By John Kemp
LONDON Oct 21 Britain's inflation performance
is much worse than that of the other advanced economies and
rapid price rises are more widespread than officials are
comfortable admitting in public.
A surging inflation rate is recognised as a problem
everywhere but at the Bank of England -- where officials
stubbornly insist the phenomenon is a "one shot spike", that is
Inflation was running above the Bank's 2.0 percent target in
all but one of the 12 main components of the consumer price
index (CPI) in the 12 months to September, according to the
Office of National Statistics (ONS) (Chart 1).
The only category in which inflation was below target was
recreation and culture (where prices fell 0.6 percent in the
year to September). In the case of clothing and footwear, price
rises were close to target (2.1 percent). What distinguishes
both categories is their highly discretionary nature.
In every other category from food (6.4 percent) to health
(3.6 percent), education (4.6 percent), transport (8.9 percent)
and communication (5.9 percent), prices were rising much more
quickly than the Bank is supposed to permit.
Faster inflation has not been restricted to food, fuel and
imported items (so-called first round effects) but has filtered
through into a wide range of secondary manufactured items and
services (second-round effects).
Britain's problem is worse than in the United States, where
faster inflation is mostly restricted to food, fuel and
clothing. Prices are rising faster than the Fed's informal 2
percent target in half the main categories (4) but more slowly
in the other half (4) (Chart 2).
INFLATION IS THE MAIN PROBLEM
Rising prices are now Britain's main economic problem. "The
real cause of economic weakness has been the surprise of high
inflation that is not matched by income growth," as Chris Giles
wrote in the Financial Times on Thursday ("Blame Britain's
feeble recovery on high inflation").
"Through higher imported inflation Britain is learning that
increased competitiveness via currency depreciation is pretty
similar for most households to the wage cuts imposed by other
crisis-hit economies," according to Giles.
Unfortunately, policymakers at the Bank and senior
commentators continue to treat high inflation as a temporary
symptom of the country's structural adjustment programme. This
involves fiscal austerity and monetary stimulus coupled with
competitive depreciation to re-orient the economy from
consumption to export-led growth while protecting the
government's credit rating and the banking system.
But inflation is now the main threat to the project's
success. Spiralling prices unmatched by wage gains have brutally
squeezed consumer spending and confidence. Export sectors are
simply too small to offset the simultaneous slowdown in consumer
and government spending and the lack of confidence and
investment by businesses.
NOT MUCH RELIEF IN SIGHT IN 2012
Officials at the Bank have stressed they believe inflation
is at or very close to its peak and will fall "pretty fast" in
the first half of 2012.
In an arithmetic sense, they are right. The impact of the
value-added tax increase at the start of 2011 will drop out of
the figures from January 2012.
Bank officials are also betting the sudden rise in commodity
prices will level off in 2012, though here their forecasts are
on shakier ground.
As the Financial Times' Giles observes: "Commodity prices
have stopped rising for now, so once the gas and electricity
price rises have been absorbed, most households do not have
another big shock to incomes in the offing. Inflation as an
income and growth killer should be just a 2011 phenomenon".
It is an argument shared by economists at the Bank of
England and Professor Paul Krugman in his blog for the New York
Times. I wish I shared their confidence. Crude prices have
steadied not far from the peak earlier in the year. Only
darkening clouds over the advanced economies have halted the
relentless upward pressure.
If the economies somehow muddle through and begin growing in
2012, upward pressure on commodity prices could quickly resume.
Prominent investment banks active in commodities, such as
Goldman Sachs, continue to warn about upside risks to oil
Central bankers and macroeconomists may be underestimating
the extent to which tight oil supplies have become the main
constraint on non-inflationary growth in the global economy.
They may also be overestimating their ability to predict
where commodity prices will go. There is a tendency for
outsiders to understate the challenges of commodity price
forecasting. If oil forecasting were as simple as the Bank of
England thinks, it would put tens of thousands of people who
work in commodity markets out of employment.
I will gladly swap roles with a member of the Monetary
Policy Committee so they can understand just how difficult it is
to make a confident prediction of what will happen to oil prices
in 2012. It is just as difficult to forecast what will happen to
oil prices as the Bank has found it to forecast what will happen
to UK growth and inflation.
TOO MUCH AUSTERITY TOO QUICKLY
Once the 2011 VAT increase drops out of the inflation
comparisons in January 2012, inflation will fall sharply.
However, it will still be significantly above the Bank's 2.0
percent target, and more importantly, it will still be rising
faster than earnings. The squeeze on consumer spending will
continue to get worse, just more slowly.
For inflation to come back to target, commodity prices will
have to flatten off (something the Bank cannot be sure about) or
recession will have to force retailers and service providers to
accept price reductions and margin compression (which can hardly
be welcome). Much of the Bank's thinking seems to rely on
recession curing its inflation problem.
Britain's problem is that the response to the crisis and the
need to promote medium-term economic adjustment has been too
unbalanced. Fiscal policy is much too tight, and monetary policy
is far too loose, creating another set of big distortions in the
The Bank and government are right about the need to curb
excess domestic consumption and government spending to shift
resources to the export sector. But labour and capital are not
very fungible and are not quickly or easily redeployed. Just
because a shift is desirable in the medium term does not mean
that policymakers should try to achieve it all at once.
The Bank and government insist they had no choice. Swift
consolidation of public finances was necessary to avoid a
sovereign debt crisis. But Britain now has a cast-iron credit
rating and low government borrowing rates but no growth.
In the end, rising inflation and sluggish growth threaten
even the austerity programme as they cause the cyclical budget
deficit to worsen as tax revenues fall.
Just because something is good (structural adjustment,
maintaining a high credit rating) does not mean more of it
faster is always better.
The outlook is grim, as Giles notes in his FT article. The
response to the renewed slowdown has been even more monetary
stimulus, while fiscal policy remains unmoved and tight, which
is only making the imbalance worse.
The more the economy slows, the more the Bank tries to
stimulate it with monetary measures. But that risks a further
slide in the exchange rate or accommodating above-target
inflation longer, both of which will hurt the consumer sector
The Bank and government continue to ignore inflation to
focus on growth. But that is viewing the problem the wrong way
around. Unless they can get inflation under control, growth is
unlikely to resume. The urgent priority is fiscal stimulus,
especially on investment, to boost jobs and growth, coupled with
a readiness to tighten monetary conditions modestly if inflation
fails to come down quickly.