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The Bank – At Last – Gets Tough With Inflation

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The Bank – at last – gets tough with inflation

Anatole Kaletsky


A month ago I wrote on this page that Britain was facing an economic disaster and that time was not on our side. Some regular readers found this gloom surprising, since Panglossian optimism – especially on the British economy, on property prices and on sterling – had long been a hallmark of my work.

What such critics failed to notice was that my anxieties were very different from those of the Jeremiahs I had been attacking for most of the past decade. Unlike the financial pundits and Tory politicians predicting national ruin in every blip of the unemployment figures or trade statistics, worldwide depression in every judder of the stock markets and an apocalyptic “day of reckoning” in every headline about record of mortgage debt, I gave a warning last month about the opposite risks.

The danger, in my view, was not a weak economy but an overstrong one. It was not falling retail sales but a high street bonanza. It was not collapsing asset prices but an even bigger property and stock market boom. A month ago I was so worried by the dangers of severe economic overheating that I accused the Bank of England’s Monetary Policy Committee of falling asleep on the job – and even suggested a few days later in the business section of The Times, that Mervyn King, the Governor of the Bank, might be “guiltier of high treason than Guy Fawkes”.

Today I want to withdraw this indictment. Not because inflation, as measured by the consumer price index, fell back last month to marginally below 3 per cent. Nor because some of the recent statistics on house prices, high street sales and employment have been slightly weaker than expected. The reason for withdrawing my imprecations against the Governor is that the quarterly inflation report that he presented yesterday on behalf of the MPC made it crystal clear that most of the risks to inflation “are on the upside”, that a further increase in interest rates to 5.75 per cent is almost certain and that interest rates will keep rising beyond that until inflation is brought back to the 2 per cent official target – and then anchored securely at that level, despite all the upside risks.

Before discussing the importance – and difficulty – of achieving this objective, let me explain the inflation report’s immediate significance for anyone more interested in the cost of next month’s mortgage. While the MPC has always said that interest rates are set one month at a time and firm commitments are never made about moves in the future, the latest inflation report – and Mr King’s comments on it – make it almost inevitable that the MPC will announce a further rate rise, to 5.75 per cent, either at its meeting in early June or in early July.

This can be stated with confidence because the inflation report includes charts and tables showing what would happen if interest rates rose to 5.75 per cent from July onwards – and concludes that, even with interest rates at this level, inflation would be more likely to remain above the 2 per cent target than fall below.

Only one conclusion is possible if we combine this statistical analysis with the unequivocal peroration at Mr King’s press conference yesterday: “The Monetary Policy Committee is determined to meet the 2 per cent target and will take whatever further action may be required to do that.” If the Governor expects anyone to pay attention to his promises in the future, this must surely mean that, in the absence of unexpected shocks that suddenly reduce the pressure on prices between now and the end of June, interest rates will rise in the first week of July to at least the 5.75 per cent level assumed in the inflation report.

Having dealt with the immediate prospects, the more important question is what may happen after July – not just to interest rates and inflation but to the British economy. The Bank assumes that inflation will fall quite sharply between now and early 2008, as last year’s steep rises in fuel and utility prices give way to stability and even some cuts, while other costs generally remain well contained. It is notable, however, that even on the favourable assumption that nonenergy prices remain stable, inflation will be rising again from the middle of 2008 onwards, which is why at least one further tightening of the monetary reins is almost certainly required.

But the problem that worried me a month ago, and which apparently now perturbs the Bank too, is whether it is reasonable to assume that nonenergy prices will remain generally stable, as they have been for most of the past decade. Several of the restraining forces on inflation remain very powerful. The most important of these, according to the Bank, are productivity growth and business competition, immigration of both skilled and unskilled workers and low-cost competition from China and other developing countries.

There are signs, however, that other disinflationary forces are starting to dissipate. The high streets and industries of Britain may be more intensely competitive than they were in the 1970s and 1980s, but surveys show that shopkeepers and business managers now feel more freedom to raise their prices than at any time in the past decade.

Most wage deals are still struck in a 3 to 4 per cent range, but trade union bargainers and personnel managers are increasingly aware of the gap between the 2 per cent official inflation target and the much higher inflation perceived by ordinary workers. Meanwhile, the influx of immigrant workers may be peaking, while the cost of Chinese imports is starting to rise as China revalues its currency. To make matters worse, the CPI statistics now targeted by the Bank inherently understates inflation because it excludes housing costs and gives more weight than the old retail prices index to expensive durable goods, such as cars and computers, which are falling in price, but which most people buy only rarely.

Most importantly, there is the outlook for global economic growth. By late 2008, with America emerging from its present economic slowdown, with Europe shaking off this year’s higher taxes and with Asia continuing to experience explosive growth, the entire world economy will probably be enjoying a coordinated boom of a kind not seen since the end of the last decade.

Under these conditions, most of the serious risks to inflation must surely be on the upside. The Bank of England says it has understood this message. Now it must show that it really means what it says.

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