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Growth Before Inflation Will Ruin Us

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Sometimes, politicians say the silliest things. In expressing alarm this week over the latest inflation figures, George Osborne said that he fully supported "what the Bank of England is doing in its fight against inflation". It made me laugh, because to most of us, it seems like the Bank is doing nothing at all. In fact, it might be making things worse.

Now, if the Chancellor had said that he supported everything the Bank was doing in the fight against unemployment, it might have been closer the truth. In the trade-off the Bank has to make between jobs and inflation, jobs seem to win every time. It's plain as a pikestaff that interest rates need to rise to cool inflation, but the Bank won't act. This certainly suits the Chancellor who, with the impact of public spending cuts still to be felt, would be dismayed if it did.

Mervyn King, the Bank's governor, will shortly be writing his fifth letter of explanation to the Chancellor in as many quarters about why inflation has remained so persistently above the Bank's 2 per cent target. We know what he will say. He will argue that it's mainly down to one-off factors such as rising sales taxes, commodity and energy prices, all of which are beyond the Bank's control. It's also because of devaluation, which makes imports pricier – but this, too, is a temporary factor that will eventually run its course. Does it really make sense to risk pushing the economy back into recession when the inflationary threat is likely to prove so transitory? Further squeezing private demand – which is already fragile – would certainly do the trick in bringing inflation to heel, but might result in the opposite problem: price deflation, and even greater unemployment.

What King won't say, however, is that we've been here before. Back in the 1970s, there was exactly the same debate about inflation versus jobs. Both in Europe and the US, governments attempted to counter rising joblessness by keeping monetary and fiscal policy as loose as possible, even as they were hit by a series of crippling external price "shocks".

At the time, very similar arguments were deployed to justify policy-makers' disregard for the inflationary threat – including my favourite piece of economic sophistry, the contention that since the rising price of essentials such as food and fuel takes money out of people's pockets, it depresses domestic demand and therefore acts in a deflationary way.

Unwilling to tackle inflation by clamping down on the money supply, governments resorted to income and price controls. Already, we are seeing a return to such policies. In China and some other developing economies, price controls are widespread; even in Britain, the two-year public sector wage freeze that the Government is trying to impose might reasonably be regarded as a form of incomes policy.

It made little difference back then, and is unlikely to work this time, either. Inflation is not being driven by higher wages: today's unions are a pale shadow of their former selves, with a limited ability to push through the inflation-busting wage settlements they won in the 1970s. High unemployment ought, by creating slack in the labour market, to act as a powerful constraint on inflation.

In any case, the Bank's excuse for not acting is that output remains well below pre-crisis levels, creating a high degree of spare capacity. This, it is argued, means that the economy has an awfully long way to grow before it starts knocking up against capacity constraints and thereby generating domestic inflation. The Federal Reserve's policy in the United States is governed by much the same thinking.

Is this the right approach? I'm sceptical. Even the Bank of England admits to extreme difficulties in measuring spare capacity, or even assessing its impact. What's more, the great bulk of this unused capacity seems to come in the form of unskilled labour. For the bits of the economy that matter, there are already severe skill shortages – and most of the companies I talk to plan to test the market with significant price increases this year.

Yet we still have this bizarrely inverted form of policymaking, whereby the Bank attempts to meet its inflation remit by reference not to prices but to the threat – or reality – of unemployment. No wonder it keeps on getting it wrong.

Concern for lives blighted by joblessness is a laudable sentiment, but the Bank's job is to control inflation, not to set social policy. And as the rioting in the developing world over rising food prices demonstrates only too plainly, inflation can be just as big a scourge as unemployment. It's not just that it destroys savings; for the world's poor, it is quite literally the difference between a good meal and starvation.

I don't want to exaggerate the extent of the problem. In the UK, if you ignore the effect of rising sales taxes, the Bank is actually not so far adrift from its target. Yet we know from experience how painful it is to get rid of inflation once it takes hold. For a highly indebted country like Britain, it is particularly important that the problem is nipped in the bud. Any advantage we have in inflating away our debts will be more than outweighed by the higher interest rates that markets will demand if they sense that the inflation target no longer means anything. A stitch in time saves nine. The Bank must act before it is too late.

Edited by exiges
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The Telegraph Editors are hitting this from every angle of argument. See also Damian Reeces piece:-

Borrowers have had their time in the sun, this is the year of the Bank Rate rise

If this is the year of the rate rise it will also be the year that consigns the Tories to another decade in opposition. A rise will hit the 'Middle England' floating voters right where it hurts.

I say "Bring it on" :blink:

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