Last week’s inflation figure was a real stench. You might have been fooled into thinking this was good news because the overall rate fell from 10.1% to 8.7%, but this drop was only caused by the exceptional increase in energy prices. last April, out of the annual comparison.
The villain of the coin was the core inflation rate – which, far from falling back as some had hoped, actually rose from 6.2pc to 6.8pc. Nor can it be blamed on the current popular scapegoat, namely food prices. They are excluded from the basic measure.
No, it was plain inflation, felt just about everywhere, everywhere. What is going on?
The Bank of England previously argued that the forces driving prices up were “transitory”. The same word was used by the US Federal Reserve. Both central banks were right in this assessment of the stimulus, but completely wrong in the conclusions they drew from it.
Central banks should never have forgotten that transient increases in costs and prices can have persistent aftereffects, with wages and prices continuing to rise. The huge increases in oil prices in 1973/4 and 1979/80, which were followed by runaway inflation, could have been considered transitory.
The Bank finally admitted that it had made mistakes during this period, and in particular that there was something wrong with its inflation forecasting model.
One problem that I and others have pointed out is the Bank’s apparent complete inattention to the money supply. Another is the overemphasis on inflation expectations. This was compounded by the assumption that because the central bank is committed to keeping the inflation rate at 2%, 2% would be the generally expected rate of inflation.
In practice, under normal conditions, I never thought that expectations had such an overwhelming influence on people’s behavior. In general, individuals and businesses are more concerned with what has happened in the recent past and what appears to be happening in the present than with speculation about the future.
We live in a price-wage spiral where the main influence has been the pressure on the standard of living imposed by the enormous increase in costs.
This happened at a time when the labor market was extremely tight, due to various factors which depressed the available workforce, in the context of an accommodative fiscal policy and a very tight monetary policy. accommodating.
This failure of forecasting led to failures of policy. Not only did the Bank not raise interest rates soon enough, but it also did not raise them fast enough. The boldest move she seems to have ever considered is a rate hike of 0.5%, instead of the usual 0.25%.
Yet in the past, when the authorities wanted to control inflation, they were much bolder. In June 1979, the discount rate was increased from 12% to 14% all at once. Moreover, within a few months, interest rates were increased by another 3%, from 14% to 17%. In September 1981, the authorities increased the rates in two bites, from 12 to 16%. And many readers will remember the fateful day, September 16, 1992, when interest rates were raised twice from 10% to 15%.
There is no doubt that bold monetary policy moves are risky, even at the best of times. And we are certainly not living in the best of times.
Ideally, the Bank would like to keep inflation under control without hurting economic growth or jobs, and without risking a financial crisis – the latter concern was compounded by the collapse of pension funds last year following the Truss/Kwarteng mini budget.
But this is the school of economic policy of motherhood and apple pie. In practice, once the cat is out of the bag, it is extremely difficult to put it back inside. And this can cause considerable pain.
It is important that the monetary authorities strike early and boldly against inflation. The problem is that if the central bank acts gently, inflation could continue to move away from it. Indeed, when inflation really picks up, the real interest rate may fall even as the central bank tightens.
What can we expect now? It is possible that the headline inflation rate will decrease over the next few months, as the monthly increases in the price level of last year are no longer taken into account in the annual comparison. In addition, the rate of increase in producer prices – meaning both inputs into the production process and the price of goods leaving the factories – began to slow.
Yet, the inflationary process has already moved on to stages two and three. It is no longer mainly the price of goods that is the source of the problem but rather the increase in unit labor costs. This is particularly relevant in the service sector where labor costs are the dominant input.
If productivity growth remains minimal, to be compatible with inflation at 2%, average income growth should not exceed 3%, compared to around 6% currently.
For a while I thought interest rates should go up to around 5%. It used to be a pretty aggressive view. But not anymore. Financial markets are now anticipating a rise to 5.5%. I now suspect that rates will have to rise to 6pc or even 7pc to put that tiger back in its cage.
If I’m right, not only would this deal a severe blow to current and potential mortgagees, but it would surely depress economic activity.
The International Monetary Fund may have recently become more optimistic about the UK economy and no longer forecasts a recession later this year. But if something like these interest rates happens, it will be hard to avoid a downturn.
Roger Bootle is Independent Senior Advisor to Capital Economics: roger.bootle@capitaleconomics.com
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