Sunday, February 29, 2004
Inflation beast starts to stir
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

On my shelves at The Sunday Times are historical documents, some dating back before many readers were born. I have, for example, the Treasury’s April 1969 budget report, the red book, stamped for some reason “Peter Jay, economics editor — not to be taken away”.

The interesting thing about this document is that it does not mention inflation, still less forecast it. On the cusp of the great inflationary episode of the 1970s, when inflation became economic enemy No1, the Treasury’s big worry was Britain’s balance of payments.

Back then, as is now well known, policymakers took their eye off the ball. It fell to monetarists like David Laidler and Sir Alan Walters to warn that big inflation was on the way, and their warnings were ignored. The establishment sleepwalked into economic disaster.

Nobody can be accused of ignoring inflation today. The Treasury forecasts it and so, in more detail, does the Bank of England. The Bank’s only goal is to achieve 2% inflation. The legacy of past disasters may mean that we over-analyse, even over-emphasise, inflation now.

Despite this, we may be slipping unknowingly into a new inflationary episode, according to a new report. The annual Barclays Equity-Gilt Study, which lays claim to being the City’s oldest continuously published research document, sets the cat among the pigeons by warning of a new outbreak of inflation. Inflation has been slumbering, it says, but will soon be back on the prowl.

Several of the conditions of the late 1960s, which gave way to the great inflation of the 1970s, are in place today.

What are those conditions? Then one of the first signs of trouble was a sharp rise in commodity prices. Dearer raw-material costs meant higher prices, higher pay to compensate and, before you could say Jack Jones, a wage-price spiral.

Today, many industrial raw materials such as copper and tin are at their highest for more than eight years. The Economist dollar-price index for industrial commodities is up by about 30% on a year ago, the Reuters index by 32%.

Extraordinary demand from China, which accounts for a fifth of the world’s demand for base metals, is pushing up prices. Gold, a traditional harbinger of inflation, is hovering around $400 an ounce, up 50% in two years.

The inflation story of a generation ago would not, of course, be complete without oil. The Organisation of Petroleum Exporting Countries (Opec) exerted its market power. Now that is happening again.

Oil prices, remember, had been expected to leap during the war with Iraq and then fall sharply afterwards. Instead, after a brief downward flurry they have moved higher again. Last week crude-oil futures hit their highest level for a year on news of low American inventories. Prices of more than $30 a barrel now look to be entrenched.

What does this mean? According to Barclays Capital, rises in raw- material and energy prices have traditionally been “early warning signals that, unobserved, economic trends are starting to undermine price stability”.

Tim Bond of Barclays Capital, the study’s editor, adds: “The history of the 20th century provides a vivid illustration of how an initial rise in raw-material prices can be translated into broader inflation by monetary policy.” Even allowing for the fact that energy and raw materials have less of an inflation impact now than in the past (because of smaller industrial sectors), there is still a link.

That brings us to the second big point. Have central banks, in their determination to head off deflation and keep economies growing in the face of war, terrorist threats and other blows to confidence, relaxed too much? There is no simple answer. It would be hard to argue that the European Central Bank has played fast and loose with inflation. The Bank of Japan, having got a stagnant, deflation-hit economy out of the mire, can hardly be accused of failing in its anti-inflation duties.

The Bank of England will have sat up and taken notice of last week’s upward revision of 2003 growth from 2.1% to 2.3% and an unexpected (and surely misleading) 3% February rise in house prices from the Nationwide building society. But the monetary policy committee is in any event in the process of raising rates, probably not this week but certainly in April or May.

As I have said, it is unlikely that this process will stop before rates rise above 4.5%, although I would hope they do not have to exceed 5%.

Elsewhere, the charge of monetary irresponsibility is easier to level. The Chinese authorities, in their determination to prevent their currency from rising against the dollar, are allowing inflation to rise. Inflation in China, after a long period of deflation — falling prices — is not necessarily a disaster. China, after all, is a rapidly growing emerging economy. Even pessimists expect Chinese inflation to remain comfortably in single figures.

Less forgivable, however, is what is happening in America. A man from Mars would conclude that US interest rates at 1% are absurdly low, that the budget deficit of $500 billion (267 billion) is dangerously out of control, and that the authorities have deliberately and irresponsibly let go of the dollar.

I would be inclined to agree. Policy in Washington is driven by the goal of getting George Bush re-elected. The Federal Reserve is a proudly independent central bank but it is hard to imagine that, were the politicians running monetary policy, they could ask for more. As an admirer of Alan Greenspan, the Fed chairman, I am having grave doubts.

You might imagine a Faustian pact between the Fed and the White House in which the price of re- election was spelled out as 4%, 5% or 6% inflation in a year or two, a deal the administration would grab with both hands. The consensus is that American inflation will average 2% next year. That looks much too low. Barclays Capital suggests 4%.

If America catches the inflation bug, even mildly, could Britain remain immune? Yes. Commodity prices have risen sharply in dollar terms but, expressed in sterling, the indexes are barely up at all. Official figures show industry’s raw-material and fuel costs are no higher than a year earlier.

Earnings growth, at 3.4%, is benign. Many prices of goods, and some for services, notably recreation and culture, are falling. Inflation on the new measure is 1.4% and while the Bank expects it to rise — hence higher interest rates — there is no reason to quarrel with its view that it will stay below 2% for most of the next two years.

All of which gives us an interesting prospect. The story of the past two to three years is one in which the world had a recession but Britain did not. The story of the next two or three looks to be one where we move into somewhat higher world inflation but inflation in Britain remains low. It is a very different prospect from the disasters of the 1970s.

PS: My request for examples of punitive taxes and onerous red tape did not fall on deaf ears. Such was the volume of correspondence that not only does the chancellor have a case to answer but it seems I might as well put on the black cap now.

The picture that emerges is of business men and women who do not know whether to laugh or cry about the amount of red tape that strangles their best efforts. The rule seems to be that the smaller the business, the bigger the burden, and that things are getting worse.

I am still putting together the case for the prosecution. Anybody who has time to spare from dealing with the latest batch of regulations and wants to contribute should do so now.

Alternatively, those who think business folk moan too much and have never had it so good should also let me know. I will pass their contributions to the defence barrister.

From The Sunday Times, February 29 2004