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Sunday, 13 March 2011

Inflation isn't the problem. Stagflation could be.

We are about to see an example of how psychologically influential inflation is in the UK. There can be no other reason why the Bank of England could even be considering raising interest rates right now.

Recently (10th March 2011), the Bank of England Monetary Policy Committee (MPC) voted to leave its Base Rate at 0.5%. This means the rate has been at an all-time low for 2 years now. But, like a swan, the serenity on the surface belies a lot of action underneath, and it is almost certain that this vote was very close and we're about to see some real action in the form of a rise in interest rates. But the fact that this might happen when we are possibly in the midst of a double-dip recession (should April's growth figure be negative then we are officially back in recession) shows the problem with the Bank of England's sole objective, to target inflation.

When teaching macro-economics, I am at pains to point out to students that when faced with an essay on policies to deal with a problem they must consider openly the cause of that problem. So, should they be asked to discuss policy options available in the event of rising inflation, they would struggle to get near top marks should they not point out the dependence of the corrective policy on what caused the inflation in the first place.

My view on this is that the causes of this inflationary spike cannot be remedied by raising interest rates. Therefore doing so could cause worsening unemployment and confirm the journey back into recession. I also suggest that the only reasons why interest rates would rise is because the Bank of England is too focussed on its primary aim (inflation stability) at the expense of its secondary aim - to support the government in meeting their targets for growth and employment. This may be because of the hold that inflation has on economic fears. Maybe the MPC thinks Britain needs inflation credibility more than anything. Well, I would like to control inflation too, but not at the expense of growth and employment at a time when we don't have enough of either. It's frustrating enough waiting for the Coalition government to come up with a strategy for growth without the MPC making it even more unlikely.

Anyway, back to causes. In this case, inflation is now consistently running at and over double the Bank of England's target - which is 2% (plus or minus 1% let's not forget) - for three main reasons:

1) The rising oil price
2) The rise in VAT from 17.5% to 20%
3) The rise in food prices

The rising oil price

The rising oil price is a particular problem for the UK. It pushes up inflation because we import so much oil so business costs rise, pushing up prices and consumers spend more on the petrol made with it. It also can cause unemployment because as it pushes up business costs rational employers may look for other ways to cut costs, through firing or not hiring people. It can also cause a slowdown in economic growth and possibly cause a recession. Inflation is often caused by rampant economic growth, with a concurrent growth in employment. This time, we have inflation accompanied by negative economic growth and high unemployment. That is called 'stagflation' and the problem is that it's more or less here. Raising interest rates will do nothing to stop the rising oil price. The Government can reduce fuel duty on it - BUT they have to reduce the deficit, so they are stuck in a bind too.

The rise in VAT from 17.5% to 20%

This automatically put prices up. Remember, inflation is measured using a basket of goods, weighted for the importance of the items within it. Many of those items have just seen their prices go up by the amount of the rise in VAT.  This was done by the Coalition government, again because of the need to raise tax revenue to deal with the deficit. An economist from afar who didn't know this happened might think that consumption had gone up, raising aggregate demand and so raising interest rates would help, but the VAT rise makes that connection different. Raising interest rates will do nothing to deal with the impact of this rise.

The rise in food prices

This has mainly been caused by extreme weather events in the major food producing countries. It has been exacerbated by speculators but they are not really to blame. The problem again here is that the rising cost of food imports  pushed up the costs of many businesses who then pass those onto customers in the form of higher prices, causing inflation. Again, rising interest rates will not stop this happening.

It would be nice to think that there was a simple answer to the economic ills of the UK. We have a massive deficit, massive debts, huge unemployment, a government without a recognisable growth strategy and now inflation. We need to deal with all of those problems and a rise in interest rates will probably make them worse.

For instance, the upcoming job losses in the public sector are supposed to be offset by job gains in the private sector. But the investment needed in the private sector for that to happen would need to be funded from somewhere, and a rise in interest rates will make that more expensive, and therefore less likely.

Many commentators feel that in the medium term there is more of a danger from deflation, in which case nothing should be done now to hurt growth.  I'm going to add my name to them.


  1. Does the sterling exchange rate not deserve a small mention given our pattern of trade? Although $1.60 ish is fairly well valued, 1.16 euros appears about 10-15 undervalued to me

  2. Where did my %(percent) symbol go? :)

  3. You're right, sterling exchange rate does deserve a mention BUT we do not have control over it.

    Growth would be helped by a devalued currency increasing export demand (which is why manufacturing grew last year) BUT it would cause a further rise in imported price inflation so that doesn't help.

    More importantly, our interest rate is at 0.5%, so it's not like we could get it any lower to help lower our exchange rate. We also don't want to get into the realm of competitive devaluations.

    If 1.16 euros is undervalued it will probably go up which could help bring down imported inflation BUT hurt growth as 60% of our exports go to Europe.

  4. You were listing the reasons for inflation being above target. What has 'control' got to do with anything? We don't have control over oil or food prices either.
    I was merely pointing out that given the origin of many of our imports, a relatively weak Sterling/Euro exchange rate must be an issue.

  5. We do have control over the effect of oil prices on inflation - we simply lower the fuel duty. We also have in theory some control over food prices - in that we could subsidise them or set a maximum price ceiling - although hell will freeze over before that happens.

    I talked about control because I was listing possible policies and explained why exchange rate manipulation can't be one of them