The going gets tougher
February 15th, 2011
The Governor of the Bank of England has recently warned us that we in the UK are living through the longest and worst squeeze on real incomes that any of us have ever witnessed. It was scarcely cheering news. For once the Governor may have overdone the severity of his forecast, but he is right about the direction of travel.
The squeeze is severe for two related reasons. Inflation is much higher than target. Taxes have been increased sharply to tackle the large public sector deficit. Private sector wages and salaries are rising just a little more than 2% a year. Public sector wages which have been more buoyant, will now enter a period of pay freeze. Meanwhile the Retail Price Index has shot up by 4.7%. The Governor expects more rapid inflation in the early months of 2011, as the higher rate of VAT kicks in.
Normally such a situation would commence an inflationary spiral, with employees demanding and getting higher wage increases. The Bank of England, which spends money on surveys of inflation expectations, confirms that people now expect prices to go up more rapidly than the 2% target, and for the higher inflation to become the norm. Most forecasters, and the Bank, remain united in believing wages and salaries will stay under control. The public sector surely will stick to its pay freeze given the state of the public finances. The private sector faces very competitive markets which impose natural limits to what many companies can offer. The Bank has a couple of hands hovering over the higher interest rate button, just in case wages should start to respond to galloping prices.
The Governor’s explanation of why inflation is almost double the target rate depends on forces outside the Bank’s control. He attributes the inflation increases to a combination of sharp upward movements in the world prices of energy and food, and to the tax increases needed to curb the deficit. As a result he takes the view that the Bank should look through these external and temporary factors, to a world of lower inflation beyond. What, he reasons, would be the point of putting up interest rates when the problems are world commodity price increases and the change to VAT?
The problem with this argument is that American or German inflation has not hit the highs we are experiencing in the UK, even though they too have to pay the same high and rising world commodity prices. There is a special UK element to the inflation, which comes from the big decline of the pound during the Credit Crunch crisis. The UK’s inflation is much higher than most advanced countries because the sterling price of food and energy has risen more than the prices in stronger currencies. The state of the pound is the Bank’s responsibility. Interest rates do have an impact on its value, as do decisions on how many extra pound to create as part of money policy.
Most commentators took one look at the fall in UK output in the last quarter of 2010 and decided it meant the Governor would prevail – there will be no early interest rate increases. The Governor’s main target is to control inflation, but the Bank seems mightily preoccupied by the impact of their policies on the wider economy. However, here too they have to explain a problem. Why, given the fact that they printed plenty of money and kept interest rates on the floor didn’t the UK economy respond more positively to all this stimulus? Part was the weather, and the figures may be revised up a bit in due course for the underlying position. The rest of the answer is the impact of the inflation. Too much inflation cuts into people’s living standards and discretionary spending money. It is hitting the hotels, the restaurants, the leisure breaks, the nice to have services as people spend what money they do have left in their pay packet on the food and tax bills.
Surging oil and food prices have just made the UK recovery tougher to bring about. The Bank is now discovering the hard way that allowing faster inflation and more sterling depreciation can be forgiven all the time the economy is expanding well, but it makes choices very difficult when the monetary stimulus helps the inflation but does not produce growth.
As published in Investment Week.
