Sunday, November 22, 2009
The nutters can relax - for a while
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


The word “nutter” and Bank of England are only occasionally used in the same sentence. It was used soon after Bank independence in 1997 when Diane Abbott, the Labour MP, accused the governor, then Eddie George, of being an inflation nutter.

It was used again recently by Adam Posen, the newest member of the Bank’s monetary policy committee, who referred to some of those worrying about the return of high inflation as “nutters”.

For the sake of clarity, Abbott and Posen have different definitions of inflation nutters. She was concerned about central bankers obsessed with keeping inflation ultra low, whatever the economic cost. He was referring to those who fear hyperinflation is lurking round every corner.

I should say too that nutter is being used here not to refer to people who go nut-hunting in the woods, still less those with mental conditions. A better expression might be silly bloggers.

Let me also make clear that not everybody who worries about inflation meets that description. It seems to me that we should think about inflation in three distinct time-frames. The first is the very short term; the next few months. The second is the short to medium term, the next 2-3 years. The third is the longer-term, say over 5-10 years.

We know what is happening in the very short-term. After hitting a low in September, figures last week showed the start of what the Bank expects to be a sharp rise over the next few months.

Consumer price inflation rose from 1.1% to 1.5%, while retail price deflation eased from 1.4% to 0.8%. The eight-month long curiosity of annual retail price falls, something not previously seen since March 1960, is now almost over.

Inflation will rise further. The Bank expects consumer price inflation to average 1.85% in the final three months, implying it will be above the 2% target by December, and 2.71% in the first quarter.

Some City economists think the rise will go above 3%, requiring Mervyn King to write a letter justifying a 0.5% Bank rate at a time of significantly above-target inflation. King does not expect to have to write, however, and is probably right.

Why is inflation rising? Mainly because of what was happening a year ago. In the autumn of 2008 plenty of prices were falling sharply, including petrol and diesel, which dropped by a record amount between September and October 2008. The contrast between those falls and this year’s modest rises is enough to produce a sharp rise in measured inflation.

The biggest effect of this type will come in January, when Vat goes back up to 17.5%, a stark comparison with a year ago, when it was cut in December.

This very short-term rise in inflation need not concern us even slightly. Not only does the Bank fully expect it but King has assured us that the MPC will look through the short-term rise to what lies beyond it.

What lies beyond, the Bank says, is prolonged low inflation. The second half of next year will see a drop back below target and it will not be until late 2012 until it gets back there. Some City economists point that the Bank’s recent record has been to under-predict inflation but if there is one lesson from Britain’s economic history it is that recessions are good at destroying inflation. That is usually why we have them.

Spare capacity, in the jargon a large output gap, keeps inflation tame. That will be true this time, as it has been on every previous occasion. Posen made the point that even if the Bank wanted to create inflation in current circumstances it could not do so.

“Long historical experience in the UK and elsewhere ... bears this out even for normal times,” he said, “let alone for times when the financial sector is so troubled and there is downward pressure on wage growth and prices.”

What is true for Britain is not necessarily true for other countries. Andrew Milligan of Standard Life makes the point that emerging economies like China that have introduced big stimulus packages but have been less affected by the global recession may be more vulnerable to an inflation rise over the next couple of years.

For advanced economies like Britain, the test will come in the longer-term. Contrary to many of the headlines you will have seen, last week’s official figures did not suggest the public finances have suffered another lurch out of control. The Institute for Fiscal Studies suggested the government is still on course for its £175 billion deficit projection for the current year. The Treasury appears to agree, and any revisions to this year's borrowing forecast in the pre-budget report on December 9 will be minor.

Even so, public sector net debt is up to 59% of gross domestic product and rising, as it is in other countries. How big will be the temptation, once some of that spare capacity is used up, to try and inflate away the problem of public and private debt? Inflation is a lot easier than the hard slog of raising taxes and cutting public spending.

That and the fact that the Bank may find it hard to raise interest rates and reverse quantitative easing is where the inflation danger could lie. As I say, we are not talking about the next 2-3 years but somewhere beyond that.

A debate has been running on the letters page of the Financial Times about whether the break-even inflation rate implied by the difference between conventional and index-linked gilt yields tells us markets are pricing in significantly higher inflation for the next decade. The high gold price, if it has any logic, must reflect inflationary fears. Rising asset prices could be a forewarning of inflation on the horizon.

How big are the risks? At some stage central banks will have to show they are prepared to be very unpopular. It is not hard to imagine quite a sharp rise in interest rates in the run-up to the election after next if the Bank is determined to stick to its 2% inflation target.

At the very least, just as the outlook is for a more unstable economy than in long run-up to the crisis, so inflation will be much more volatile. There is no need to worry about inflation over the next few months. There may be more cause to worry in the long run.

PS Should a state-owned bank be a permanent feature of Britain’s financial system? The issue came up at two separate meetings I attended last week. One was at the British Academy, which has been holding a series of events, including a seminar a few weeks ago which tried to answer the Queen’s question on the crisis: “If these things were so large, how come everyone missed them?”

Last week’s event was on where we go from here. One strand was whether banking is too important to be left to the private sector. This question, unthinkable not long ago, is now mainstream. If you want low-risk “utility” banking, why not provide it by the public sector?

Just along Carlton House Terrace, the Royal Academy of Engineering hosted an event on renewing British manufacturing jointly run by the ERA Foundation (the old Electrical Research Association) and Civitas, a think tank.

Among ideas for reviving manufacturing presented by Sir Alan Rudge, ERA chairman, was a Bank for Industry. The Engineering Employers’ Federation backs something similar.

Manufacturing has complained of being starved of finance for decades but the crisis has brought this home, while demonstrating that bankers were not nearly as good as they thought. State-owned banks provide seed and investment capital in plenty of countries. I never thought I would write it but is this an idea whose time has come in Britain too?

From The Sunday Times, November 22 2009