Will inflation soar when QE is withdrawn?

December 15, 2009

MarkBolsom - Mark Bolsom is Head of the UK Trading desk at Travelex, the world’s largest non-bank foreign exchange and international payments provider. The opinions expressed are his own. -

The rise in November’s CPI figure was larger than expected, but not a total surprise and markets have largely ignored the data.

In the Bank of England’s quarterly inflation report, published last month, Mervyn King reiterated his belief that short-term inflation looked set to rise quite sharply, in line with higher oil and petrol prices. There is little doubt as well that Sterling’s relative decline against a basket of other currencies has also contributed to inflationary pressure. This is particularly significant for the UK, as Britain remains a net importer of goods, and thus far there has been no sign of a reduction in the trade deficit. In fact the trade deficit actually widened to 3.2 billion pounds  in October from 3.1 billion pounds in September 2009.

In the short-term, we expect inflation to carry on rising, as the reversal in VAT, scheduled for January (currently at 15 percent, set to revert back to 17.5 percent), will add to inflationary pressures. As the pace of the global recovery picks up, we also expect the cost of raw materials to increase, further adding to upwards price pressure and quite possibly pushing inflation to 3 percent by the end of the first quarter in 2010.

Nevertheless, even with the pick up in underlying inflation, the higher CPI number is unlikely to significantly impact the Bank of England’s monetary policy. Mervyn King has stated that he will be focussing on the medium term outlook, preferring to concentrate on spending relative to the spare capacity in the UK economy. Given this outlook, and the probability that wage inflation is also likely to remain subdued, we expect the Central Bank to persist with a policy of low interest rates. We expect rates to stay on hold at 0.5 percent until 2011.

However, only when the MPC start to withdraw their quantitative easing programme will we get a true indication of the currently bolstered CPI figure. Thus, the real question is what will happen to inflation rates when the MPC start to withdraw economic stimulus?

Comments

It won’t make any difference, inflation is coming regardless of when QE ends, you can’t put the genie back in the bottle. Buy hard assets and snorkels and hold on to your hats, the tidal wave draws nearer.

Posted by Steve | Report as abusive
 

I think inflation will start to surge well beyond the BoE target of 2% in 2010 and not come down as the BoE conveniently predicts. The BoE has completely abandanoned its duty to fight inflation and seems to be totally focussed on creating growth even if it is inflationary growth.

The impact of QE has already been seen on asset prices which have all risen rapidly off their lows. Money pours into the most liquid and accessible markets first so unsurprisingly stocks have risen on the back of QE and the general monetary largesse by central banks. We already have an asset bubble re-energing.

Consumer price rises will surely follow in 2010. The situation will be exacerbated by increasing evidence of a lack of political will to grasp the magnitude of action needed to remedy the UK’s budget position. Without a fiscal tightening and exceptionally loose monetary policy gilt investors will head for the exit forcing a painful series of adjustments to the economy.

The real test will come when gilts start to rise and sterling decline rapidly sometime in 2010. The market will anticipate a surge in consumer price inflation well before it appears in the headline figure, only then will the full distortion caused by QE become apparent. Importers will start to raise prices, savers will start to panic as the value their sterling holdings erodes in value. Wage earners will demand higher pay rises so the inflationary super-cycle will begin.

QE and near zero interest rates threaten to make the UK a banana republic but the same economists who utterly failed to predict the credit crunch now mistakenly argue this is the only way out.

 
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