One of the biggest questions that policymakers face is whether the economic crisis triggered by the COVID-19 epidemic will lead to a Japanification of developed economies – or to run- away inflation. Ouida Taaffe reports from a recent Bank of England webinar.
“There are forces pushing in both directions,” said Silvana Tenreyro, an external member of the Monetary Policy Committee and a professor of economics at the London School of Economics, in a Bank of England webinar in April. “We will be learning over time. If you press me now, I think the balance is leaning towards more deflationary pressures.”
She pointed out that falls in the purchasing manager’s indices (PMI) and expectations surveys suggest record drops in economic activity. That has led to a steep fall in oil prices. The latter, she said, “makes it very likely that inflation will fall below 1% in the coming months”.
In February 2020, CPI inflation stood at 1.7% and was not expected to hit the price stability target of 2% during 2020, Tenreyro added.
However, a “crucial aspect” of the economic shock from COVID-19 is that it “should be temporary”, Professor Tenreyro said. She said that the path the economy takes will depend on a number of factors including how quickly we get out of lockdown and how effective the various stimulus policies are.
She also stressed that the upheaval the economy is going through has radically changed the type and quantity of data available to the MPC, which makes it difficult to interpret what is going on and what the future might hold.
However, factors pushing in the direction of deflation – aside from the collapse in the oil price – include lower commercial rents as more people shop online and companies see potential savings in having more people work from home. Also an increase in the scale of the leading retailers, such as supermarkets and online players, could “weigh heavily” on retail unit wage costs and CPI inflation, Tenreyro said.
Interest rate changes
The “key task” for policy is to try to minimise business failures and job losses, Professor Tenreyro said. One of the first policy steps by the MPC was to lower the bank rate to 0.1% on 19 March 2020 – a new record.
In principle, lots of cheap money should lead to asset and price inflation. In the run-up to 1990, for example, Japan boomed and saw large asset bubbles. However, since the middle of the 1990s, Japan has suffered from deflation. One of the reasons often given is the change in Japan’s demographics: as its society ages the natural rate of interest has fallen and, along with it, expectations for future income growth. [There have been many examinations of this. (e.g. See Nishizaki K, Sekine T, Ueno Y, Kawai Y (2012), ‘Chronic Deflation in Japan’. Available at: https://www.bis.org/publ/bppdf/bispap70c.pdf).]
Japan is not alone in having an ageing society – nor in having negative real interest rates. The question now is whether it shows how other developed economies might develop. Could, for example, interest rates in the UK go even lower?
The MPC “will do whatever it takes to achieve its remit [of price stability] … I cannot tell you whether policy will need to loosen or tighten in the future,” said Tenreyro during the webinar. She added that, if demand recovers more quickly than supply it is within the MPC’s remit to tolerate an overshoot in inflation to support growth. The MPC has also “been in trade-off territory before”, she added.
Since the financial crisis of 2008, the Bank of England has undertaken quantitative easing and greatly expanded its balance sheet to buy (mainly) government bonds. The aim of QE was to boost growth by lowering real interest rates and encouraging investment in risky assets. In theory, QE should have led to high inflation. Professor Tenreyro was asked on the call whether the additional QE the Bank has undertaken could lead to more inflation.
“The expansion of the Bank of England’s balance sheet is in response to a very big shock and we were starting from a position of undershooting inflation by around 1 percentage point,” she said. She added that some estimates suggest that the additional QE will lead to 70bp of inflation, “which does not even get to the target [of 2%], so I don’t think there is any inflationary risk linked to QE.”
Professor Tenreyro was unwilling to be drawn on the outlook for unemployment. She said that the Bank would issue projections in May. However, she did say that “it looks like the exit from the crisis will be less ‘V-shaped’ than one would want…We will update as know more about the exit strategy and the effect of the pandemic on various sectors of the economy.”