Lately, the Bank of England (BOE) has faced a tough choice over whether to stimulate the British economy (also known as loosening monetary policy), either by lowering interest rates or injecting money into the financial system. The latter, known as quantitative easing (QE), was most recently done from early 2009 through early 2010, when the BOE injected £200 billion into the banking system in an attempt to help it recover from the 2008 financial crisis.
Earlier this week, BOE monetary policy committee member Adam Posen made headlines calling for the bank to begin another round of QE, saying he believes this necessary to boost the British economy, which has slowed in 2011. Adding money to the banking system can help increase consumer lending, which in turn can increase economic activity. However, it can also cause inflation to rise.
Since British inflation has risen since mid-2009, some people are questioning the wisdom of Mr. Posen’s suggestion. As measured by the Consumer Price Index (CPI), inflation rose to a 4.5% annual rate (also known as headline inflation) in August, well above the BOE’s mandated maximum rate of 3%. Core CPI, which excludes food and petrol prices, rose to a 3.2% annual rate. However, both figures include the effects of the Value-Added Tax (VAT) increase this past January (higher VAT automatically means a higher amount paid for each good). A third CPI measurement was created to remove the tax’s impact, and this rate was a more modest 3%, which is right at the BOE’s maximum threshold. From that standpoint alone, it would seem the BOE may have at least some flexibility to stimulate the economy without inflation increasing substantially.
However, the international trade landscape may throw a spanner in the works. Exhibit 1 shows import and export growth rates since 2006:
Exhibit 1: Import and Export Growth Rates*
Exports increased at an annual rate of 8.9% in August, and imports increased at an annual rate of 7.9%, for strong total trade growth. However, gross domestic product (GDP), a common measure of economic growth, doesn’t include total trade in its calculations. Instead, it includes what’s known as net exports, which is calculated by subtracting imports from exports. In August, the UK’s net exports were -£4.45 billion, which disappointed most economists, who expected it to improve to -£4.2 billion.
As the chart above shows, exports grew much faster than imports earlier this year. Policymakers hoped this trend would continue and the trade gap would narrow, in turn boosting 2011 economic growth. Can the BOE adjust policy to help exports increase more, narrow the trade gap and, by extension, help GDP grow more? Exhibit 2 shows import and export price trends since 2006:
Exhibit 2: Import and Export Price Changes*
In August, export prices rose at a slower pace, which is probably one reason exports grew at a higher rate. Therefore, in theory, loosening monetary policy could help exports increase, as it would lower the cost other countries would pay for British goods—when goods are cheaper, sales are generally higher. However, it would also weaken the pound, forcing Britons to pay higher prices at home—on top of the substantially higher prices they paid for imported goods in August.
Since, as mentioned above, the UK’s headline inflation rate is already above the BOE’s mandated maximum, significant price increases would likely put the economy in a troublesome spot. Therefore, policymakers face a difficult question: Do they take steps to jumpstart economic growth, knowing that could push them into more dangerous inflation territory?
It’s not yet clear how the bank will answer this. Thus far, Mr. Posen has been the lone monetary policy committee member publicly calling for the bank to take action, though when the minutes from the most recent committee meeting are released, we’ll learn whether additional members supported him behind closed doors. We’ll watch closely as this unfolds.
*Source: Thomson Reuters as of 9/13/2011