Sunday, March 30, 2014
Falling inflation lifts the mood and helps the Bank
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.

Inflation has been below the official 2% target for two months in a row, something it has not been possible to write for a long time.

You have to go back to 2009, five years ago, when the economy was falling off a cliff, for the last time this happened.

Inflation at 1.7%, as it was in February, has come down from more than 5% in the space of less than two and half years. Even last autumn it seemed we were stuck at closer to 3% than 2%.

The fall is a feather in Mark Carney's cap though I am sure, given the lags in monetary policy, he would give some credit to his predecessor, Lord King.

One set of crossroads has been written about a lot. Is this the point when wages - average earnings - start to rise faster than prices, the consumer prices index? As regular readers will know, my view is that this has been happening for some but it will not be generally accepted until the monthly data from the Office for National Statistics confirms it.

The second set of crossroads, what it means for the Bank of England, is as important. The course of inflation over the next 12-18 months matters. Some, like Fathom Consulting think this is the briefest of below-target interludes.

Fathom thinks lack of spare capacity in the economy will, alongside stronger growth, push inflation back up to 3% by the end of the year. They have a bit of history on their side. Even in the deep recession of 2009 inflation was below target for just five months. Why should it be better during a period of recovery?

In the opposite camp are regular inflation optimists such as Capital Economics, who expect inflation to drop to 1% later this year. They see the pressure from global commodities, and thus food price inflation, continuing to ease.

Even more optimistic is David Owen, an economist with the City firm Jefferies International, who sees sub-1% inflation. Falling inflation is common in recoveries, he notes, and there is more evidence of price discounting by retailers, including supermarkets.

Energy price rises, which have pumped up inflation in recent years, are being replaced by freezes, led by SSE. Generalised energy price falls, like the recent drop in petrol and diesel prices, are a possibility.

Tellingly, as Owen points out, the proportion of goods and services in the CPI (consumer prices index) basket rising by more than 3% has come down sharply. That is reflected in the drop in inflation but may also be a sign of things to come.

The Bank of England is somewhere in the middle. Based on market interest expectations (which are for a mdoest rise starting in a yearís time), it expects inflation to go back above 2% shortly and stay there until the autumn, before dropping a little below it - in a 1.7% to 1.9% range - through to the early part of 2017.

Interestingly, if Bank rate were to stay at 0.5%, inflation would stay above 2%, though not by much, perhaps averaging 2.2% or 2.3%.

I know what you are thinking. Given the vagaries of the data, though inflation numbers are trusted more than most, this is dancing on the head of a pin.

Given Britainís past inflation gyrations, the difference between 1.9% and 2.2% is small beer. So, in the grand scheme of things, is the difference between 1% and 3%.

But it matters. If inflation is 1% over the next 12 months, that guarantees a rise in real wages for the four-fifths of people who work in the private sector. Earnings in the private sector in the latest three months were up 1.7% on a year earlier and the trend is for faster growth.

We will soon reach the point in which growth in real pay for private sector workers is incontrovertible. The only thing that will stand in the way of it is a rise in inflation back up towards 3%.

Politically, rising real wages are important, neutering if not destroying the Labour partyís cost of living argument. But it is important for the economy too. Sustained real wage growth is the only sound long-term basis for rising consumer spending.

The evidence, from the national accounts and the annual survey of hours and earnings, is that real wages have been rising for a while now. The latest retail sales figures, showing a 1.7% jump in spending last month and a 4.3% increase in the latest three months compared with a year earlier, lend support to that view. But perception is important and risijng real wages need to be in the headlines, not the statistical detail.

What about public sector workers? We are in a time, unusual in recent years, in which private sector pay is rising faster than in the public sector, where the latest rise is a mere 0.5%. That, however, is dragged down by falling pay in the state-owned banks, Royal Bank of Scotland and (for now) Lloyds.

Take them out and public sector earnings are rising by 0.9% and the growth in pay is accelerating. Even public sector workers could find themselves with real pay rises if inflation drops to 1%.

Low inflation also matters for the Bank and its credibility. If inflation were to go back up to 3%, its process of beginning to raise interest rates, set to start next year, would be from a position of weakness.

It would also, given that under those circumstances it would probably coincide with a continued squeeze on real wages, be harder to do, adding to the pressure on hard-pressed households.

Raising rates at a time of below-target inflation, on the other hand, would be a good thing from every perspective. It would show the Bank was responding to the risks of future inflation, not reacting to existing inflation. Households would be better able to take it with real wages rising. Savers would love it.

When it comes to low inflation it is possible, of course, to have too much of a good thing. If inflation falls so much that deflation is seen as a risk, the Bank would be reluctant to embark on an even a gradual rise in rates. 1% inflation would be good. Too far below 1% maybe not so good.