Sunday, January 21, 2007
How the Bank can avoid being blown away
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Events are driving the agenda. Britain’s economy has suddenly become very interesting — even exciting — and not a little worrying.

On the Bank of England’s website there is a film called What if? “Just imagine what it would be like if inflation got out of control,” it says, before showing us how things might be if it did. It drew on the services of a serious-looking Evan Davis, the BBC’s economics editor, who speaks direct to camera on the imaginary crisis and its gory economic aftermath.

Businesses fail in their tens of thousands, house prices tumble and unemployment rises sharply as the Bank lifts interest rates to “record” levels. The message is clear: low inflation is good for us, and we should never abandon it, by accident or design. This is reinforced in the film by the reassuring presence of Mervyn King, the Bank governor.

Is life imitating art? We are a long way from the kind of scenario depicted in the Bank’s film but the governor and his colleagues are facing the most difficult challenge in nearly 10 years of independence. King has often warned us the “nice” decade could turn nasty. With more inflation and interest-rate surprises in the first weeks of January than we usually have in years, there is a danger he will be right.

Gordon Brown, the chancellor who promised stability, is now presiding over a higher headline inflation rate — 4.4% on the retail prices index — than when his Tory predecessors, Norman Lamont and Kenneth Clarke, left the Treasury.

Headline RPI inflation has not only doubled in a year but is at its highest since December 1991. This was before Britain’s new monetary arrangements came into force in the autumn of 1992, when the Bank was given an enhanced role and began publication of its quarterly inflation report.

The consumer prices index (CPI) came in at 3% last week, a tenth of a percentage point below the trigger point for an open letter from King to Brown. I will return to that. On the target the Bank used until three years ago, RPI excluding mortgage interest payments, inflation jumped to 3.8%, above the 3.6% trigger point for the governor to put pen to paper.

And the newly independent Office for National Statistics is doing its bit to complicate matters by launching its personal inflation calculator. At a time when the Treasury and Bank are trying to focus attention on the 2% CPI target, a high proportion of people are finding that even RPI inflation does not capture the extent of the rise in their cost of living.

These, as I say, are uncomfortable times. How much of it is the Bank’s fault? Geoffrey Dicks of Royal Bank of Scotland points out that the rise in CPI inflation from below 2% to 3% over the past year can be put down to three things — energy (a global factor), food (last summer’s heatwave) and higher university tuition fees (government policy).

In some respects, therefore, we are into blip territory, caused by factors outside the Bank’s control. Energy prices are now falling, with crude oil flirting with $50 a barrel. Unless this year’s summer food- price effect is worse than last year’s, it will not add to inflation. Tuition fees are now included in the numbers.

On the other hand, as Dicks also notes, the Bank’s job is to achieve 2% inflation even when some prices are going up, by ensuring others come down. That can be difficult when rises are unexpected, but means we should not absolve the Bank of responsibility.

Higher inflation, apart from the immediate threat of big wage rises to compensate, may also encourage imitative behaviour. Chris Watling of Longview Economics calculates that half of the 56 components of the CPI have inflation rates above 3%, but only two of these are directly oil-related.

The bigger question is whether we are reverting to inflation type. Is the low inflation of recent years just the product of a series of fortunate events — a strong pound, the impact of the “China effect” on prices and immigration keeping wages down?

CPI in Britain is 3%, alongside a 5.25% Bank rate. The equivalent inflation rate in euroland is 1.9%, with a 3.5% interest rate from the European Central Bank. Why the difference? There are three reasons. Britain’s much-vaunted competitive environment for energy has, paradoxically, led to bigger increases in gas and electricity bills than in the rest of Europe.

Brown once lectured the rest of Europe on the need to keep their budget deficits under control. Now his own deficit is the problem, and the higher taxes needed to control it are pushing up inflation.

There is also demand. Even under the pressure of higher energy bills, interest-rate rises and those higher taxes, Britons remain enthusiastic spenders. Retailers did well in December, with sales volume rising by 1.1%. Enthusiasm verging on overexuberance has also characterised the housing market. Some would point to the strong growth of M4, the broad money supply, although this is not being driven by lending to individuals.

