Recession is a bigger threat than inflation

by Ed Bowsher on 06 August 2009  |  6 comments
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The Bank of England is going to carry on 'printing money.' It's still worried about the threat of a long recession.

Last month, it looked like the Bank of England was getting ready to wind down its programme of quantitative easing.

One month on, that's clearly not the case. The Bank of England is more worried about the threat of a long-running recession than any threat of looming inflation.

So what's happened?

Today the Bank of England said it would leave the base rate unchanged at 0.5%. That's not surprising. The more interesting part of the announcement was on quantitative easing (QE) - the bank's scheme to create fresh money to stimulate the economy.

Last month, the Bank had surprised the financial markets by saying that it wouldn't expand QE beyond £125bn at that stage. That announcement suggested that the Bank thought it had the recession pretty much under control.

Now the Bank has surprised the markets for the second month running, and said it plans to take the total spend for QE to £175bn. So it looks like the Bank is still very worried about economic output and the prospect that inflation could fall too low. Or that we might even see deflation.

Has the bank made the right move?

Of course, there's a risk that the monetary stimulus will trigger higher inflation in the next couple of years. (If there's too much money chasing too few goods, you'd expect prices to rise.) And given the size of the stimulus, you can't dismiss this risk completely.

But overall, I suspect the Bank has made the right call. Yes, we have seen some economic 'green shoots' in the last couple of months, but this has been a bad recession and we mustn't choke it off with higher long-term interest rates.

You might be thinking: why is he talking about long-term interest rates? Isn't the base rate still at 0.5%?

Well, the point about long-term interest rates is that they are not set by the Bank. Instead they're driven by bond prices. Especially government bonds, known as gilts.

The Bank has been using its QE cash to buy gilts. These purchases have kept gilt prices high and yields low. That should mean low long-term interest rates which is great news for businesses.

But the problem has been that the financial markets have been expecting those QE purchases to stop. That expectation has meant that gilt prices have fallen and yields have risen.

Now it's clear that QE is going to last longer than expected, gilt prices should start to rise again. So long-term interest rates should fall or at least rise more slowly than would otherwise have been the case.

What does this mean for you?

In recent months, we've seen rate rises for some fixed-rate mortgages as well as savings accounts. I think today's news should slow down that rising trend. In fact, rates for new fixed-rate mortgages could start to fall. But I'm not going to make any firm predictions. The Bank may change its mind again next month......