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.


  1. rates up, inflation down, what is so hard to understand?

  2. I think they will spout some clap-trap about inflation not being the real issue. This will be their excuse to lower interest rates and allow inflation to boil over on the back burner. I think the logic I heard was that the inflation causing commodities are external to the UK economy and so raising rates won't help. Hmmm, what happens when the pound continues to weaken and we need to pay for these external commodities I wonder.

  3. Sweep the streetsMay 14, 2008 at 12:00 PM

    A compelling chart - is it really that simple - interest rates up, inflation down?

  4. Mervyn has no clue what to do. Cut and he gets inflation, increase and he has failing banks.

  5. I wonder if we are going to get a widening of the divide between public sector and private sector workers, as the former use unions and guilt-tripping to bully their way to inflation-busting national wage increases while the latter are stuck with global wage arbitrage and an increased tax rate to pay for the public sector's wage hikes.


  6. Aaagh... The simple version of events is that higher interest rates means lower inflation and vice-versa. That works rather well when the monetary system is functioning normally.

    The monetary system is not functioning normally.

    The abrupt end to the securitisation of debt has left a lot of money looking for investment opportunities. This is what is driving up the commodity markets and is why we're seeing alarming price rises creeping rapidly through the system.

    This effect is not like ordinary inflation where more money lent into the pockets of ordinary people drives up prices wherever supply does not outstrip demand. Where (M4) money is invested in securitised debt, this pushes repayment out long into the future.... but allows the borrowing it funds to be spent on commodities today. Where money is "invested" in commodities (driving up their wholesale price) this doesn't prop-up the ability of the consumer to buy them at their inflated prices. The "investment" is self-defeating because it will push down demand. Playing the commodity card is a 'one-shot' deal - not something that can be perpetuated month-on-month; quarter-on-quarter; year-on-year. The price of goods will rocket in the near term (giving some scary big CPI numbers) but this is distinct from traditional inflation. It can't be repeated over-and-over... it will cause at best a slow-down in economic growth (what increased rates are supposed to do) or, potentially, far more than that... a full-scale economic recession/depression.

    Pushing up interest rates at this point would not reduce prices, it would just reduce demand... goods would either be sold outside of Britain (to a nation with lower interest rates, probably), or (more likely, IMHO) simply not sold.

    CPI Inflation is rocketing now - but not for the reasons it has in the past. Dramatically rising rates (as much as it would suit my interests) is simply not an option... it would likely result in a crippling blow to business - resulting in mass unemployment... debtors would desperately strive to increase their prices, not decrease them, in a frantic attempt to keep up their interest payments and avoid bankruptcy... while eliminating all discretionary consumption... a futile effort if most of their customers are in similar dire straits.

    I believe King... this is extraordinary rather than ordinary inflation. It is extremely unlikely to react to increased interest rates... but increased interest rates are extremely likely to cause a major recession.

    The BoE is all-out-of-options... all that is left is to wait until the economy stops aqua-planing and re-gains traction before we start taking decisive action.

    I'm not saying that rates can't rise - but this rise won't be caused by an effort to tackle CPI inflation. It might be caused by a sovereign debt crisis... for example, if for some reason (like in 1992 when ERM manoeuvres failed spectacularly) our national debt needs to expand abruptly. This would, in a modern context, represent an economic disaster for the vast majority in Britain.

  7. asteve,

    Let me get this straight. Are you saying:

    1) Money can buy assets or goods;
    2) Money no longer buying assets (e.g. houses, equities, ABS) is now chasing goods (particularly food and oil)
    3) Therefore inflation as experienced by purchasers of food and oil (while deflation in assets)
    4) And thus it's temporary because the money is parked there and eventually will come back out

    Did I paraphrase that something like you meant?

    I too agree commodities are a one-shot play and about to burst but that's the inflation side. There's also the supply/demand side, which for oil is a one-way ride to peak oil, with temporary pull backs due to reduced demand in a recession.


  8. asteve,

    BTW, the whole point of a recession is that it's a cure for the excesses of the bubble. Business failures and borrower defaults shouldn't intimidate the BoE from their mandate because it's not their job to prop up crappy companies and foolish debtors.

