Wednesday, March 25, 2009

Ten reasons why inflation will accelerate

First, a confession. I didn't expect inflation to pick up in February. I anticipated a short-term dip in 2009 as the economy slowed. The inflationary surge would come next year due to the combined effects of a mammoth fiscal deficit, zero interest rates, and the Bank of England printing truckloads of cash.

As part of my recovery from the shock of yesterday's CPI data, I began to reconsider the case for a more accelerated move towards rapid inflation. The more I thought about it, the more yesterday's number made sense, and why it could be the precursor of some very unpleasant inflation numbers in the near future. Eventually, I came up with ten reasons why inflation could be coming to town sooner rather than later.

1. The underlying CPI sub indices are rising more rapidly than expected

February food price inflation was particularly disturbing. The annual rate was over 12 percent, while the monthly increase was a full 1.5 percent. That sharp rise was not due to seasonal factors. In February last year, the monthly increase was just 0.3 percent. Other sub indices, such as furniture, household equipment and maintenance, clothing and footwear, also point to persistent inflationary pressures.

2. Oil prices are rising again

The price of a barrel of crude is now $53. A few short weeks ago, it was hovering below $40. That represents roughly a 30 percent increase. Just as the collapse in oil prices led to a deceleration in inflation towards the end of last year, the recent surge in oil prices will push the rate back up again.

3. The gold price is also rising

Today, gold is trading at $925 an ounce. Only a few short months ago, it was bouncing around at about $700 an ounce. Since gold is the ultimate inflationary hedge, the sharp price increases tells me that inflation expectations across the world are swinging upwards. No doubt some of those gold investors are UK residents.

4. The sterling depreciation will keep inflation bubbling in the short run

According to Mervyn King, sterling has depreciated by 28 percent since the credit crunch started. As if this was somehow detached from the policy choices of the Bank of England, King acknowledged that this would pass through into inflation via elevated import prices. We may not have seen the full force of the devaluation in the CPI. This alone should guarantee a few more difficult months for the Bank of England.

5. Foreigners are selling UK assets, which could put further downward pressure on Sterling

External liabilities of UK banks are perhaps the most alarming numbers produced by the Bank of England. It shows that nonresidents are pulling their cash out of UK banks. This capital flight probably accounts for the recent dramatic fall in the value of sterling. If this capital flight continues, then sterling could come under additional pressure, pushing import prices up further.

If nonresidents panic, the UK could have an exchange-rate crisis. The consequences of such an event are too dreadful to contemplate. It is a scenario which I would prefer to leave in the dark recesses of my imagination.

6. The UK money supply is growing at almost 17 percent a year

This fact is perhaps the most difficult one for deflationists. UK monetary growth is accelerating. The standard deflationist response to this awkward number is that it doesn't matter because most of this new money is being held by banks hoarding liquidity.

In the short run, that may be true, but that doesn't make money held by banks any different from money held by households and corporations. When banks stop hoarding cash and release it into the economy, it will feed directly into higher prices.

7. UK policy rates are highly negative

The Bank of England's policy rate, adjusted for inflation is minus 2.8 percent. OK, I will admit that this is not my strongest argument, not least because the bank rate is now irrelevant in terms of managing overall liquidity conditions. However, it still has powerful symbolic value, expressing the policy confusion that has gripped the MPC.

8. Fiscal policy is out of control

In terms of fiscal policy, New Labour has lost the plot. The UK government is about to run out the largest deficits since the Second World War. These deficits will be larger than anything produced by those ancient lords of inflation - Heath, Wilson, and Callaghan.

9. The Bank of England will monetize the fiscal deficit

All hyperinflations are due to one thing; central banks printing money to cover government deficits. While I'm not suggesting that the UK is in imminent danger of turning into Zimbabwe, the fact remains that monetizing the fiscal deficit is always and everywhere highly inflationary.

10. UK policymakers have lost control

The Bank of England and the Treasury are no longer in control of events. New Labour is paralyzed with fear, knowing that a painful fiscal adjustment before an election will destroy the party. Darling knows that he needs to cut the deficit, but it is politically impossible.

The Bank of England is also powerless. The MPC cut the bank rate too far. It is now disconnected from real economy. The MPC can no longer control liquidity conditions, a fact implicitly recognized in a recent speech by MPC member - Kate Barker. Under normal circumstances, yesterday's CPI data would have required a robust hike in rates. However, the MPC know that it would need to raise the bank rate by several hundred basis points in order to regain some policy traction. In the current political environment, such a move is inconceivable.

So what is the argument against higher inflation? The economy is slowing and therefore firms will be reluctant to push up prices. This may come as a shock to some people, but rapidly rising inflation is invariably associated with weak economic growth. A quick look at the UK growth numbers during the 1970s will confirm this fact.

The UK economy is certainly slowing, and in the short run this might put some modest and temporary downward pressure on prices. However, the prevailing reality is that the UK macroeconomic framework is a total mess. It is incoherent, irresponsible, and driven by short-term political expediency. Sooner or later, this toxic cocktail of confusion will feed into higher prices.


