Persistence of inflation raises fears of stagflation

'Core' inflation rises despite weak economy
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The Independent Online

Inflation is proving more persistent than many economists predicted, according to the latest figures from the Office for National Statistics (ONS).

The ONS reported yesterday that the Consumer Price Index (CPI) measure of inflation fell from an annual rate of 2.3 per cent in April to 2.2 per cent in May. The older established Retail Price Index (RPI) is still showing that the cost of living has fallen compared to this time last year, thanks to lower mortgage rates not reflected in the CPI – but the rate of decline has eased, from 1.2 per cent to 1.1 per cent.

Of more concern is that "core" inflation – which strips out erratic items such as food and petrol – also rose marginally, from 1.5 to 1.6 per cent. Indeed, if it were not for the VAT cut, economists pointed out, the Governor of the Bank of England, Mervyn King, would have had to write another open letter of explanation to the Chancellor about why the rise in CPI was more than 1 per cent above its official target of 2 per cent.

At a time when the economy is still extremely weak, the persistence of such pressures will be a disappointment to Bank of England policy-makers. It leaves open the possibility that the economy could soon see a combination of relatively high inflation coupled with a feeble recovery – the stagflation scenario that has threatened to transpire periodically over the past two years. This will make the already sharp dilemmas facing the Monetary Policy Committee – especially when to reverse the programme of quantitative easing and interest rate cuts – still more acute.

The major upwards pressure on prices last month came from Budget-related rises in the cost of alcohol and tobacco; but the rising cost of food, DVDs, televisions, clothing and footwear also made their presence felt. Some of this is due to the deprecation of sterling, although the pound has strengthened in recent weeks, and the revival in the price of oil and other commodities. The price of a barrel of crude has doubled since December.

"CPI inflation is likely to fall in coming months because of helpful base effects, but, like the US, euro area and Japan, there is, in our view, little chance that CPI inflation will go negative" said Michael Saunders, of Citi European Economics. "It is misleading to regard the negative RPI inflation rate, depressed by mortgage rates, as a sign that deflation is a serious risk. As gains in import prices continue to feed through and tax effects reverse, we expect CPI inflation will rise above 3 per cent next year".

Colin Ellis, European economist at Daiwa Securities, added: "We are increasingly nervous that any boost from quantitative easing may show up in prices, rather than real growth. Policy-making is not going to be boring again for some time."

Rate setter: MPC appoints US academic

An American academic who has called for the sacking of executives responsible for the banking crisis is to join the Bank of England's Monetary Policy Committee later this year.

Adam Posen, a senior fellow at the Petersen Institute for International Economics in Washington, will join the MPC in September, replacing Tim Besley, whose term on the committee is due to finish at the end of August.

Mr Posen will move to the UK in order to take up the post, though he will be free to continue working in other capacities – in addition to his academic post, he is also currently employed as a visiting scholar at a number of central banks. He is to be paid an annual salary of £128,000.

In testimony to Congress earlier this year, Mr Posen called for the US to take a hard line on banks that had been forced to ask for state bailout cash. "They must have top management replaced and current shareholders wiped out," he said.

Mr Posen was previously best known for his study of the decade of deflation that kept Japan's economy stalled for much of the 1990s, expertise that could prove crucial as the MPC tries to steer the UK back towards financial health. He has also co-authored a book on inflation with the US Federal Reserve governor, Ben Bernanke.

Mr Besley is regarded as a hawkish member of the MPC and his replacement's previous and future comments on monetary policy will now be closely scrutinised. Yesterday Mr Posen told Bloomberg that "the biggest challenge facing all central banks is deciding when to pull out of the deflation-mode and emergency stance and return to normal policy."

Mr Posen's instincts in the past have seemed to echo Mr Besley's hawkishness. Last year, he suggested a global pact between central banks to raise interest rates together would help to counter domestic criticism.

Alistair Darling, the Chancellor, praised Mr Posen for "his deep understanding of monetary policy and financial system issues, combined with his proven ability to communicate clearly to diverse audiences."