Is the Bank’s cash injection enough to stave off deflation?

Why did the Bank of England not go the whole hog and cut interest rates to zero yesterday? If 0.5% is a suitable rate for saving some businesses from failing, would not a more drastic reduction to zero save more? Probably, but when you have very few bullets left, every one has to count – and that is a near impossibility when the target is moving.

The six cuts in bank rate since last October have proved less effective in stimulating the economy than experience would suggest. The recession is gathering pace and consumer spending is expected to fall by 3.5% in real terms this year despite money never having been cheaper and falling inflation providing a boost to spending power. Unemployment is rising rapidly, but most Britons are still working and have more in their pockets than at this time last year due to falling mortgage and loan rates. Add to that the fact that savers are earning such paltry returns on their deposits that they might as well not bother and the question becomes one of why is spending on such a steep slide?

The latest attempt to stimulate consumption is to create what is hoped will be a mild dose of inflation by the Bank injecting an extra £75 billion into the economy through creating new money, which is not the same as printing more bank notes. Since the autumn, the public has watched retailers of every hue attempt to create cash flow by slashing prices and offering even deeper discounts – can you name a chain that has not offered incentives since Christmas? The expectation is of deflation, that prices (despite rising costs, especially of imported goods) will fall further. The message is “Keep the cash in your pocket, you’ll get more for your money tomorrow”.

But the Bank cannot know whether £75 billion is too little, too much or just right to stave off deflation. It is in uncharted territory and so has held back £75 billion of the total the government has permitted it to create as well as leaving itself scope for a further – and final – rate cut to zero. It is holding some ammunition in reserve, but not much.

Let’s hope its strategy works. Deflation is more crippling than inflation but if it takes hold, how will those companies offering 2 for 1 and other deep promotions get their prices back to sustainable levels in the medium term? They might collapse first.

 

Finance on Friday, 06.03.09