Are the waves coming or going?

This month's increase in inflation could be a sign of an overheating economy - but it's not likely
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Have you ever stood on a beach, watching the waves lap against the shore, and asked yourself: "Is the tide coming in or going out"? If you have, you'll know it is hard to tell from the waves alone. Sometimes a big one washes up further than the previous few - the tide is coming in, you think - only to find it followed by a feeble strand of froth that drags the waterline back down the beach. Only by staring for quite a long time can you make a definitive judgement about the direction of the oceans.

British economists are now standing on the shore, looking at monthly statistics repetitively lap against their ankles, and going through a similar kind of mental anguish in trying to determine whether the economic tide of inflation is coming or going. Yesterday's figures, announcing a rise from 2.9 per cent to 3.3 per cent - and those on producer prices released on Monday - appear to have represented a minor surge. Strong evidence for asserting that inflation is on the up.

But inflation is a funny old thing, and, in fact, it is much harder to tell what is really happening than these figures would suggest. Here are three reasons. First, even if inflation is falling, the price of almost half of what we buy can still be rising by more than the rate of inflation. If eggs and apples are going up by less than the Retail Price Index, the fact that bread is going up faster does not provide any evidence that inflation is picking up. In a healthy economy, change is continually occurring: some things (like mobile phones and computers) are becoming relatively less scarce, and other things are becoming more so. It is natural that relative prices should change, that, for example, the number of loaves of bread you need to give up to buy a mobile phone will fall as mobile phone technology catches on.

It is a mistake to confuse relative price changes with inflation - a rise in the general price level. And that means we must always be very careful about putting too much weight on selective indicators, such as factory output prices, which represent only a small part of the economy.

A second difficulty in assessing inflation is that even in an economy where the medium-term trend is downwards, there can be sustained periods over which the annual inflation figures pick up. Indeed, in the Eighties, Britain went through exactly that experience. From 1981 to 1986, the economy grew at a rate faster than its historic norm, with the inflationary undercurrent clearly heading downwards. But there was a mini-inflation tide in the middle of that growth, as a devaluation of the pound pushed up the price of imports. We would have been quite wrong to tighten policy to respond to that devaluation - the economy was not overheating, was not operating at capacity, and was not inflationary. As soon as the effect of the devaluation passed through, inflation got back on its natural course and started falling again.

The third problem is in stripping out one-off factors that raise prices but aren't really the inflation we worry about. Tax increases and mortgage interest rate changes, for example, raise the cost of living and, it could be argued, need to be taken into account when indexing wages or social security benefits. But let us be clear: tax increases and mortgage rate increases are not inflation. They do not represent a decrease in the value of money, and it is that which we should really be concerned about.

So where do these statistical shenanigans leave us with regard to Britain today? The inflation figures do appear to have markedly deteriorated in the last few months. Even stripping out the effect of tax rises, mortgage interest rate changes, seasonal fluctuations; even looking at a wide selection of commodities (using the Bank of England's sophisticated variants of the inflation index), it is clear that the rate of inflation more than doubled in the last part of last year. That gives some support to the Bank of England's view - made in the Inflation Report last week - that "most measures suggest inflation has now passed its trough".

But that is not the end of the story. If inflation is rising already, something very strange is going on. In general, Britain's economy behaves with some regularity. It has a certain limit, a level of capacity, at which people, buildings, factories and machines are all comfortably busy. When the economy is operating below that comfortably busy level, the least busy factory-owners, people, and building owners tend to cut their prices to bring more work in. If they think inflation is going to be 3 per cent, they raise their prices by a mere 2 per cent, say, to leave their relative price lower. As long as most people are trying to do that, then inflation will fall. Of course, once the economy is comfortably busy, then extra demand will tend to be inflationary.

On virtually any measure, Britain's economy is still operating below its comfortably busy level. We fell so far below in the recession that we have been able to grow very quickly without actually hitting the constraints or limits of our economic potential.

It is true that the labour market is beginning to tighten, and we see commercial property filling up. But there is room for plenty more where that came from. Workers who are not registered as unemployed but who would like to work are aplenty. Wages - executives apart - are not growing at a rapid rate at all. Commercial property can be created. And it is within the limits of our economy to expand capacity. Benign, sustained growth is exactly what we achieved just a decade ago. That was all fine until 1986 when inflation turned.

So, can we reconcile the upward drift in prices - the bad news - with the slack left in the economy? In reality, the process of falling inflation is a messy one. Companies don't know whether they'll get away with price rises or not. If the economy is occupied, they will, otherwise they won't. The likelihood is that firms are trying it on a bit at the moment. They will see whether they can raise prices and still sell plenty. If they cannot, and there is plenty of evidence they can't (high-street sales are as damp as the weather), they'll go back to where they were and good inflation news should pour in again. The upturn will prove to have been exaggerated.

If that isn't the explanation, then we can only conclude that Britain's economy has less potential than we thought; that we are all already comfortably busy and that the misery which causes us to cut prices - and drives inflation lower - has gone. We are all as economically cheery as we can be.

It is possible, but it just seems a bit unlikely.

The writer is the BBC Economics Correspondent.

Hamish McRae is away.