    If you can't survive and interest rate hike you don't deserve to live (metaphorically speaking).

    Keeping interest rates artificially low punishes good businesses by allowing bad businesses to stay in business. We need the creative destruction.

    To paraphrase Andrew Mellon, liquidate them all.


  9. With the BOE remit on CPI the UK is much more likely to have a recession than the US.
    This seems to be being ignored by the "Growth is good" mantra from Brown.
    Strange as it sounds a recession is actually good for an economy as it eliminates wastage. Not so good for your average person though.........

  10. A little off topic for this post, but I think I've just solved the housing crisis and public sector debt. Consider this plan:

    Build a huge council sink estate on unused land in the middle of nowhere. Put a huge wall around it with barbed wire and snipers on the top. Put the following amenities in the centre: Aldi, Netto, a post office, a tanning salon, a kebab shop, a William Hill, an Argos.

    Dump into it everyone who has been:
    - On benefit for over two years
    - Imprisoned more than once.

    Oh yeah, sterilise everybody on the way in.

    And there we have it. Rehousing for society's most vulnerable, stimulus to the construction industry, reduced welfare costs, and the end of the underclass in a single generation.


  11. Nick, I have long thought that this would be a good solution. Paying Housing Benefit to subsidise and hence push up rents in city centres where working people would like to live is madness.

    Alice, top marks for this:
    "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."

    The Sahara looks damp compard to that.

  12. Only 4%? I bet the real inflation rate is much higher for the bottom, what, third of the populace?

  13. Nick (post 1):

    Your four-point plan is similar to what I'm saying, except that I am approaching it from the sense of commodities - not goods. A hoarding demand for commodities rises - but the demand for goods falls. This is the trigger for a recession. The commodity play is risky - it might work or it might fail... the decision falls down to the willingness of governments to bale people out when they see the risk of abject poverty... and, in doing so, enrich the speculators. It is a tough game of poker, but it is all about speculation and little to do with supply and demand (right now) - since demand will fall and we have no reason to believe that supply will fall faster. After the recession, of course... it is anyone's guess.

    I am familiar with peak oil, but I am not a "believer" - in the sense that I do not believe it credible that we will experience a supply driven shock. We use a preposterous amount of oil right now - completely unnecessary amounts - technology can and will provide alternatives solutions in a timely fashion - in my view.

    Nick (post 2):

    Part of me agrees with you without compromise... but there is a snag. The viability of Britain depends upon the strength of our currency... which needs to devalue, but not collapse. This, I strongly suspect, is very difficult to orchestrate... As far as I can see, over recent years, inwards investment in Britain (swelling the proportion of world cash reserves held here) can be seen as a bubble in its own right. If that bursts rather than slowly deflates, shifts in currency would make it almost impossible for any British business to operate in today's global environment. I think that the only potentially viable strategy is a policy of attrition against those who morally, maybe, should spectacularly implode.


    Yes, I think that the UK is likely to have a recession. The latest BoE inflation report confirms a 10% official probability of a recession lasting over a year starting in 2008. (See the fan-chart for GDP.) One should recognise that the BoE mandate is for economic growth... not just to control CPI inflation.

    Brown's mantra for economic growth (i.e. rising GDP) is utterly critical... as, without it government borrowing - even at its current levels - would not be viable. If you review Brown's policies they are all to keep the GDP figure high and rising... and not principled strategies to strengthen the British economy. At some point such a strategy is doomed to failure... I think that time is now.

    Nick (Post 3) & Mark:

    I hope that's an attempt to be amusingly dark.

    This is frighteningly close to the Nazi solution to dwindling wealth. In case you missed the history lesson... it didn't work out very well.


    CPI is _expected_ to rise to 3.7% - we already know that food inflation can be at ~6% when CPI is at ~2.5%

    The thing about inflation is that it isn't a belief spectacular rate of inflation that serves you a jolly-good-kicking, it is sustained and moderately high inflation that really hurts... especially those on fixed income and long-term contract rates...

