Financial News, a Dow Jones Company., 21st February 2011
UK inflation is running at double the Bank of England’s 2% target and is expected to rise further, some say to 5%. But the economy is far from booming. GDP fell in the fourth quarter of 2010 by 0.5%, possibly because of bad weather. Divergent and uncertain news on the economy is reflected in differing views on policy. Two members of the Monetary Policy Committee, Andrew Sentance and Martin Weale, want things tightened up by a rise in interest rates while another, Adam Posen, wants them loosened by a further round of quantitative easing. Adam Posen thinks that prices have been pushed up by one-off events. These are weak sterling, rising food and fuel prices and the increase in VAT. He assumes that when these are behind us inflation will fall because the UK has a large output gap (i.e. the economy is running below its potential.) Andrew Sentance puts his main emphasis on “global challenges – a strong rebound in growth across the world economy and upward pressure on energy and commodity prices”. Martin Weale worries about expectations of inflation. He remarks that a small rise now would be much better than a large one later, which would be the price of allowing fears of inflation to become “ingrained”.
Behind the disagreements over policy lie doubts about our ability to forecast either output or inflation. The recent crisis has also raised doubts about the economic theories which underpin the forecasts. The simple view is that inflation declines when there is an output gap. This became untenable when stagflation took over in the 1970s. The revised view is that inflation will fall back when there is an output gap, unless there is a rise in inflationary expectations.
There are, however, problems even with this revised view. It may not be possible to know if we have an output gap, except with the benefit of hindsight. Inflation is also imported as well as home grown and this is particularly true for the UK. There are therefore several good reasons for higher interest rates, even though unemployment is high.
First of all, it is clearly important to keep expectations at bay. A rise in interest rates might do this. At the very least it would demonstrate the commitment of the Bank of England to low inflation. Secondly, the UK may not have an output gap at all. Thirdly, the weakness of sterling, the rise in food and fuel prices and taxes may not be temporary.
If we take out the effect of tax changes, then inflation falls from 3.7% to 2% and falls below this target level if we allow for the fall in sterling. There is a good case therefore for ignoring them. But we must not exclude these changes unless they are temporary, and this seems improbable. In common with other developed countries, the UK is likely to grow slowly compared with emerging economies. According to theory, this means that sterling should fall steadily in real terms compared with the currencies of emerging economies, for as long as the gap in growth rates continues. I must emphasise that this is one of those theories, all too rarely found in economics, which has worked in practice.
Before the crisis, inflation was kept down by the falling prices of goods we import from emerging economies, even though service prices were rising at 3.5% to 4% a year. But this won’t happen again if sterling needs to keep falling compared with the currencies of the developing world. The problem will be even worse if raw material prices keep rising, which is another result of rapid growth in emerging economies.
If inflation is no longer going to be held back by falling goods’ prices, the burden will fall on services. Flat or even falling prices of services will then be needed for the Bank of England to be able to meet its inflation target of 2%. This may be very painful.
The main influence on service prices are wages and improvements in labour productivity. We will be lucky to find productivity in services improving by an annual rate of more than 1%. It is a most unpleasant idea but, if inflation is to hit its target, wage increases may need to fall below their current annual rate of 2%. To get there, unemployment may need to rise even further, as the government’s fiscal policy tightens.
Even if these worries are justified, it doesn’t mean that the inflation target should be raised above 2%. It is difficult enough to keep down concerns about inflation as it is, and they would surely and sensibly increase if the target was increased or even seen to be temporarily waived. Martin Weale is surely right that the damage that would come from a small rise in interest rates now is much less than the costs of allowing fears of inflation to become ingrained.
There are, however, several lessons which we can learn from the current problems. These are mostly about past errors of judgement. First, inflation needed to undershoot when sterling was strong. Second, it also needs to undershoot when fiscal policy is weak. The two often go together, as they did when Gordon Brown was Chancellor of the Exchequer. We are suffering today from his errors and the misjudgement of the Monetary Policy Committee at the time in not aiming, in the short- term, for below target inflation.
Given all these uncertainties we can only guess at what should be done, let alone what will be done. My own hope is that there will be no change in interest rates. But it’s a hope which depends on there being no need to increase them. I would have to change my view if the economy grows at 3% a year or more, or inflationary expectations pick up.
About the only thing that seems clear amid all this uncertainty is that a tough fiscal policy looks sensible. If we need to slow the economy when we have a budget deficit of 10% of GDP, it is surely better to do this by reducing the deficit before raising interest rates.
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This article first appeared in Financial News.
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