High inflation is denting recovery: The Bank of England must act now

 
Andrew Sentance
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IT’S official. The Bank of England has confirmed in its latest Inflation Report that it is unlikely to get inflation back to target in the next couple of years. On its central forecast, the Bank is not expecting inflation to be back around the 2 per cent level until late 2015 or early 2016.

As a result, the UK will have suffered a decade of almost continuous above-target inflation since the mid 2000s – with two major inflation spikes above 5 per cent, and the likelihood that inflation will rise above 3 per cent again this year. This has happened despite the financial crisis and a major recession, which was originally expected to create serious deflationary forces in the UK and other major economies. Deflation has been forestalled, and instead we are suffering inflation.

To me this is not a surprise. Two years ago, in my final year as a member of the Monetary Policy Committee (MPC) I warned that we were set for a persistent period of relatively high UK inflation. I was branded an inflation “hawk” or “uber-hawk” as a result. Well, I’m afraid those warnings were correct. And the Bank of England has officially acknowledged this in its latest Inflation Report.

The reasons that inflation has remained stubbornly high are exactly those which I highlighted in my final MPC speeches in early 2011, and they’re still available on the Bank of England website. First, the Bank of England’s economic model and forecasts vastly overestimated the downward pressure on inflation from spare capacity in the economy. In particular, we have seen services prices in the consumer price index rising at 3 to 4 per cent consistently since 1997. The recession has made little dent in this rate of increase.

Second, strong economic growth in Asia and other emerging market economies has continued to push up global energy and commodity prices. Despite the impact of the Eurozone crisis, and disappointing growth in many western economies, the oil price is around $115-120, and could well rise further if the global economy picks up as forecast this year and next.

Third, the UK has suffered from an additional surge in import prices due to the weakness of the pound. In February 2011, I described this as Selling England by the Pound – the title of the classic Genesis rock album released 40 years ago. The recent decline in our currency is worrying from this standpoint. A renewed bout of sterling weakness would give added momentum to the rise in inflation, which the Bank is already forecasting for the first half of this year.

These arguments were well-aired in the columns of City A.M. But it is all very well to say “I told you so”. The harder question is: what do we do now?

The answer from the outgoing Bank of England governor Sir Mervyn King yesterday was the same as he has been giving throughout the crisis. We have to keep interest rates low to support economic growth, and the prospects for the economy would be worse if we did anything to curb inflation.

That was exactly the right policy in the depths of the financial crisis in 2009, but I don’t think it is the right approach now. Tolerating inflation is contributing to the squeeze on consumers, which is one of the main negative factors behind weak growth. Savers have suffered from low interest rates for a prolonged period of time and are also cutting back on their consumption.

Another concern is the impact of a very low interest rate policy, accompanied by high inflation, on the value of the pound. The official Bank of England view is that a weak pound helps the rebalancing of the UK economy towards exports. But we have seen little evidence of that because UK exports are not price sensitive and the UK doesn’t have lots of spare capacity in exporting industries. Instead, a weak currency squeezes consumers and probably does more harm than good.

In the short term, the MPC is reluctant to take action to keep inflation on target. But relatively high inflation and a weak currency are becoming part of the problem for UK economy, rather than part of the solution. The sooner we recognise this, the more quickly we can plot a course ahead for a genuine and sustained recovery.

Andrew Sentance is senior economic adviser at PwC, and a former member of the Bank of England’s Monetary Policy Committee.