Duncan’s Economic Blog

Operation Twist: Or what the Bank should do about inflation

Posted in Uncategorized by duncanseconomicblog on April 11, 2011

Given the outlook for inflation, the Bank of England is widely expected to soon follow the lead of the ECB and begin its own tightening cycle with the first rise in the next two or three months. Only a really bad set of Q1 2011 growth figures could prevent this.

To be clear from the start, I don’t think a monetary tightening will be at all helpful for the economy – especially as the cuts bite.

The entire theory of ‘expansionary fiscal contraction’ is premised on the idea that tight fiscal policy would allow the BOE to maintain loose monetary policy, to tighten both would be doubly damaging to the still-fragile economy.

Indeed analytical work from the IMF suggests that a 1% of GDP cut in government spending subtracts 0.5% from growth if interest rates fall, but around1% if there is no monetary easing.

But whilst I don’t support a straight forward, traditional monetary tightening cycle I would support something a bit more imaginative.

Because we can’t just ignore inflation at its current levels.

The current level of inflation is the single largest factor behind the squeezed real wages and declining living standards that I’ve been writing about for the past few months (and government policy on the fiscal side is generally making this worse rather than better).

Two years ago I wrote a lot about deflation and how it was a real risk to the UK economy, that time has passed. My current view (a strange mix of Posen and Sentence maybe) is that core inflation (i.e. inflation excluding food & fuel) is likely to be quite weak given the lack of wage pressure and corporate pricing power but that headline inflation is likely to continue at elevated levels driven by high commodity prices.

One response to this (and one I’ve used myself in the past) is that there isn’t much the Bank can do about global commodity prices. But of course there is something it could do – aim to raise the value of sterling. The importance of the exchange rate here can’t be underestimated. Oil for example is currently trading around the $120 mark, well below the peak of $147 reached in 2008, but given sterling’s fall the oil price in sterling terms is at a record high.

A 10-15% appreciation in the pound would have a significant impact on lowering imported inflation and hence raising living standards.

(Note this is a reversal of my view of two years ago, but then two years I was worried about domestic deflation – now the threat is high headline inflation).

What about our exporters? Wouldn’t a rise in sterling harm them? I’m not so sure about this – high producer price inflation would be lowered by an appreciation, potentially taking some cost pressure of them.

But more importantly I’m doubtful about the prospects of export-led growth. My worry is that two years of weak sterling have increased inflation without any real impact on net trade.

The question then becomes how to strengthen sterling without killing off the recovery by hiking interest rates?

The answer may well be found in the early 1960s, when the US Fed embarked on Operation Twist.

The project, started in 1961, was called “Operation Twist.” It was intended to lower long-term interest rates (to stimulate investment) while propping up short-term interest rates (to attract capital from abroad and support the dollar).

The Bank, repeating the Fed’s precedent, could raise short term interest rates in order to make sterling a more attractive currency to hold whilst buying long dated bonds in order to keep long term interest rates around their current level.

Now, Operation Twist has divided academic opinion but for a good introduction to how it could work and some evidence, there’s a excellent blog post from Professor Bill Mitchell.

A standard tightening cycle would be damaging to the economy, however some UK updated version of Twist might be worth a try.

6 Responses

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  1. Agog said, on April 11, 2011 at 2:07 pm

    Interesting – and maybe a side-effect of flattening the yield curve could be to spur the banks into lending a bit more?

  2. Mark Stephenson said, on April 12, 2011 at 10:17 am

    I’m pretty sceptical that the BoE has any meaningful control over FX and I don’t think using the US in the 1960s is really a meaningful benchmark given how capital flows have evolved over the last decade or so.

  3. Mark Stephenson said, on April 12, 2011 at 10:42 am

    Incidentally, I don’t agree with the view that weak sterling has had no impact on exports. It’s very clear that world trade collapsed and UK exports have performed well on that backdrop, ie the UK has been raking a larger share of a smaller pie.

  4. Imogen said, on April 12, 2011 at 7:35 pm

    How bad is really bad though? Given that falling construction could knock 0.3% off GDP if RBS are correct. This combined with the news of a spectacularly poor figures from highstreet retailers with the largest fall in growth since they started their records, and that CPI has already fallen 0.4%, I think the likeihood of a rates rise is much reduced.

    Given the data that is currently available I would expect 2011 Q1 GDP to be around +0.3% Something that, after 2010 Q4 -0.5%, would continue to give BoE pause on increasing rates. Consequently I believe that a rates rise is unlikely until after the Q2 results for this year are published in August.


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