High inflation puts on Plan B on hold – is there a Plan C?

George Osborne has announced the biggest tightening of fiscal policy over a four-year period since World War II, to be achieved mainly through cuts in public spending. He believes that it will lead to lower long-term interest rates and, by increasing certainty about future levels of taxes, boost consumer and business confidence.

George Osborne has announced the biggest tightening of fiscal policy over a four-year period since World War II, to be achieved mainly through cuts in public spending. He believes that it will lead to lower long-term interest rates and, by increasing certainty about future levels of taxes, boost consumer and business confidence.

As a result, stronger private sector demand (and employment) will offset contraction in the public sector. In particular, he hopes that business investment and exports will contribute significantly more to growth than in the past. This is Plan A.

Of course, it may not work. Mr Osborne’s model of the economy could be wrong. Households may worry about the effect of public spending cuts on employment levels, reduce their spending and build up greater precautionary savings. And businesses could react to the uncertain outlook for future demand by holding back investment plans.

Or the plan could be blown off course by events out of the Chancellor’s control. The Irish economy’s problems have put the economic future of the eurozone back into the headlines in recent days. Weaker growth in Europe would put a severe dent in hopes that exports will lead the UK’s economic recovery.

So there is a Plan B: easier monetary policy. The Chancellor will not accept that he might have to change his fiscal policy as a result of economic circumstances, arguing instead that the Monetary Policy Committee (MPC) can ease monetary policy if the economic recovery starts to falter.

With short-term interest rates already at just 0.5 per cent, this would mean an increase in the scale of quantitative easing (QE), the amount of cash that the Bank of England pumps into the economy (currently £200 billion).

However, there are two potential problems with this plan. First, no one can be sure that it will work. The first round of QE appears to have been very effective in helping to unfreeze money markets and getting banks lending to each other.

This ended the ‘credit crunch’ – a necessary condition for the economy to emerge from recession. But it does not follow that an increase in QE now will boost economic growth, particularly if household and business confidence is declining.

Second, the MPC might be reluctant to increase the scale of QE while inflation is well above its 2 per cent target rate. Figures released today show that it increased, unexpectedly, to 3.2 per cent in October as a result of higher fuel prices.

In his latest letter to the Chancellor, Mervyn King continues to blame this on temporary factors – including a weaker pound, though sterling touched its low point at the end of 2008 and has subsequently appreciated by more than 10 per cent. But, with one member of the MPC now voting for an increase in interest rates, there is a clear risk that high inflation will prevent the implementation of Plan B.

This risk was perhaps evident in the Chancellor’s reply to Mervyn King, when he pointed out – more in hope than expectation perhaps – that the MPC also has to be vigilant against too low inflation. If this is a broad hint that the MPC should increase the scale of QE, then it shows how much George Osborne’s thinking has changed since he described it in March 2009 as ‘a leap in the dark’.

Of course, like the strength of the eurozone economy, some inflation forces – such as oil and commodity prices – are outside the control of the Chancellor. Inflation could remain higher than expected over the next year or so and Plan B may be on hold indefinitely. If so, let’s hope the Chancellor is working on Plan C.

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3 Responses to “High inflation puts on Plan B on hold – is there a Plan C?”

  1. Spir.Sotiropoulou

    RT @leftfootfwd: High inflation puts on Plan B on hold – is there a Plan C? http://bit.ly/aTH7xC

  2. Families Against National Debt

    Having been critical of a recent post – an excellent article.

  3. Mr. Sensible

    Tony I think this analysis and recent events serve as another reminder of what a risk the chancellor is taking with our economic recovery.

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