Outlook Suddenly, we're all worrying about inflation. Well, perhaps not everyone is: US inflation is running at an annual rate of only 1.5 per cent Stripped of volatile food and energy components, it is a mere 0.8 per cent. But inflation in the eurozone is now up to 2.2 per cent, above the European Central Bank's target. In the UK it is at an uncomfortable 3.3 per cent (4.7 per cent in RPI terms), forcing the Governor of the Bank of England to write apologetic letters to the Chancellor explaining why the hallowed 2.0 per cent target is being overshot.
Levels of economic activity in the Western world remain relatively depressed and there's little in the way of wage pressure. So why are prices rising? Economists used to argue that there were only two types of inflation: "demand pull" and "cost push". If demand was too high, prices would rise. If costs were driven up, again prices would rise. In the absence of these forces, inflation was supposed to remain well-behaved. Recent events, however, give pause for thought.
Although US inflation is still relatively low, America's recent experience is nevertheless consistent with developments in the eurozone and the UK. The gap between headline and core inflation has widened, a consequence of higher food and energy prices. These, in turn, are a reflection of booming demand for commodities. Gold, base metals, oil or food, prices have surged over the last couple of years. Given the lack of decent economic recovery in the developed world, this looks odd.
There is, however, a straightforward answer. I've just returned from a trip to China, Hong Kong and Singapore. These parts of the world are booming, benefiting from the global consequences of the quantitative easing policies pursued in the US and the UK, among others. Investors can borrow cheaply in dollars, sterling or euros and re-invest the proceeds in the emerging world where growth prospects are better. The resulting boost to emerging growth lifts commodity prices, reflecting heavy demand for infrastructure (often sadly lacking in the emerging world) and a shift from vegetarian to meat and dairy-based diets (feeding humans via animals is inefficient).
Higher commodity prices may be a sign of success in the emerging world but they act as a "tax'' on the West. In a world of scarce resources, significant increases in commodity consumption in the emerging world requires a reduction elsewhere. For Western nations, prices rise relative to wages, reducing purchasing power and crimping consumer demand. To that extent, quantitative easing has backfired: by boosting growth in the emerging world, it has led to higher commodity prices, pushing up prices in the West with no corresponding rise in wages. So we are worse off. While this story helps explain the overall rise in Western inflation, it's not good enough to explain the UK's particularly caustic experience.
This demonstrates that central banks have limitations. Policymakers have made a virtue of the UK's monetary independence. A couple of years ago, they rejoiced in the flexibility of sterling, arguing that monetary independence provided the UK with an escape route from the financial crisis. If financial services weren't all they were claimed to be, the UK could simply devalue, boost exports, create jobs and live happily even as the eurozone lurched between crises.
A nice idea at the time but it doesn't look quite so clever now. The UK's trade position has, if anything, worsened despite the biggest currency devaluation in recent history. Admittedly, during the recession, the trade gap narrowed a bit, but that was more a reflection of haemorrhaging demand for imports than a sudden desire to ''buy British'' overseas. Indeed, for all the supposed benefits of sterling's decline, UK exports have performed no better than Irish exports despite the Ireland's entrapment in the eurozone. Sterling's decline has, however, had other effects. It may not have led to a rebalancing of the so-called "real" economy but has led to a rebalancing of the "nominal" economy by delivering wage cuts as a consequence of higher inflation. Wage growth is currently running at an annual rate of a little over 2 per cent so, with CPI inflation rising at over 3 per cent (almost 5 per cent in RPI terms). So the average British worker is gradually becoming worse off.
In many ways, this is an unfamiliar form of inflation. In the old days, we used to think about wage-price spirals. Today, although prices are rising relatively rapidly, wages are not. Workers are receiving real term wage cuts. The effects in the UK have been unusually large because the UK has seen a particularly big drop in the exchange rate, raising import prices faster than in other countries and creating room for domestic producers to raise prices without fear of being squeezed out of home markets.
Most inflations lead to a redistribution of income in one form or another. In the 1970s, workers with large mortgages gained (as wages rose, the real value of debt fell), pensioners with their cash savings lost. Today, the winners include the Government – low interest rates reduce debt service costs, higher inflation boosts revenue growth – and large companies not constrained by the credit crunch - higher profits associated with improved pricing power. The losers are workers.
Admittedly, those with large mortgage-related debts may still be better off overall through lower mortgage costs as a result of lower interest rates. However, rates cannot fall any further (they're at zero) and inflation is refusing to go away. The benefits are increasingly in the past by contrast to the costs.
The bottom line is that workers are bearing the brunt of the adjustment to hard times. To that extent, the UK experience is not so different from that of Ireland, where inflation is running at 0.6 per cent while wages are declining at an annual rate of 1.2 per cent, a reduction in real take home pay of 1.8 per cent, quite similar to Britain.
Ireland, however, has had to do it the hard way, by demanding actual wage cuts rather than delivering wage cuts by stealth via higher inflation. With Irish unemployment up to 13 per cent compared with a figure of around 8 per cent in the UK, there's no doubt which country is having the tougher experience. Then again, given sterling's collapse against the euro, it's not so surprising that Ireland's in such a mess: in part, we've exported our economic problems to them.Reuse content