How the Goldilocks recovery will trigger a sharp inflation rise

 
Andrew Lilico

THE UK economy is going gangbusters, and has been doing so for about a year. GDP in the first three months of 2014 was up a solid 0.8 per cent on the last three months of 2013, and up a cool 3.1 per cent since the first three months of 2013.

Gone now are the days of “triple dips” and “too far too fast” austerity that was “playing with fire”. Those economists and politicians who said the UK was “going Japanese” and would face a “lost decade” have long since wiped the egg from their faces and started penning or pondering a so-called “Goldilocks recovery” – not too hot and not too cold – with solid growth and low inflation the new partners for rock-bottom interest rates and ever-tightening austerity.

How long can it last? In particular, the politicians whisper, can it last until the 2015 General Election? Very probably yes. Quarterly GDP is still around 0.6 per cent below its 2008 peak, which will almost certainly be surpassed in the April-June 2014 quarter. Some commentators note that US GDP surpassed its pre-recession peak long ago. But the US had only about half the depth of recession we had in the UK – probably indicating that, before the recession, UK GDP was much further above its sustainable equilibrium level than was the case in the US.

On some estimates, there is little to no slack left in the UK economy, because the sustainable growth rate fell very low during the recession. On others, there is much more slack. But for the next 18 months that’s unlikely to matter much either way for growth, because interest rates will stay very low – certainly below 2 per cent, perhaps being raised from their current 0.5 per cent level only once or twice. There remain risks – war in Ukraine, deflation getting out of control in the Eurozone, hard landing in China – but for now it’s probably “let the good times roll”.

Two curious things about growth so far are that it hasn’t involved nearly so much business investment as one might have expected; and that it hasn’t involved credit growth. (Yes, you read that right. Contrary to billing, this isn’t a “credit-fuelled recovery”. Aggregate credit has virtually not expanded at all.) I expect both those things to change.

If I’m right, the initial phase of growth we’ve seen should prompt banks to be more willing to lend (as increased house prices and wage prospects help heal bank balance sheets) and businesses to be more willing to invest, triggering rapid credit growth and an investment boom from the second half of this year, boosting inflation significantly by late 2015.

Of course, most economists disagree with me. Yesterday’s data, showing GDP rising 2.3 per cent annually, triggered a bet I made last year with Jonathan Portes of the National Institute of Economic and Social Research. If inflation doesn’t reach 5 per cent by September 2015, I’ll have to pay him £1,000 (inflation-adjusted, of course!). He (and most economists apart from me) think there’s plenty of scope for rapid growth without inflation. We’ll soon see who’s right.

Andrew Lilico is chairman of Europe Economics.