Sean O'Grady: Inflation isn't as bad as it feels, but it will be painful, all the same

At the risk of sounding like a Mervyn King stooge, you just can't make policy like that. A war in Korea would push up inflation. So would a scrap over Iran
Click to follow
The Independent Online

One of the abiding sins of journalists is to treat the subjects of their articles as if they were stupid. So let me say from the outset that the men (no women) of the Monetary Policy Committee who will meet this week at the Bank of England to discuss their latest decision on interest rates are not stupid. In that corner of the City this Wednesday and Thursday will be found one of the heaviest concentrations of brains anywhere in the country, if not the world. I'm serious. If there is one thing this lot are not short of, it is intellectual firepower. That's comforting. Up to a point.

What it does not mean, of course, is that they can foresee the future, individually or collectively, but I doubt anyone – not even the cleverest of journalists – is able to say with much precision where world commodity prices will go this year.

The jump in the price of oil and the rest is the source, together with VAT and duty hikes, of much of the current inflationary spike, and the consensus, for now, is that commodities are soaring and will continue to do so. They will. Yet common sense also tells us that they cannot continue to rise at their present rate indefinitely, because the very fact of booming commodity prices tends to choke off demand, either naturally, because firms cannot pass on the increases in their costs indefinitely, or because central banks take pre-emptive action to deal with the incipient inflation. To that extent, rising commodity prices are a self-correcting phenomenon. They burn themselves out – provided they don't spark an independent inflationary cycle domestically.

Yet journalists, just like economists, are herd creatures, prey to conventional wisdom, fashionable nostrums, the sins of extrapolation and the lure of big, round numbers. Thus if oil is $90 at barrel, as now, then $100 cannot be far off, we tell ourselves. And if $100 is weeks away then surely $200 must be only months off. And perhaps then $300 is only a matter of time. And so on. None of these hypothetical levels are inevitable, though, or sustainable. There are, to be sure, long-term structural and demographic trends that will leave food and raw materials costs higher in the next decades than in the last two, but that was true in 2009, and it didn't stop the price of oil halving and more. At that time a global contraction in credit and private demand pushed economies down; this year it could easily be a global fiscal contraction (America excepted) that hammers inflation.

Ironically, given all the hype about the wonderful new economies in the east, inflationary spirals in India and China are a much more realistic danger than they are in the West, including Britain. Just as the West suffered a meltdown in asset prices in 2008-09, no one would be amazed if that happened this year in China. There is nothing, for example, to prevent widespread economic dislocation there this year, if the bubble in China's real estate market goes pop – asset price inflation far outstripping even retail prices. That, in turn, would destabilise China's opaque banking system and derail the fitful efforts to rebalance its economy towards domestic consumption. All that would make it more reliant on exports and a cheap yuan, and make the "currency war" with America even more bitter. Unknowable consequences would be wreaked upon the rest of the world if China started dumping its $2 trillion in dollar-denominated assets in retaliation for the US printing trillions more dollars to devalue the greenback.

Booming commodity prices might not long outlast such events. And everyone would ask why the Bank of England didn't see the bursting of the Chinese bubble coming. At the risk of sounding like a Mervyn King stooge, you just can't make policy like that. A war in Korea would also push world interest rates and inflation higher. So would any scraps over Iran. A really bad euro crisis would have truly chaotic effects. You have to work with the world as it is. The movements in copper, cotton, sugar, oil and other prices seen over the past six months or a year pretty much guarantee that this year will see an inflationary spike, and one that the Bank, as recently as November's Inflation Report, probably did not adequately account for – with hindsight.

There is nothing that can be done now, however. CPI inflation may well go higher than the 3 to 4 per cent range the Bank sees it peaking at this spring, and in February, in the next Inflation Report, the Bank will have the tricky task of explaining why it is doing nothing to raise interest rates this month or next (by far the most likely outcomes) – while the Bank's forecasts for CPI inflation have to be revised upwards yet again towards the 4 to 5 per cent range in a few weeks' time.

The Bank will have a lot of explaining to do. Yet the point stands that there is nothing that can be done now to stop the spike. Nor, more controversially, should anything have been done before: Just think how barmy it would have been to raise rates last spring, when the economy seemed poised on a "double dip".

To me the most powerful argument is simply that inflation now would be half where it is now had VAT not been put back up in January last year, and inflation would be falling fast if the Government had not decided to raise VAT again this January. The annual CPI rate would, in November, have been 1.6 per cent – below the official 2 per cent target. True, it will resume an upward trajectory later on, but there should be rather less excitable talk of loss of control.

Central banks cannot "control" administrative inflation like VAT hikes. To make an absurdist, but graphic version of the argument, what if George Osborne went mad and raised VAT to 100 cent tomorrow morning? What would the MPC be able to do to bring inflation back to 2 per cent?

The question is whether higher inflation has sparked an inflationary spiral. The rise in inflationary expectations is a worrying sign, and public and media chatter does suggest more of an inflationary mindset than we've seen for most of the last decade. According to the LexisNexis database, there were 1,271 mentions of inflation in UK newspapers in December 2009, but 2,130 in December 2010.

What no one can foresee is how those expectations will change behaviour. We can be sure that more of us will be looking for a pay rise; we cannot be sure we will secure one in the face of rising unemployment and public pay freezes. We know that firms will want to pass on the rise in costs, but we cannot know how successful they will be when disposable incomes are coming under such strain from tax hikes. If interest rate policy is evidence-based, then the evidence of a "wage-price" spiral, of underlying inflationary pressures ramping up, is not yet there.

Because of the freak weather, the VAT hike and the usual uncertainties, the fourth quarter GDP data for 2010, to be published in a couple of weeks, may not tell us that much. A better idea will come when the first quarter data for 2011 come out on Thursday 28 April (the day before the royal wedding). That might, just, set the scene for a rate rise in May, although it's unlikely. August, with the second quarter under their belts, and another Inflation Report due, is probably optimal timing for the MPC, and what the market expects.

Meantime, the Bank needs to hold its nerve and direct its great intellectual resources to countering the charge of "complacency" – and even "stupidity". It just shouldn't expect much help from us journalists.

Comments