Jeremy Warner: Stubbornly high inflation poses challenge for Bank
Wednesday 17 June 2009
Outlook Is it good or bad news that inflation is proving so resilient? The good news is that the deflationary threat, which only a few months ago seemed as if it might plunge the world into a second Great Depression, is now receding fast. The downturn is slowing and may even be reversing.
The bad news is that it limits the Bank of England's scope for underpinning the recovery with quantitative easing (QE), and may bring forward the day when the Bank will have to start removing its monetary stimulus by raising interest rates. The last thing the Bank wants to do is snuff out the recovery before it has even properly begun by being forced into premature tightening.
Despite what may still turn out to be the worst recession since the Second World War, inflation remains stubbornly above target. Under the CPI measure, it eased just 10 basis points last month, to 2.2 per cent. Most forecasters expect it to continue falling over the months ahead to perhaps as little as 1 per cent, but that's quite a bit higher than forecasters were anticipating just a few months back. Hardly anyone now expects outright price disinflation under the CPI measure.
Tax rises on alcohol and tobacco announced in the Budget explain only some of the resilience in the inflation rate. The rest seems to be down to the weakness of the pound, which is causing the price of imported goods such as DVDs, televisions, clothing and footwear to rise. The renewed surge in the price of oil and other commodity prices has yet to feed through to the official numbers, so there may be quite a bit of inflationary pressure still in the pipeline.
Prices as measured by the old Retail Prices Index (RPI), which takes account of mortgage rates and other housing costs, were still falling fast in May, but even judged by this measure, the pressure is on the upside. RPI price deflation was less pronounced in May than it was in April.
In any case, inflation is not as dead as it might seem, forcing the Bank of England to start thinking about its exit strategy rather earlier than expected. The general assumption was that the Bank would be back for more once it had burnt its way through the entire £150bn of money sanctioned by the Treasury for QE. That assumption is now looking questionable.
The positive way of looking at all this is that the policy is working just as the doctor ordered, and if anything rather too well, leaving the Bank of England facing the classic central banker's dilemma of when to start removing its support. Do it too early, and the recovery may stall. Do it too late, and before we know it the economy may be back in the midst of another inflationary boom.
Admittedly, this latter possibility remains the least of our worries right now, with unemployment still rising fast despite the now manifest green shoots of economic spring. A little inflation might even seem a good thing. But with the economy being flooded with cheap money, a rapid bounce back that will quickly absorb the spare capacity opened up by the recession shouldn't altogether be discounted.
Ministers would never admit to it, but the Government might privately welcome a renewed bout of inflation, for there is nothing quite so guaranteed to fix a big fiscal deficit than inflation. For debtors, inflation offers an apparently pain-free method of default. There has only been one act of technical default by the UK Government in the past one hundred years – in the early 1930s the Treasury cut the coupon on war loan. That stain is still ingrained on the Treasury's consciousness, and it is not something the mandarins ever intend to repeat.
But why in any case would you default and incur the wrath of international markets when there is always inflation and currency devaluation to do the job for you? At least two world wars as well as the welfare state have been paid for by this method.
Bad for savers and creditors, inflation is good for anyone with leverage, for it offers an apparently painless route back to manageable debts. This is because the nominal value of the debt remains the same even as it shrinks relative to inflating income. Yet inflation also destroys savings, and is the very reverse of what Britain would seem to need to restore balance to an economy which has relied too heavily on credit-fuelled consumption.
For the Bank of England, the policy dilemma has rarely been more problematic. Let's hope that Adam Posen, the US academic who was named yesterday as the latest addition to the Bank of England's Monetary Policy Committee, is able to bring a fresh perspective. He's got a reputation for plain talking, and his analysis of what needed to be done in the banking crisis – save the banks for the sake of the economy but sack the managements – was spot on.
In any case, tonight's Mansion House speeches from the Chancellor and the Governor are eagerly awaited. The two men normally manage to present conflicting messages, but perhaps this time, having been through so much fire together, they'll be more in harmony. We'll see.
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