Friday, December 16, 2022
A year of damaging inflation - and of a loss of credibility
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. Not to be reproduced without permission.

When you look back on this year, one thing sticks out like the proverbial sore thumb. The return of inflation has been painful and all-encompassing. It has dominated economic and business decisions, given us the worst industrial relations climate in decades and led to more interest rate hikes in any year since 1988, of which the latest was the expected half-point rise on Thursday, taking Bank Rate to 3.5 per cent, its highest level since early November 2008.

Though the latest inflation figures a few days ago showed a fall in the annual rate, from 11.1 to 10.7 per cent, and may indicate that we are past the peak, we are ending the year with inflation in double figures, which not many expected. Retail price inflation, and you may wish to cover your eyes now, was 14 per cent last month, from 14.2 per cent in October.

This time last year, it was possible to report on an inflation rate which, while rising, was still only just over 4.5 per cent. Forecasters expected a peak in the spring and a fall in the second half of the year. In the Bank of England’s case, the spring peak was expected to be about 5 per cent, before a fall to roughly 3.5 per cent now.

They did not factor in or expect the Russian invasion of Ukraine, though it is likely that their forecasts would have provide optimistic even in the absence of it. Measures of “core” inflation, excluding food and energy, are indirectly affected by higher energy prices, but have averaged close to 6.5 per cent in the second half of the year. Core inflation is currently 6.3 per cent.

Businesses, which a year ago were looking forward to a strong post-Covid recovery, had every incentive to invest this year, it seemed, given the corporation tax “super deduction” announced by Rishi Sunak when he was chancellor. But managing their way through rising costs and high inflation took priority and business investment was down marginally in the latest quarter, and 8.4 per cent below pre-pandemic levels.

High inflation, meanwhile, fundamentally changed the labour market and wage calculations. Regular pay growth in real terms turned negative in November last year and has remained sharply negative since. Real wages have been falling, and particularly sharply for some groups of workers. Inflation gave us the biggest drop in household real incomes since records began in the mid-1980s.

Inflation’s return, in the form of a powerful economic shock, has also shaken us out of the complacency of recent decades. In that respect it is a bit like the as yet elusive quest for a return to normal rate of productivity growth. Before the financial crisis, it was a given that, no matter what you did to the economy, productivity growth would still trundle along at 2 per cent a year. Then the spell was broken, and a return to that 2 per cent would be regarded as a triumph.

For inflation, where 2 per cent is also the relevant figure, as the official target, this year’s surge has changed the way we will think about it. For 25 years, the target was also a magnet, in the sense that whenever inflation deviated from it, it always seemed as though it was bound to return to it.

Indeed, some Bank policymakers argued that the target itself, by affecting the behaviour of businesses and individuals, in price-setting and in wage negotiations, could almost be regarded as self-fulfilling. Whenever inflation deviated from 2 per cent, as on a number of occasions it has over the past quarter of a century, it seemed inevitable that it would be pulled back towards it.

That will, in the end, be the case this time, and one of the stories of next year should be that of falling inflation. But this episode of prolonged and dramatically above-target inflation has shaken confidence in the inflation-targeting regime. The question of whether low inflation was the result of the skills and good judgment of central bankers or a confluence of fortunate events, including the “China effect” which held down the price of goods, is a live one.

Thus, while inflation is expected to fall sharply next year and into 2024, coming back down to the 2 per cent target or even below it, keeping it low will present more of a challenge than in the past

Rob Wood, a former Bank economist now with Bank of America (BoA), writes in a new assessment that this year’s huge overshoot has exposed the UK’s inflation vulnerability. The UK, he suggests, has an underlying inflation problem, the result of weak supply growth, which means that even a modest economic upturn is likely to generate inflationary pressure. A structurally weak economy is more inflation-prone than a strong one and the UK is “particularly vulnerable to persistent inflation”.

That will not stop inflation falling sharply over the next two years – BoA’s prediction is 1.5 per cent in 2024 – but will pose a challenge in keeping it low, to 2 per cent, after that. It is why, when the Bank of England decided that official interest rates have reached their peak, which may not be too far away, it is unlikely to be in any rush to reduce them again.

Very low interest rates – and negative real rates – were consistent with 2 per cent inflation for a decade after the financial crisis, but that is unlikely to be the case in the future. It is a sobering thought that only last year the Bank was considering whether it might need negative interest rates.

And, if inflation proves harder to hold down than in the past, the debate will be reignited over whether an inflation target of 2 per cent is right for the long run. This is not something that could be done by one country acting alone, and it could be interesting. But all that is for later.