If we are reverting to type it does not bode well for the inflation target. The CPI is new but the RPI has a lineage extending back 100 years. Roughly speaking, a 2% CPI target is equivalent to 2.75% on RPI. Mostly, though, Britain’s inflation has not been anything like as low as this. In the 1950s, RPI inflation averaged 4.3%, dropping to 3.5% in the 1960s. This, remember, was our previous low-inflation “golden age”.

In the 1970s it averaged 12.6%, coming down to 7.5% in the 1980s and 5.1% in the 1990s (the average was bumped up by high numbers at the start of the decade). It is true that since 1993, average RPI inflation has been 2.6%, suggesting the target is in the right ballpark. But this should remind us we have been in a time of unusually low inflation.

How does the Bank ensure we maintain that? Actions speak louder than words and the three rate rises since the summer show its willingness to take action.

Words, though, are also useful. King will give one of his three “big” annual speeches on the economy to the Birmingham Chamber of Commerce on Tuesday. These speeches to business audiences are useful.

Sometimes, though, you have to mix it a bit with the general public, rather than just their bosses and the readers of the business pages. When news of the jump in inflation broke last week, it was

Ed Balls, a junior Treasury minister, who toured the radio and television studios. But why didn’t we hear the governor over the airwaves, or see him on the 10 o’clock news? Protocol is probably the answer, but protocol can go too far.

What he would have said is the same as if he had been forced to put pen to paper — the Bank has taken the action that is needed to get inflation back down to 2%, is prepared to take more, and neither wage bargainers nor firms should assume the current high inflation is here to stay. As it is, we’ve been in a bit of a vacuum.

The Bank’s website movie has the right message; low inflation is too precious to lose. But sometimes that message needs hammering home harder.

PS: The MPC has held its January meeting and voted 6-3 to keep interest rates unchanged at 0.25%. No, not another Bank of England “what if?” fantasy, but what happened in Tokyo last week. The Bank of Japan’s monetary policy committee, under pressure from the government not to raise rates, obliged.

The Japanese economy, having surprised with its recovery over the past couple of years, is expected to grow by only 1.8% this year, accelerating modestly to 2.3% in 2008, according to Consensus Economics. Inflation should stay low, at 0.3% this year, slightly more next. It is not too long since Japan escaped from the clutches of deflation — falling prices.

Japan’s very low interest rates mean the yen is close to its weakest levels for more than a year. The view among economists is that the Bank of Japan, which only ended its long-running zero interest-rate policy last summer, will hike in the coming weeks, and perhaps again before the end of the year. Standard Chartered predicts a rise to the dizzy heights of 1.5% by the end of next year. Monetary policy “made in Japan” is rather different to everywhere else.

From The Sunday Times, January 21 2007


I'm not an economist, but I did work through the period of high inflation in the 1970s and 80s. Apart from Ted Heath's mad scheme to link wage increases recalculated every month to prices ~1974, my recollection is that inflation was linked to wasteful government spending.

I recall that Margaret Thatcher reduced the number of civil servants by ~500,000 - approximately the same as the increase under Blair/Brown - and my memory associates the reduction in inflation with her tighter controls.

I've also read that the broader money supply number is increasing by 14% annually in the UK, apparently higher than anywhere in the developed world.

Is it possible that these two factors - massive wasteful increases in government spending and increasing money supply - are the real causes of higher inflation? And if it is, who is really responsible - Eddie George or Gordon Brown?

Posted by: Tony Green at January 21, 2007 10:10 AM

I just googled an Independent article from October 23 indicating the startling increase in the August money supply of 14%. While we can measure and spend a great deal of time lamenting the consequences of inflation in there various statistics, I believe it's excess money supply growth that plays the most important role. Debase the currency at your own risk.

Posted by: Gary Bezowsky at January 21, 2007 03:59 PM

Hello all,

I do not disagree wth anything mentioned in the article, other than the grave omittance of an indesputable fact. Last year the MPC caved in to public and political pressure to reduce rates.....and they did!....In doing so they signalled two facts.
1. our primary commitment to protect a monetary equilibrium is not only based on facts and relevant economic knowledge, we are open to suggestions of the press and other interested parties be it political or otherwise.

