Britain's inflationary relapse

Britain's inflationary relapse Jan 6th 2011 | from PRINT EDITION

Too late, mate
AS THE financial crisis took its toll and Britain slid into a severe slump in 2008 and 2009, one big worry was that the economy would also slip into deflation, exacerbating the difficulties of debt-laden households and firms. The scare was short-lived. Only a year since the recovery began, prices are surging rather than falling. Inflation, the scourge of Britain’s economy until the 1990s, seems to have returned.

George Osborne has made many changes since he became chancellor of the exchequer last May but he has retained a central plank of economic policy: setting an inflation target and empowering the Bank of England to meet it. But the bank’s credibility is starting to be questioned as inflation keeps on exceeding the 2% target for consumer prices. Since the middle of 2006, undershoots have become the exception, with inflation above 2% in all but a few months (see chart). Throughout 2010 it was at or above 3%, most recently moving up to 3.3% in November.


The inflationary relapse is set to get worse in early 2011. The main rate of VAT, a consumption tax, went up from 17.5% to 20% on January 4th. The rise is an essential part of Mr Osborne’s plans to plug the budget deficit—but an unwelcome side-effect is that it will add to inflation. Because the tax increase is permanent, it is likely to be passed through to prices in full, whereas only about half the rise was passed on a year ago when VAT returned to its previously normal level of 17.5%, after being lowered to 15% to fight the recession.

There are other inflationary forces at work, too, as Asia’s rapid economic growth stokes up commodity prices. Most food escapes VAT, but that will not spare consumers: global food prices have risen by 27% in the past year, according to The Economist’s commodity-price index. World oil prices have also jumped recently.

This unhappy confluence of upward pressures on inflation may well push the rate up to 4% by the spring. But the Bank of England believes that inflation will then subside as spare capacity opened up in the recession bears down on prices. In its most recent central forecast, in November, it envisaged inflation staying above 3% for the rest of this year before tumbling to the 2% target at the start of 2012, when the VAT rise drops out of the inflation calculation.

Confidence in that prediction has been undermined by repeated overshoots and the bank’s forecasting lapses. In August, for example, its central projection was for inflation to run at 3% rather than 4% in early 2011. But this does not necessarily undermine the validity of the bank’s view that the impulses pushing up inflation will prove short-lived, whereas the effect of spare capacity will be more enduring.

Just how far below its potential output the economy is operating is a vexed question. One of the malign effects of financial crises is that they impair productive capacity, but estimates of the damage vary widely. With unemployment at 2.5m—7.9% of the labour force, compared with 5.3% in 2007—there are clearly spare resources. The Office for Budget Responsibility (OBR), which is now in charge of the government’s forecasting, estimated late last year that the output gap was 3.3% in the second quarter of 2010.

That margin of spare capacity should persist this year since growth is likely to be lacklustre, not least because Mr Osborne’s austerity measures include harsh spending cuts and other tax rises starting in April, as well as this month’s VAT increase. Although the economy has recovered more briskly than once expected, growing by 2.7% in the year to the third quarter of 2010, that pace will abate. The OBR is forecasting especially low growth in the first half of this year, and for GDP to rise by just 2.1% in 2011 as a whole—below its 2.4% estimate of the economy’s trend rate of growth.

One worry is that inflation expectations have been rising. A household survey published by the Bank of England last month showed that people are expecting inflation of 3.9% over the next year, up from the 3.4% rate they predicted last August. But while business conditions remain tough and unemployment high it is difficult to see these elevated expectations actually leading to higher wages growth. Regular pay, which excludes bonuses, has picked up a bit but the most recent rate of 2.3% is still subdued by historical standards.

The Bank of England may have lost some credibility of late, but it has not lost the argument about spare capacity. As a fierce fiscal contraction gets under way, the current ultra-loose monetary stance remains reasonable. If the economy performs more strongly this year than expected, that should be the spur to start tightening, by raising the base rate from its all-time low of 0.5%.

from PRINT EDITION | Britain