  1. Hyperinflation is definitely on the way.

  2. Need it be hyperinflation? Would a few years of 10%-30% per annumm do the trick? N.B. I take it for granted that HMG will default on its debt and that inflation will be the chosen method of default. But I suspect that hyperinflation won't be chosen, that it would arise only by cock-up. Mind you, cock-up is what they are notable for.

  3. Agree.

    I've been telling anyone who cared to listen - or who couldn't run away fast enough - that inflation was the sleeping dragon we should all be worried about.

    The good news though, the American's will be able to say next year that global inflation started in the UK. Gordon should love the irony in that.

  4. Well let's look on the bright side. Those with huge mortgage debts who can hang for a bit longer should see their real debt whittled away. Keeping the house price debt binge going was one of the factors that lead to this mess. If you have savings, it may be worth thinking about converting some of them into assets soon.

    If you have a minute and a half to spare, here's a little joke on a related subject, by Peter Schiff, about the prospects for the Chinese getting their money back from the Americans. Again, inflation will be the likely result.

    (Just the first 1 and a half minutes)

  5. All ten very good reasons. Let us worry a great deal, but not talk about hyper-inflation.
    Hyper-inflation is defined as over 50 per cent PER MONTH. This is Zimbabwe alright, where it is close to 100 per cent PER DAY. But leave the doom terminology where it belongs, it does not belong to England. YET.

  6. Briefly then, Brown has succeeded in economic terms where Hitler failed? Is there not a case to have the man apprehended, held in the Tower and then executed in public on Newgate?

  7. China and Japans massive fall in exports also means there will be too few items, in stock, in the shops for consumers to spend their money on. This will also fuel the inflation.

  8. Interestingly Caronte, I heard on the world service that Zimbabwe had a very low inflation rate in January. They said it was because they had given up on their own currency and were using the USDollar. Would we be better with the Dollar or the Euro when we do the same?

  9. "Those with huge mortgage debts who can hang on a little longer ..." (20.40)

    If your wages keep pace and interest rates remain low.

  10. Brilliant stuff Alice!
    Keep up the good work! That's the best analysis of the inflation scenario I have read today, and I have read a lot of them!
    I love your site.
    Housing Bear

  11. If your wages keep pace and interest rates remain low.

    Hmf: I got a 4%, 30 year fixed rate mortgage. I want rates to RISE!

  12. I think the 17% increase in money supply is the most worry thing, because when this does hit the market, inflation will really take. Its all well and good the banks and governments inflating their way out of debt but for the rest of us with mass unemployment and wages decreasing, this will have an increased effect.

    This is the biggest transfer of wealth in history - Gordon Brown is the modern day 'reverse' robin hood. Robbing from the poor to feed the rich.

  13. Also "In the current political environment, such a move is inconceivable." - you suggest that interest rates are really politically controlled.

    That's backed up by Gordon Brown's back tracking in New York trying to claim borrowing to insolvency is only one of three ways he plans to wreck the economy.

  14. Missouri man

    Your point by point rebuttal was rather poor.

    You appeared to concede most of the arguments anyway. For example, food inflation is rising because the exchange rate is falling, and the UK imports most of its food.

    However, let me address one point. The exchange rate is the relative price of two currencies. If the relative supply of one currency rises, its price will fall.

    The relative supply of sterling is increasing at 17% a year. This is why it is crashing, and yes it can go on forever. Hence food inflation is up.

    Exchange rates don't have a bottom. It central-bank prints enough money, the inverse of the exchange rate can fall to zero, which is another way of describing hyperinflation.

    Besides, the data is against you. UK inflation is rising not falling.


  15. Alice - I think a persuasive counter-argument is to be found here, in the comments by hbl:

  16. VADO:

    1) The only thing I am conceding is that a fall in the value of sterling will give a small and temporary push to inflation.

    2) You say: "If the relative supply of one currency rises, its price will fall.
    The relative supply of sterling is increasing at 17% a year. This is why it is crashing,"

    But the evidence is against you.

    Over the period 2002 - 2007, the growth in the UK money supply increased from about 6% a year to about 14% a year.

    Over the same period, sterling appreciated from about $1.43 to over $2.00, a rise of about 40%.

    So, no evidence of a crash in Sterling due to increases in the money supply.

    3) Alice (and you?) appear to argue that rises in the money supply are a strong cause inflation.
    Again, the evidence is against you.

    Over the period 2002 - 2007 when the money supply was rising strongly, the rate of inflation as measured by the CPI see-sawed in the range of 1% - 3% with a slight upward drift towards the end of this period. It is difficult to make the case that CPI is strongly affected by changes in the money supply.

    4) Both you and Alice choose CPI as the measure of inflation, but CPI excludes housing costs, so it is not very realistic.
    Housing costs are the largest item of expenditure for many households. These costs are included in the RPI, where it has by far the largest weighting, more than double that of food or anything else.

    Real-life inflation, as measured by the RPI, has fallen to zero. So, no evidence of runaway inflation here.

    5) Bottom line:

    - Increases in the money supply have no effect on the value of sterling, and little or no effect on the real rate of inflation.
    - Simple "Supply and demand" arguments do not adequately explain the value of sterling or inflation.
    - We are not at the start of a massive and long-lasting upswing in inflation.

  17. Three interest rate announcements from the Reserve Bank of Australia, Bank of Japan, and Bank of England will take the center stage in the week ahead.