2. Inflation is not the be all end all, we have the power to influence the markets and public with impunity.

In summary, the PR exercise now is hopefully not too little too late!

My greatest respect is reserved for Mr King who has been consistent with reality and was dissapointedly outvoted on the interest rate cut last year. (just for the record)

Regards to all,

Arik Schickendantz

Posted by: Arik Schickendantz at January 21, 2007 05:48 PM

M4 has been a very poor predictor of inflation in Britain and there are reasons to suppose recent figures are distorted. We shouldn't ignore it, but we shouldn't make too much of it either. By the way, M4 growth has coe down a little over the past couple of months. Here's a copy of a comment I recently posted on this:

"The rise in M4 has been extensively debated, including on this site. Is the rise in M4 caused by a surge in consumer borrowing/mortgage lending? No, that has shown no acceleration. What it is caused by is a sharp rise in lending to other financial institutions. That's partly caused by private equity and hedge fund activity but may also reflect some technical distortions. As you will know if you read the site, several members of the shadow MPC are keen followers of M4 and believe in its predictive power. But the OECD has just published some research saying its links to general inflation have broken down in recent years:

Posted by: David Smith at January 21, 2007 07:13 PM

PS The point about wasteful government spending is well made. Eddie George, however, has been gone from the Bank for well over three years now.

Posted by: David Smith at January 21, 2007 07:15 PM

Yep, that August rate cut is starting to look like a big mistake now! 6.0% here we come. Have you seen the LIBOR recently???

Posted by: Yoshi at January 21, 2007 11:07 PM

I read somewhere that pressure is being created elsewhere when inflation juggling by the BOE results in higher interest rates.Inflation increments usually mean that the pound is losing value and therefore should lose value in the currency mart.

When the pound is losing value by 10-12% as m3 or m4 suggests,it helps the pound in that America is fiscally deficient ie trade deficits and the like,and the pound will only lose value once and if the deficit in America becomes manageable

Posted by: Hitesh Damani at January 22, 2007 02:19 PM

I can't help but feel the Bank is making rather a mountain out of a molehill. I think the real danger lies, not in inflation creeping up to 3-4%, but the possibility of a substantial fall in UK housing prices. It is true UK house prices continue to buck pessimistic predictions but if interest rates were to rise anothe 0.5% or so, maybe this would be sufficient to change the confidence of the housing market into pessimism and a slump in house prices. I feel that falling house prices could be as devastating on the UK economy as they were in Japan in the 1990s. It is interesting you quote the example of Japan, because I think that is a good example of a country where they gave far too much importance to the benefits of low inflation.

Posted by: Richard at January 22, 2007 04:17 PM

Not a landlord by any chance are we, Richard? Interest rates up, house prices down. Good. A recession? Even better - it's overdue, and inevitable. Let's get it out the way and get back to sustainable real wealth creation instead of debt-leveraged financial speculation and bloated public sector job creation masquerading as a successful economy.

For the majority of people, who keep their jobs, recessions are raher good. It's unfortunate for those who do lose their jobs, but also unavoidable - our system of unfettered credit creation can do nothing but lead to boom and bust, time after time.

Regarding inflation, try telling a group of pensioners that it's not important. A very naive view. Inflation is evil and I'd rather take 1990s Japan over 1970s Britain any day, thanks.

Posted by: Yogi at January 23, 2007 09:19 AM


The problem is that higher interest rates don't affect the public sector directly. It is the real wealth creators, especially those that have to compete overseas or against overseas suppliers, that suffer most, and first, when interest rates go up.

Higher interest rates will nor rebalance the economy towards wealth creation. Only a reduction in public sector spending and lower taxes can do that.

Posted by: HJ at January 24, 2007 10:04 AM

Inflation is a lie, raise them rates and bring house prices back down to normal levels. Tighten credit, and then maybe just maybe this countries debt problem might start to heal itself.

Posted by: Kev M at February 5, 2007 05:37 PM