QE and inflation denial

What's Mr Bootle taking? As a leading proponent of Quantitative Easing and one of the world's inflation deniers, his piece in yesterday's Daily Telegraph came as a shock. It seems that he feels that there is a risk of inflation in 2011 after all!

Better late than never, this shift of stance, but I would suggest that we are already past the "minor uptick" he refers to; RPI has run at an annualised rate of 3.7% since January. I don't expect today's figure to halt this trend.

A key plank of Mr Bootle's argument for persistent deflation, is that of "spare capacity" in the economy. Unfortunately, there are few idle machines because in a service-based economy, there were few active machines prior to the downturn.

The argument thus hinges on labour availability. I would suggest that employers have little demand for workers at the minimum wage of #5.80/hour and the associated red-tape headaches of employment, equal opportunity and anti-discrimination etc. legislation - (it's a miracle that anyone is employed). In fact they would rather employ immigrant "gang" or other cheap manual labour to staff the leisure and food production sectors or outsource the job overseas, if it is an indirect service.

The same service industry skew means that sterling weakness does not boost exports to any great extent compared with past crises. It may serve to increase tourism levels in the UK, if the elevated oil price doesn't deter potential visitors, but for all the imported food, goods and energy, sterling's weakness is inflationary.

Back to the spare capacity argument, what about the supply of labour at #5.80/hour? It is perhaps not that great after all. Many of the unemployed would seem to be better off on benefits at a higher equivalent hourly rate. Furthermore, despite the internet, the plethora of databases and employment agencies, the ability to match buyers and sellers of labour has not noticeably improved. Systemic unemployment may well be higher than many think.

On the other side of the inflation equation, I haven't seen anything to threaten the pricing power of retailers, energy suppliers or tax gatherers.

QE at #200bn will be about 10% of money supply as measured by M4. Unfortunately, M4 still hasn't grown to reflect the QE already smouldering away. It has been totally useless because unlike national stimulus schemes that have targeted the borrower, such as in Singapore and Australia, throwing money at the banking system will never work if their potential customers remain too scared to borrow.

So more QE and more loose money until after the election next May. But what if inflation takes hold and the world tires of sterling before then, will we get a rise in interest rates to defend sterling? What about the capital loss on the government's holdings of debt which will be dramatic given the long duration of their holdings?

So will it be an IMF rescue or a surge in UK interest rates? Probably both.