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Inflation: Risks on both sides

The December inflation numbers are at the high end of expectations – with the target measure of inflation, the CPI (Consumer Prices Index), rising by 3.7% compared to December 2009. But energy and food prices are responsible for most of the rise – indeed, the 1.6% increase in food prices between November and December is the highest on record.

 

No-one is happy that inflation has remained so far above target, for so long – least of all the Bank of England. With so many households seeing the effect on their shopping bills, you can see why David Cameron would want to signal recently, in an interview with Andrew Marr, that he shares their concern. Indeed, the chances are that the CPI will rise even further in the next few months – maybe reaching 4% by February or March.

However, there is little sign that a majority of the MPC (Monetary Policy Committee) is minded to respond with an early rise in the base rate. They remember that this has happened before, in only 2008, when commodity price rises pushed the CPI up to 5.2%. At that time, above target inflation led to the MPC seriously contemplating an interest rate rise, just weeks before Lehman Brothers collapsed. The Bank of England then had to slam into reverse, with unprecedented cuts in rates.

At least, in 2008, the Bank had room to slash rates to support the economy. Those who say the MPC should keep rates low point out that there isn’t that kind of leeway today, if the recovery falters. They also note that inflation itself could pose a risk to the recovery.

Asked to name the single largest threat to growth this year, most would probably say public spending cuts, and the recent rise in VAT. But the recent rise in the price of energy, food and other imported goods – not to mention increases in pension contributions and the like – will probably have a much larger direct impact on the disposable income of the average household than this year’s squeeze in public spending.

In predicting moderate growth for the UK in 2011, the OBR (Office for Budget Responsibility) is assuming that consumers will continue to do their part, with little change in Britain’s still low personal savings rate. But, in the face of this kind of squeeze, it is surely possible that households will instead seek to cut back, with negative consequences for growth.

If that argument is right, high inflation could actually be deflationary in the medium term, and the MPC should continue to provide the economy with all the support it can get.

But of course, there is another possibility: that the squeeze in incomes will eventually lead people in work to demand – and obtain – higher wages to compensate them for their losses. If that happened, the private sector would not be able to create as many jobs, for a given amount of demand, as the OBR is expecting, meaning that unemployment would stay higher, for longer.

A broad-based rise in wages would also, almost certainly, trigger a response from the MPC. Naturally, the committee that sets Britain’s official interest rates will be watching the inflation figures over the next few months. But they will be looking just as closely at what happens to wages.

Update 1240: Most City analysts have taken today’s inflation numbers in their stride – many of them urging the MPC not to be “spooked” into raising rates. But Simon Ward from Henderson Global Investors has some interesting points to make for the other side. Here’s what he says:

“It has recently become fashionable to quote the tax-adjusted inflation measures, CPI-CT and CPIY, which are running well below headline inflation, at 1.9% and 2.0% respectively (up from 1.5% and 1.6% in November.) CPI-CT is calculated at constant tax rates while CPIY excludes indirect taxes altogether.

“These measures, however, understate “true” inflation because they are calculated on the assumption that indirect tax hikes are passed on in full to consumers. ONS research on the December 2008 VAT reduction from 17.5% to 15% indicated pass-through of only one-third. Assuming that one-half of the increase in VAT and other indirect taxes last year was reflected in the prices charged to consumers, inflation would now be about 2.8% had tax rates remained stable.

“The current inflation overshoot should be viewed in a longer-term context. The consumer prices index for December was 4.4 percentage points above the level implied if the Bank of England had achieved 2% inflation since the target was switched to the CPI in December 2003, implying an average overshoot of 0.6% per annum. The RPIX measure (i.e. retail prices excluding mortgage interest costs) has exceeded the previous 2.5% inflation target by 5.3 percentage points over this period.

“Advocates of a rise in interest rates are not “inflation nutters” but believe that believe that action is required to prevent an upward drift in inflationary expectations that would worsen the output-inflation trade-off, thereby depressing medium-term growth prospects.”

The point is well made. It is simplistic to look at CPIY or CPI-CT and say, just because they are below 2%, there is no reason to worry. After all, those aren’t the measures of inflation that the MPC is legally obliged to target. Nor do they correspond to any common understanding of inflation. When we get to the check-out, we can’t ask the cashier to charge us only at “constant tax rates”. We have to pay the whole lot.

It’s also worth remembering that these, more “benign” measures of prices rose just as much as the target measure in December. CPI at constant tax rates rose by 0.4 percentage points between November and December, from 1.5% to 1.9%; CPIY rose from 1.6% to 2%. That is what you would expect: the rise in VAT in January can only have affected the December figures indirectly. Food and transport prices were doing most of the work.

I don’t get the impression that the MPC relies too heavily on either CPIY or CPI-CT in making their judgments. They are a rough indication of what might be going on beneath the surface – nothing more.

Like Mr Henderson, their focus is on what these high inflation figures might mean for future wages and inflation expectations, and ultimately, the long-term potential growth of prices and the economy. But for now, at least, they are drawing a different conclusion.

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