Wednesday, May 14, 2008
Brace yourself for 4 percent inflation
Mervyn King is looking for understanding as price stability goes out the window. He promised reporters that "Inflation will return to the target and growth will eventually recover to a sustainable rate. But we will have to be patient".
Patience is not what the problem needs right now. If the MPC was serious about reducing inflation, it would raise rates. The relationship between rates and inflation is a straightforward one, as the chart above clearly demonstrates. It goes something like this; higher rates, lower inflation, lower rates, higher inflation.
Recent UK experience amply bears out this simple relationship. After a seriously misjudged rate reduction in 2005, inflation surged in 2006. Towards the end of the year, the MPC got the message, increased rates, and by early 2007, the CPI edged downwards. Two more rate increases followed and inflation was close to being under-control.
Why did it all go pear-shaped? Along comes Northern Rock, sub prime, and the credit crunch. The banks whinge about a systemic crisis, the government panics and bullies the MPC behind the scenes to do something. The MPC flakes under the pressure, reduces rates three times, and inflation picks up sharply.
Instead of following their mandate, King told us today that he doesn't have the stomach for a serious attack on inflation. However, rates aren't going anywhere for quite some time. The Bank are now promising 4 percent inflation and a vague forecast that by 2010 the Bank might actually meet their target. That is the best they can do, right now.
If inflation reaches 4 percent, then 6 percent isn't so far away. At that point, base rates would become negative. As the experience of the 1970s attests, there are few economic distortions more damaging than negative rates.
A hopeful disposition is not a counter-inflationary strategy. As a recent BoE survey suggested, inflationary expectations are picking up. The labour market remains very tight. Once wage setters fix on the idea that inflation will hit four percent, the Bank of England might have to face some serious difficulties.
Interest rate policy comes down to a simple case of backbone. Raising rates back up to 6 percent would see inflation come down quickly. A little courage today, prevents a lot of pain and misery in the future. When it comes to inflation, cowardice and indecision never goes unpunished.