By John Kemp
LONDON, Oct 21 (Reuters) - 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 “very temporary”.
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).
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.
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 prices.
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.
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 economy.
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 even more.
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.