Sunday, October 23, 2011
An Irish alternative to high inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Unemployment is at its highest rate for 15 years and its highest level for 17. Inflation has matched its record high on the consumer prices index and is at its highest for 20 years on the retail prices index.

For followers of the misery index (the unemployment rate plus the inflation rate) this means only one thing; we have not been this miserable for 19 years. Some young people have never been.

So the Nationwide building society reported on Friday its consumer confidence index fell three points to 45 and is lower than when gross domestic product was falling. It is just above its all-time low in February, after the Vat hike to 20%.

The rise in consumer price inflation to 5.2%, and to 5.6% on the retail prices index, came less than a fortnight after the Bank of England had announced a further £75 billion of quantitative easing (QE).

The best way to think about QE is as the Bank does, the equivalent of cutting interest rates when there is no room to do so in the normal way. It calculated in its latest quarterly bulletin that the £200 billion of easing undertaken in 2009 was the equivalent of cutting Bank rate by between 1.5 and 3 percentage points.

The extra £75 billion, on this basis, is equivalent to a further 0.5 to 1 points off Bank rate. That the monetary policy committee did this unanimously ahead of figures showing inflation so far above the 2% target was either brave or very foolhardy.

Applying this relationship mechanically suggests monetary policy is operating with the equivalent of a Bank rate between minus 1.5% and minus 3.5%. It is a long time since monetary policy has been so accommodative or real interest rates (rates adjusted for inflation) so negative.

Sir Mervyn King gives four big speeches on the economy each year, together with the occasional television interview. I’ll come back to another aspect of his latest speech in Liverpool a little later, but on inflation, the content was familiar.

So, inflation is close to a peak and should soon fall significantly and, in any case, it is outside the Bank’s control. As he put it: “Domestically generated inflation remains subdued – and on some measures barely above zero. Increases in energy prices, import prices and Vat account for the current high level of inflation.”

And, while not spelling it out in this speech, his line is that to have kept inflation close to target would be by inflicting further pain on the economy. There was no realistic alternative, in other words. There would have been at least as much misery, though distributed differently between unemployment and inflation.

I would take issue with some of this. You cannot divorce import prices from the performance of the pound. Sterling’s fall, and the fact it has stayed down, has been a key element in Britain’s high inflation. The Bank has blessed a weaker exchange rate and by its actions ensured it is maintained.

High inflation is also a key factor in the disappointing recovery. Retail sales figures showed people spent an astonishing 5.4% more last month than a year earlier. If inflation were 2%, that would be consistent with a strong, consumer-led recovery.

Alas, high inflation meant all but 0.6% of the rise in spending was eaten up by rising prices. Stagnant real consumer spending is a consequence of inflation.

Was there an alternative? Interestingly, as Richard Ramsey, an economist with Ulster Bank points out, you do not have to go too far to find a country with a very different inflation experience in recent years.

Since August 2007, and the start of the global financial crisis, consumer prices in Britain have risen 15.5%. Average earnings have risen by only 8.8%, hence the squeeze.

In Ireland, in sharp contrast, consumer prices have risen less than 1% over those four years; 0.7% to be precise. This is a huge contrast. Even more surprising, as Ramsey points out, is some of the detail.

Some of those ‘impossible to avoid’ price rises in Britain have, in fact, been avoided in Ireland. Food and drink prices have risen by 28% and have been a major factor in sustained above-target UK inflation. In Ireland, however, food and drink prices are 0.7% lower than they were in 2007.

To paraphrase Dickens, this is a tale of two countries. Ireland had a much more serious recession, with a peak to trough fall in GDP of 12.6% versus 7.1% in Britain, as well as ratings downgrades and a rescue. Unemployment, at 14.3%, is much higher than the new 8.1% UK level. Because Ireland is part of the euro, there could be no independent devaluation of the currency.

Ultra low inflation is partly a consequence of Ireland’s economic weakness. Some of the country’s indicators are now moving in the right direction. GDP rose a strong 1.6% in the second quarter, after 1.9% in the first. Industrial production in August was over 11% up on a year earlier.

Ireland’s consumers are not making hay on the back of low inflation. Retail sales volumes are 3.6% lower year-on-year, partly because of high unemployment, zero (at best) earnings growth and higher taxes.

I do think, however, low inflation in Ireland stands the economy in good stead for the future. It is wresting back competitiveness in difficult circumstances and, while that adjustment has further to go, it provides an an example for the eurozone that default and exit are not the only options for troubled peripheral economies.

The Bank chose a different path. The latest MPC minutes spoke of a weaker growth outlook increasing the “margin of slack” in the economy, putting downward pressure on inflation and making it more likely it will undershoot the 2% target in the medium-term. Hence more QE.

I think this is a figleaf. There has been plenty of slack in the economy over the past four years but inflation has been high. There are mathematical reasons why it should fall next year but its path over the medium term will depend more on those factors the governor listed in his speech.

The Bank, with the government’s backing, has tolerated high inflation to prevent greater short-term damage to growth. That is fine, but it should be open and honest about that, rather than dress up all its decisions in terms of spare capacity and medium-term inflation. And whether this strategy is the right one for the economy in the longer-term I very much doubt.