Sunday, August 15, 2010
No return to the golden age as inflation stays choppy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My Sunday Times piece is available to subscribers on - this is an excerpt.

Three years ago, the financial crisis broke and, it seems, blew UK economic policy off course. Even before that, however, the cracks had started to appear.

Britain’s fiscal policy was too loose in the run-up to the crisis, as is generally recognised, though the scale of the error is often overstated. It would have been better in the light of what followed to have been running big budget surpluses at the time but the current budget deficit, adjusted for the cycle, was only 0.4% of gross domestic product in 2006-7.

There was also, however, evidence of a monetary policy problem. In that period, starting in 2005 but continuing for much of 2006 and 2007, inflation had begun to move higher, an upward creep identified recently by Adam Posen, a member of the Bank’s monetary policy committee.

From May 1997 to July 2005, consumer price inflation was never above the current 2% target. Since then, it has been above it four-fifths of the time, often significantly, despite the recession. We cannot know what might have happened in the absence of recession.

In August 2007 the Bank had just raised interest rates to 5.75% and predicted that inflation would stay close to its 2% target for the next three years, alongside economic growth of 2.5% to 3% a year.

The reality was very different. Thanks to the recession, the economy has shrunk by at least 10% relative to what it was expected to be, yet inflation has been uncomfortably high.

We are in a different world from August 2007. Bank rate is 0.5% rather than 5.75%, and the Bank’s latest inflation report suggests it will stay at this record low level for some time to come, despite above-target inflation.

The point is not to revisit the crisis and all its horrors, or attack the Bank for its forecasting record, for which it has taken enough punishment for now. Everybody got the economy wrong, to a greater or lesser degree, over the past three years.

The point, instead, is that it is easy to think that the crisis was a nasty interlude between periods of low-inflation stability and guaranteed steady economic growth. My argument is that the great moderation was exceptional; the likes of which we will not see again, and that it was starting to break down even before the financial crisis.

It included 16 years - 63 successive quarters - of economic growth in Britain. Quarter after quarter, Britain’s economy trundled along in perfect Goldilocks fashion, neither too hot nor too cold. Inflation was never more than a percentage ppoint away from its current target for more than 14 years. Monetary policy appeared to operate with slide-rule precision.

What kind of world will we have when the dust settles this time? It will be one, I can guarantee, where we do not have 16 successive years of economic growth. I do not think the next recession is around the corner but it will be s surprise if there is not one over the next 8-10 years. That, by the way, increases the argument for ensuring the public finances are robust enough to withstand the next downturn.

As for inflation, there are those who would combine failed Russian grain harvests, other upward pressure on commodity prices and the temptations of inflating our way out of debt into a re-run of the inflation of the 1970s.

That is to misunderstand the process by which Britain got to high inflation then; the dangerous combination of runaway growth in the money supply, broadly measured, and a wage-price spiral. These days, even the Bank’s best efforts cannot get broad money, M4, growing by more than 3% annually, and average earnings growth is just 1.3%. Inflation has been disappointingly high, and as the Bank told us last week will take time to come down below target. But it is hard to see it taking off.

Much more likely is that it will be a lot more volatile than we have been used to. Sometimes it will surge higher on higher energy or food prices, bringing fears of its return. Other times it will lurch lower, raising the spectre of deflation.

The Bank, as is its wont, predicts a return to the 2% target over the medium-term, after a period both above and below it. It still thinks in terms of the world of the great moderation. I think that world has gone. King described the outlook for recovery as “choppy”. Choppy, or volatile, is likely to be the shape of things in the longer-term too.