So Why is the Bank of England Not Acting "As if Their Hair Was (Is) on Fire"?

Today is central bank day in Europe where at midday we will hear from the Bank of England and then some time after 1:30pm we will hear from the European Central Bank (both UK time). Both central banks are facing an environment where economies are showing signs of weakening and so both are facing pressure to ease policy. In the case of the ECB there are the beginnings of calls for an interest-rate cut which if nothing else would be embarrassing for an organisation which raised them to 1.5% as recently as July. For the Bank of England there is much less scope for interest-rate cuts as it has an official rate of 0.5% so the calls are for more Quantitative Easing are expressed here by the Chief Economist of the Institute of Directors. Expanding QE by £50bn initially is a sensible and limited response. What is happening in the UK economy? We are seeing further signs of economic weakness. If we look at yesterdays figures for industrial and manufacturing production we saw that industrial production which was hit by shutdowns in oil and gas production fell by 0.2% in July and manufacturing rose by 0.1% in July. These are not inspiring if we recall that we are supposed to be recovering from the Royal Wedding/ extra bank holiday weakness in the second quarter of the year. Also I like to look at the overall figures for these two indices as they give an idea of our overall performance over the credit crunch period. These numbers are set with 2006 as the baseline of 100 and our index of production is 88.4 and our index of manufacturing is 92.3. I think they speak for themselves. In addition the National Institute for Economic and Social Research (NIESR) published yesterday its monthly economic growth report. Our monthly estimates of GDP suggest that output grew by 0.2 per cent in the three months ending in August after growth of 0.6 per cent in the three months ending in July. So the economic picture in terms of output and production looks weak but remains just positive. What is the Bank of England's view on this? If we go back to the minutes of the Monetary Policy Committee's June meeting we see this. For some of these members, it was possible that further asset purchases might become warranted if the downside risks to medium-term inflation materialised. And if we look for possible triggers for this we got this from the same set of minutes. The current weakness of demand growth was likely to persist for longer than previously thought. Moreover, the fiscal challenges in the euro-area periphery highlighted the potential for further adverse shocks to demand. Interestingly both have continued as we find ourselves three months later with the Euro zone periphery in even more of a crisis and demand growth not only having been weak for a further three months but looking likely to remain so. What we did not know in June was how many was the some in “some members” but since then we have even seen a member who was in favour of an interest-rate rise (Martin Weale) suggest this. Substantial further weakening of inflationary pressures would, of course, mean that additional monetary support rather than a withdrawal of that support would be the appropriate policy. If other members of the MPC have shifted their thoughts in a similar fashion then it could be a tight vote today. What about inflation? Interestingly Charles Evans of the Chicago Federal Reserve Bank has made my case for me in a speech he gave yesterday. It is quite a critique of the Bank of England's current policy as it comes from a man in favour of more monetary stimulus. Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn't any doubt. They would be acting as if their hair was on fire. As the Retail Price Index is at 5% and the Consumer Price Index is at 4.4% can readers see any evidence of MPC acting “as if their hair was on fire”? It is most damning that an arch-dove such as Charles Evans thinks this and we can see how damning by the part of his speech referring to the US economy that talked of the Fed aiming for an inflation target of 3% rather than the convention of 2%. He would regard this as acceptable if in return the policy could reduce the level of unemployment from its current 9.1% to around 7.5%. As an aside we can see that it is clear that Mr. Evans will be voting for further stimulus measures at the FOMC meeting on the 20th and 21st of September. Would more Quantitative Easing do any good? When I hear cries for more of this the bit that I find is missing is the explanation of what good it would do. For example a scientific experiment would draw from previous evidence and as we have rather a lot of it (the £200 billion of QE we already have) the silence on this subject from proponents of more QE is deafening. Indeed as the bank of England website tells us that the rationale for QE was/us. But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end. So as we are above our inflation target and indeed well above their own logic as expressed above is that they should be withdrawing not adding to the stimulus. What never seems to get an answer from the proponents of QE is the answer to this question.Why should it work now when you have spent £200 billion already for little or no result? I might add, what do you think has changed that will mean it will work now as your call for it implies your previous effort has not worked? Sadly no journalist seems to have made that point when the Chief Economist of the Institute of Directors was telling them that more QE was “sensible”. It simply isn't. Today's vote It is possible that Adam Posen will be joined by another member or two in his regular call for an extra £50 billion of QE. Even if this does not happen I expect the minutes to be more dovish when they are released in a fortnight. It could be much tighter than many think but I suspect they will wait to see what the US Federal Reserve does on the 21st. The European Central Bank It too has quite a dilemma today as it is between a rock and a hard place on several fronts. I think that much of its debate will be taken up by the Securities Markets Programme which as I pointed out on Tuesday had to double its weekly settled purchases last week to over 13 billion Euros. It has been buying Italian and Spanish bonds again this week and has had a partial success here in reducing bond yields but yields in Greece have gone from bad to worse. If you are standing up please sit down as Greek one-year government bonds yield 94% and two-years yield 54%! So the pattern of the past where the ECB has been able to intervene heavily and then wind down is not working when facing the much larger Spanish and particularly the Italian bond market. Worse than that Greek government bond yields are simply starting to say “default” which when you have as many of them on your balance sheet as the ECB has must be troubling to say the least. Its recent capital increase programme may not be enough as the ECB's “mark to fantasy” system of accounting would be shattered into tiny pieces by an actual default. So it is quite possible that the ECB will discuss interest-rates very little today as it will be concerned with a possible internal crisis. When it does so I would suggest that the logical response considering it recent rises would be to announce that economic risks are now balanced and that it does not expect to have to make further increases. I think that the fact that Euro zone inflation which at 2.5% is above its 2% target will prevent them doing more and that as Mr.Trichet has only 2 meetings to go he will be likely to try to leave any policy shift to his successor. Shaun Richards is a freelance economist who writes the Notayesmanseconomics blog at Mindful Money.