The Bank of England's quarterly inflation report is suitably gloomy. Though GDP growth in the U.K. is low, the inflation rate has risen again, to 2.7 per cent, about half a percentage point higher than the central bank predicted just three months ago. The surprise can be explained by excessively insular thinking. Central bankers, and not just in the U.K., need to consider the global effect of quantitative easing.
When making policy decisions, central banks understandably think local. What the Bank of England sees at present is an economy that needs all the monetary help it can get. After an Olympic jump in the third quarter, GDP could even contract slightly in the fourth, central bank Governor Mervyn King said.
Domestic weakness is supposed to go along with disinflationary pressures. The central bank has consistently believed that inflationary pressures would abate and inflation fall below its target rate of 2 per cent. The central bank has consistently been wrong. The inflation rate could now easily increase to 3 per cent as utilities raise their prices. In turn, that could depress consumer spending again, weakening growth.
The vicious cycle of unexpectedly high inflation and unexpectedly low growth needs to be broken. To do so, the source of the inflation needs to be better understood. Some problems are domestic, most notably in October with the government-mandated sharp increase in university tuition fees.
But the profound source of the inflationary problem is that weak domestic spending does not isolate the U.K. from high global prices of energy and other raw materials. And why are those prices high? The likely answer is extreme monetary stimulus.
As Sir Mervyn himself pointed out, the world's major central banks are all following policies of extreme stimulus. And the U.S. Federal Reserve's commitment to money printing is now open-ended. There can be little doubt that the newly created money does a great deal for financial markets and commodity prices. These have an inflationary impact around the globe – one that is reducing real incomes, and dampening growth, not stimulating it.
Central banks need to think again – and think about the global impact of their policies. QE is supposed to generate growth, but it appears instead to be generating growth-killing inflation.