Inflation
January 21st, 2011
This week UK inflation reached 4.8% as measured by the Retail Price Index. It leapt to a more modest 3.7% if you prefer the CPI. It’s led to all sorts of arguments about whether a little bit of inflation is good for you or not.
We did not agree with the deflation forecasts which were very popular in 2009 and lasted well into 2010, despite the obvious evidence of inflation and growth. The doom mongers of those distant difficult times should be relieved –and apologetic – that their forecasts were so wrong. Their case was a simple one. There had been a monetary accident, causing a sharp contraction in cash and credit. The banks were very weak. If the authorities did not act to offset the slump, deflation could set in. They feared the UK would go like Japan, with falling prices, stagnant or falling demand, and no growth.
Today the Bank of England tells us there is still no immediate need to raise official interest rates to curb price rises. Although it has presided over more than a year with inflation well above target, it is sure this is a temporary phenomenon. The Bank’s forecasts are the typical optimist’s ones. Inflation spikes after rising for just a few months, and comes back to below target after a year or so. They have been saying this for many months.
Like the stopped clock, this type of forecast can occasionally surprise by being correct. So far it has been wide of the mark. It is based on the assumption that the current causes of inflation are temporary, and may reverse.
Current inflation is partly imported, and is partly the result of the government’s deficit containment programme. The big fall in sterling in 2008-9 is feeding through, raising our import prices substantially. The UK is a large importer, so it feels it more than most devaluing countries. There have been sharp increases in many commodity prices worldwide, as emerging market demand mixes with quantitative easing dollars to drive the prices higher. The Bank believes sterling may now stabilise and commodity prices stop rising, bringing those inflationary pressures to an end. There is no evidence of too much money around in the private sector, despite the quantitative easing.
The home grown element of the price rises has been strongest where government has intervened. Higher taxes, led by the VAT increases of 2020 and 2011 have pushed prices up. Rail and bus fares have risen as government has cut back subsidies. Public sector fees and charges generally have risen considerably, in preference to raising productivity to handle less generous budgets. The Bank thinks we have now seen the bulk of this as well.
So could they now be right? If markets think interest rates will rise soon, the pound could perform more strongly, which would help curb inflation. If China and India slow their economies enough to cure their own inflationary pressures, they could also cool world commodity prices. The Bank is nearer being right than a year ago.
Meanwhile, on the Bank’s side is the fact that wage increases in the UK are only running at just over 2%. With prices rising by more than double that on the conventional measurement, there is a big squeeze ahead on real incomes. If companies and the public sector keep the lid on wage growth this year it will prevent the inflation taking off, and it will depress demand.
The irony for the Bank lies here. If it is right that wages will stay under strict control the inflation it has allowed will induce a tough squeeze on living standards and private sector demand. In other words its past negligence about current inflation will depress activity. If wages do not stay under good control even the Bank will accept there is a serious inflation problem.
It confirms our view that this is going to be a difficult year for the UK economy. We expect slower growth rather than double dip. The market now expects earlier action to raise interest rates. This in turn is starting to lift sterling.
