Sunday, June 22, 2008
Slow growth will tame the inflation beast
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Your starter for 10. Who said: "The rise in inflation that we are experiencing today is a worldwide phenomenon ... Indeed, on a genuinely comparable basis, inflation in this country has increased over the past six months by less than in the G7 as a whole."

It was Nigel (now Lord) Lawson, of whom we have seen quite a lot recently. He was speaking in June 1989 about the rise in inflation on his watch.

Chancellors have two lines of attack when confronted with unacceptably high inflation. One is to blame world events, and this is always used when the same party has been in power a long time. The other, for governments new to office, is to blame the opposition.

Alistair Darling cannot blame the Tories or his Treasury predecessor. So in his response last week to Bank of England governor Mervyn King's letter explaining why consumer price inflation had hit 3.3% he also emphasised "the global nature of inflation".

To be fair, the current situation is different from the late 1980s. When Lawson was blaming the world, Britain's inflation rate was more than 8%, nearly double the G7 average. Today, euroland inflation is 3.7%, while America's is 4.2%. But to the extent that no chancellor comes out and blames himself, nothing much changes.

What about central banks? The great thing about Bank of England independence is continuity. Governments may change but the Bank carries on. Does that mean it will never blame itself?

In the past week we have had soft cop (the letter to the chancellor) and hard cop (his Mansion House speech) from King.

His letter did indeed lay the blame squarely on international factors. Last December, consumer price inflation was 2.1%; now it is 3.3%. Of that 1.2 percentage point rise, 1.1 was caused by higher food, fuel, gas and electricity bills.

Without a 60% price rise in food commodities, an 80% increase in oil and a 160% surge in the wholesale price of gas, inflation would still be close to the 2% target and the City would still be looking for rate cuts, not rises.

But, as he also made clear at the Mansion House, this does not absolve the Bank of responsibility. "The rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to," he said. "We will not."

I believe it would be a mistake for the Bank to raise rates. It would make a very weak outlook look grimmer, without any real gains in lower inflation two years ahead.

Would raising rates help the pound? Not if seen by currency dealers as condemning Britain to even deeper misery. And, irrespective of what the Bank is doing, a market-driven tightening of monetary policy is taking place, through higher mortgage rates.

What matters, though, is not what I think but what MPC members think. Rate cuts are off the agenda for the foreseeable future. What would make the Bank turn its discussion earlier this month of the possibility of a rate rise into action?

Wages are important. Everybody knows inflation expectations are elevated, including on the Bank's own measure. Most of us do not, however, have a personal inflation calculator in our heads. What we do notice are big price increases for frequent purchases and those, according to an article in the Bank's latest quarterly bulletin, are instrumental in forming our judgments about future inflation.

The key for the Bank is whether heightened expectations get converted into higher pay increases. The Engineering Employers' Fed- eration says not, with settlements down to an 18-month low of 3%, and 7% of firms having frozen pay.

However, if there are many more "special cases" like the tanker drivers, the Bank will get worried, so this one bears watching. If Sainsbury's is right and its inflation rate is 3% rather than the much higher numbers doing the rounds for supermarket inflation, that would be good news. Even better would be if today's summit in Saudi Arabia has an effect on oil prices.

The Bank is also aware, however, that in today's less-unionised labour market, wages may not be the route through which a permanent increase in inflation shows itself.

This is where much-maligned "core" inflation comes in. Core inflation gets a bad press because it excludes energy, food, alcohol and tobacco; the things that are going up most sharply. Nobody could live a core-inflation life.

But what core inflation also tells us is the extent to which inflation is spreading into general price increases. Core inflation is now 1.5%, compared with 1.4% six months ago. Some members of the MPC will be content to see it stay there. The hawks want more. They would like to see core inflation heading lower, as the squeeze intensifies. So watch the horrible headline figures for inflation but keep a close eye on the core.

Those horrible figures are a reminder of one of the most difficult challenges for monetary policy. Even when forces are in train that will bring inflation down, there will be a period, possibly quite long, when it is going up. The Bank knows this is going to be pretty bloody, with the letters flying thick and fast between Whitehall and Threadneedle Street. JP Morgan expects October inflation of 5%.

Goldman Sachs points out that it is typically four to six quarters between growth slowing below trend and the output gap (spare capacity in the economy) increasing, and inflation heading lower. Only in the first three months of this year did growth drop below trend in Britain, so there is a long way to go.

It is also very important that growth does continue to slow. May's 3.5% jump in retail sales, the biggest for nearly three decades, went wildly against the grain of a slowing economy and will be taken with a pinch of salt. But from the point of view of holding rates down, a 3.5% drop would have been better.

Finally, it matters what other countries are doing. If you had a global MPC, it would be raising interest rates. But the bits of the world where it would be raising them would be where growth is booming. That is happening. India's reserve bank hiked earlier this month and China's central bank governor, Zhou Xiaochuan, said fighting inflation was his country's greatest concern. There are similar noises from Brazil.

The more action is taken in these global hotspots, the less the need for the Bank to do anything in our sharply slowing economy. I don't sense that the MPC wants to raise rates. It merely wants to show that it isn't complacent.

PS: Sir John Gieve, whom I have known for two decades, developed a knack for being in the wrong place at the wrong time. He was press secretary to John Major during his brief period as chancellor and permanent secretary at the Home Office in its "not fit for purpose" years. He was unlucky enough to join the Bank a year before the biggest financial crisis in decades.

His career as deputy governor has a few months left and is not ending as he would have hoped. But he has always been accessible and courteous and did better in the crisis than he is given credit for. The Bank's latest Financial Stability Report was a brilliant analysis of the crunch.

Attention now switches to Spencer Dale, the Bank's new chief economist and newest MPC member. Great things are said about him at the Bank. As a "lifer" he joined from university in 1989 not that much is known about him outside, although he has spent the past two years advising the Fed. Will he be a hawk, dove, or some other bird? Watch this space.

From The Sunday Times, June 22 2008