  14. Corrections..
    On peak oil..

    ..._permanent_ supply driven shock...

    On CPI... isn't a brief spectacular...

    These comments need an edit tool. ;)

  15. Asteve,

    edit tools, you are right about that. Perhaps, what you need is your own blog. The same goes for you Nick.


  16. :o) Nah.

    I'd have nothing to start writing about on my own blog.

  17. asteve,

    Start writing about M4. I am serious. You almost have blog going on my site. You could call it son of UK bubble blog. :)

    There is definitely enough room for a few more UK economy blogs.


  18. Asteve, I second Alice. If you have a tale to tell - and you have - don't bury it in comments sections, distil your ideas and put them out in a blog. I'd read it, for a start.

  19. Asteve,

    However, I am a bit worried that if you do set a blog up, you won't come and comment on this blog quite so often.


  20. Alice,

    While I appreciate the complement I'm afraid quality blogging takes an unusual convergence of personal qualities and available time. I suspect I lack both. I tried doing a personal blog once but it was rubbish and I couldn't make the commitment.

    That fact I tried and failed makes me appreciate good blogs all the more, hence why I read this one so much.

    Asteve - Yes, my final solution to welfare was half jest, but only half. I don't believe people have a right to children (if they did, where does that right come from? The fact they CAN have children is just deriving "ought from is", an age-old philosophical error). I also believe people have children they can't/won't support themselves and shouldn't bring children into the world who are condemned to misery from birth just because they want kids. The welfare state perpetuates the underclass by keeping these scroats alive long enough to reproduce and then guaranteeing the survival of their offspring. There's a serious Malthusian problem here and I can't think of any good reason why such people should be allowed to have children.

    The solution is to stop economically irrelevant people breeding. (It would be better to simply stop supporting them, but they'd still have kids and it would guarantee very high child abuse and poverty levels - better to stop the next generation being born)

    The problem comes with the solution. How do you implement a just and fair solution to the scroat reproduction epidemic that doesn't have all kinds of unintended consequences. Such a program would be government administered and as such would be hugely inefficient, would give bureacrats too much power, and would inevitably result in the wrong people getting the wrong treatment.

    So I only meant it as a joke in the sense I think it couldn't be done properly. If Gordon Brown takes the country any further towards ruin, maybe I'll start thinking its worth the risk


  21. I think that outrageous propositions have a nasty habit of becoming reality as desperate people resort to desperate measures.

    I think that everyone has a right to have children; a right to decent safe and secure accommodation and general security. With these rights come responsibilities. None should have the right to demand their selfish ends are provided at the expense of others simply because they refuse to take responsibility. The problem, of course, is much deeper... many people face poverty, just as many live in exuberant wealth, purely as a consequence of previous ill-informed government policy.

    I refuse to accept that it can ever be appropriate for government to step in and prevent people from living their lives how they wish. Conversely, I think it outrageous that benefits such as free housing and cash handouts are earmarked exclusively for those who do not help themselves. Not only is it demoralising for the responsible but inaffluent - but it is demoralising for the demographic it sets out to assist... it enforces a Pavlovian sense of learned helplessness - which can't be a good thing.

  22. Nick,

    I would love to see more UK blogs. In the US, there are so many good ones and it is a shame that there isn't more here.

    On the question of blogs, I have given it some thought. Unless, you are someone really special, personal blogs are really dull. Blogs have to focus on a key issue that has general interest. Blogs also have to say something beyond the regular media. Finally, the audiences tend to be fickle, so you have to put something up every day.

    In the absence of a regular blog, I do hope you keep producing your excellent comments and insights here.


  23. Nick,

    I would love to see more UK blogs. In the US, there are so many good ones and it is a shame that there isn't more here.

    On the question of blogs, I have given it some thought. Unless, you are someone really special, personal blogs are really dull. Blogs have to focus on a key issue that has general interest. Blogs also have to say something beyond the regular media. Finally, the audiences tend to be fickle, so you have to put something up every day.

    In the absence of a regular blog, I do hope you keep producing your excellent comments and insights here.