difficult judgement. And who makes that judgement ­ the Chancellor or the Bank of England? Will this whole process compromise the independence of the Bank of England? The rules are being made almost on a daily basis.