Sunday, January 14, 2007
The writing is on the wall as inflation surges
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


As is often the case, the Bard of Avon put it more succinctly than the Old Lady of Threadneedle Street. “If it were done when ‘tis done, then ‘twere well it were done quickly,” wrote Shakespeare in Macbeth. And that, more or less, is what prompted Thursday’s “shock” move by the Bank of England’s monetary policy committee (MPC) to raise Bank rate from 5% to 5.25%. If rates need to rise, why wait?

I say shock, but how surprised should we have been? The Bank, it is true, has established a recent tradition of moving rates only in “inflation report” months — February, May, August and November. Informal rules, however, are made to be broken.

The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs and whose deliberations are reported here first, is developing quite a track record for predicting moves by the actual MPC.

It voted for a rate rise last August, ahead of the Bank’s shock move then, and again in November. Not only did shadow and actual MPC opinion coincide this month on the decision but the Bank, like its shadow, cited rapid growth in credit and the broad measure of the money supply as among the reasons for moving.

So I was more nervous than most a week ago, the more so when news emerged of a healthy Christmas period for most retailers and an uptick in pay settlements.

Although the pay evidence, from Incomes Data Services, was based on a tiny number of settlements, and put together in December, it may have chimed with anecdotal evidence from the Bank’s own regional agents.

The Bank is desperate to keep a lid on pay, though I sympathise with many people in business who say they are keeping their side of the bargain by keeping wage increases down but are still being hit with higher interest rates. Outside the stratospheric City, some of the biggest increases currently coming through are in the public sector. Nearly two-thirds of all pay deals will be concluded between now and the end of April.

Tied to a desire to fire a shot across the bows of pay bargainers may have been the embarrassment factor. We know inflation will show a rise this week. What we do not know is whether, on the target consumer prices index (CPI) measure, it will move above 3%. That would be a spectacularly bad result, though not on its own a reason to lift rates; current inflation reflects past monetary policy decisions. Acting now is too late.

If it does go above 3%, for the first time in nearly 10 years of independence, the Bank’s governor, Mervyn King, will have to write to Gordon Brown explaining why inflation has moved more than a percentage point away from the target, and what the Bank is doing about it.

We will know on Tuesday whether King has had to put pen to paper. But even setting that aside, the fact that the inflation outlook is worse than the Bank expected a couple of months ago explains the MPC’s urgency. Tenth anniversaries in politics are often unhappy affairs. The way things are shaping up, there might not be much of a party at the Bank.

This is not just about pay. Pricing power appears to have returned to the malls. Whenever I ventured into shops, having seen the tabloid headlines of record-breaking “shop until you drop” sales discounts — both before and after Christmas — I left disappointed.

That was confirmed by the British Retail Consortium’s shop price index, which showed that, far from discounting like crazy, stores raised prices by 2.3% last month compared with a year earlier. Records are being broken, but not in the right direction. The British Chambers of Commerce will this week report record price expectations among firms.

This is a dangerous situation. For the first time in ages, firms appear to have discovered they can lift prices without penalty.

This week’s retail prices index (RPI) will show a rise to well over 4%, with further increases to come when higher mortgage rates come through. I don’t want to scare anybody unduly, but the last time we had a retail price inflation number beginning with a four, in the early days of Bank independence, interest rates were rather higher than they are now.

In June 1998, when inflation had just risen to 4.2%, the Bank lifted rates to 7.5%. Yes, 7.5%. It didn’t last long; by the autumn the MPC was in aggressive cutting mode. But it is a reminder that rates were not always this low. As things stand, a Bank rate of 5.25% could translate into a real (after-inflation) interest rate of under 1% when retail price inflation of more than 4% is taken into account.

This is not a problem the Bank has had to deal with very often in the post-independence era. Five years ago, partly thanks to the falling cost of borrowing, retail price inflation dropped to a low of 0.7%, and even a 4% Bank rate did not seem high. There were no worries then about the return of the wage price spiral.

Internationally, normal service has been resumed. UK rates are on a par with America, also 5.25%, and well above Europe’s 3.5%.

Where do we go from here? In my end-of-year piece a couple of weeks ago, I sketched out two scenarios for Bank rate. One was that it stayed at 5% for the year, as implied by the Bank’s November inflation forecast. Neither the recent forecasts nor the MPC’s monthly minutes have been of much help to Bank-watchers. The Old Lady, who prides herself on transparency, has become flighty.

The other interest-rate scenario was that it rose once or twice in the early months of 2007 before returning to 5% by the end of the year. Scenario one is now redundant. A fortnight into the year it is too early to abandon scenario two; the Bank’s hope, and mine, will be that a stitch or two in time will save nine.

Certainly, if the aim was to get noticed, the MPC succeeded. Some of the housing market’s end-2006 exuberance should now quickly subside. But the uncertainties have increased. We are not going back to 7.5% but 6% no longer looks like a wild forecast.

The economy is between a rock and a hard place. If the early warnings of higher pay prove false and earnings growth stays low, the effect will be a significant squeeze on incomes. Christmas will be the last hurrah for retailers for a while. And a cooler wind should blow through the housing market.

But should both pay and prices accelerate, the Bank will have to keep raising the dosage. For, as King will make clear should he have to put pen to paper this week, there is no alternative to hitting the inflation target.

PS: The Office for National Statistics will tomorrow hold an unusual event, the launch of its personal inflation calculator. Journalists will work out their own inflation rates before it goes on general release.

When it does, I can make a firm prediction. Everybody who tries it online will come out with a higher inflation rate than the average.

This is not because these measures are flawed. I have problems with the CPI, which excludes housing costs, but the RPI has served us well for years. But when prices are rising for essentials — housing, food, energy, fares — things we do not like spending on and cannot just switch away from, we become easily convinced inflation is galloping away.

Even price falls may not make us happy. The economist Thorstein Veblen invented the term conspicuous consumption. “Veblen” goods are luxuries that become more attractive when their prices rise, because it takes them beyond the reach of the hoi polloi. Lower-priced luxuries thus become less attractive when everybody can afford them.

Sometimes you just can’t win. We feel put upon and squeezed, the more so in many cases as a result of last Thursday. Not the ideal environment for the Gordon Brown succession.

From The Sunday Times, January 14 2007


So I just tried out the personal inflation calculator on the ONS site and came up with a personal inflation figure of 2.4% for November, vs. 3.9% for RPI. It was kind of fun, in a geeky sort of way, though I noticed one peculiarity. If you enter any expenses related to fuel for transport, then it automatically estimates what you spent on vehicle purchase based on the national average, rather than allowing you to enter that figure directly. This assumption alone, which was not very accurate, seemed to account for about 1/3 of the difference between my rate of inflation and the national rate.

Posted by: RichB at January 15, 2007 08:34 AM

Very interesting - and you've disproved my expectation that everybody would find themselves above the official inflation rate. All other contributions gratefully received. I'll try mine later.

Posted by: David Smith at January 15, 2007 08:55 AM

Got my work colleagues (7 of us) to try the calculator. We all live differently so thought it might be interesting.

We all came out higher than current CPI (3.0%).
Lowest was 4.2%, highest was 7.5%

Nu Labour are making us poorer!

Posted by: Rev at January 16, 2007 02:49 PM