Hamish McRae: We must change our view of inflation

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The Independent Online

For most people, inflation has Jekyll and Hyde characteristics. On the one hand, when share prices or house prices are going up, most people would regard that as positive, whereas when the price of food or petrol rises, just about everyone would fret. That at least was the dominant condition through the decade running up to the current recession, the so-called "great moderation". The Bank of England was congratulated for holding current inflation at around 2 per cent, and the British middle classes preened themselves for becoming so much richer by sitting on houses in the Home Counties.

Now we are wiser, or at least have had our complacency punctured. We can see that the moderation of current inflation was something of a lucky fluke. The price of goods worldwide was held down, not so much by wise central bankers, but by low-cost imports from China and Eastern Europe. In the UK, a flood of immigrants from the new EU member states and elsewhere supplied the labour to underpin the expansion and helped prevent wages rising so much as to make the UK uncompetitive.

As for soaring asset prices, we can see that these were the result of easy credit – the mortgages of more than 100 per cent of the value of a home – and particularly in the US, interest rates below the level of inflation.

So it was not such a triumph after all. Now we have the reverse. We have worryingly high current inflation and relatively subdued asset prices. Yesterday UK inflation disappointed again, with the consumer price index still at 3.1 per cent, the more familiar retail price index at 4.7 per cent. This new government is trying to wean us off the RPI and make us shift to the CPI. It is not hard to see why: it makes their own inflation performance look less bad and it will cut the cost of pensions and other public services. The RPI may not be perfect but we should be deeply suspicious of any attempt to dump it for something that is worse: an index that does not even include housing costs.

As for asset prices, the various measures by central banks around the world to pump money into the system seem to have stabilised house prices in most countries and helped share prices recover. That is to the good, for a full frontal hard-core collapse in either would have been disastrous. But there are now some signs that house prices in the UK may be dipping again and share prices remain way below their past peaks.

So what happens next? One obvious worry is that rising inflation will force the Bank of England into a rise in interest rates before growth is solid. The Bank is stretching the limits of the credible to say that inflation will come back down to the target range on present policies.

My own concern is less about the impact on UK policy, because I think we will scramble though. After a pause later this year or early next, growth will resume and interest rates will go up from their present artificially low levels. Nor do I see any collapse in the price of homes or shares, just subdued markets in both. (If there is a market that is vulnerable, it is government securities) Rather the great concern is that current inflation globally will become embedded and have serious social implications as well as economic ones.

Growth is, and will continue to be, driven by the developing and emerging economies for the next few years. China, India and the other big countries will continue to increase their living standards. But that means continued demand for fossil fuels, for raw materials and probably also for food. The pattern of the supply/demand equation will shift. Right now the oil price seems stable but there are serious concerns about global food supplies. In a couple of years' time the pressure on food supplies may have eased a little but we will be worried again about the oil price.

So what we are seeing is more than just a reversal of the happy conjunction of the period up to 2008. It is a glimpse of the future: growth putting rising pressure on resources worldwide. At a pinch we can cope with higher food or fuel prices. But if, as in many developing countries, the norm is for more than half people's income to go on food, the picture is much darker: less Dr Henry Jekyll, more Mr Edward Hyde.

Happiness could be a statistical measure

Economists have long recognised that Gross Domestic Product per head is an imperfect measure of wealth and that other less mechanical indicators are needed. After all, if a country has high crime and has to spend a lot on curbing it, that increases GDP but it certainly does not increase people's real living standards; quite the reverse.

But trying to create wider measures of wealth – real wealth, including a sense of well-being – is harder. Economists used to write about "utility" and the way people revealed what they really wanted by their preferences in the ways they spent their money or their time. Most recently there has been a lot of work into happiness: what makes people happy. But these are slippery concepts. People say one thing and do another.

So a new effort by the Office for National Statistics deserves a welcome. An article published yesterday argues that "assessing how people think and feel about various aspects of their lives is important when measuring wellbeing". Instead of strings of top-down targets and new policies imposed by governments, the ONS is seeking to develop estimates of well-being by asking people what they think. Common sense, isn't it? As another article from the ONS also published yesterday puts it: "There's more to life than GDP but how can we measure it?"

h.mcrae@independent.co.uk

For further reading

'Measuring Subjective Wellbeing in the UK', ONS, published online at www.ons.gov.uk

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