Inflation, not cuts, is the real gamble

 
Allister Heath
THERE is a sword hanging over all of our heads, and it is not chancellor George Osborne’s spending cuts. The real danger is that inflation will remain out of control – and that interest rates will have to surge to shockingly high levels to combat it. What the authorities are hoping for, of course, is that the present burst of inflation eventually peters out without triggering higher pay demands, and that the Bank will then be able to normalise interest rates at a reasonably gentle rate. This is the real gamble – not the tax and spend measures that will be outlined in today’s Budget.

The worst case scenario would be truly terrible. In ordinary circumstances, real, inflation-adjusted short-term interest rates are at least 2.5 per cent – which means that once inflation is added in, the Bank’s base rate ought to be at around eight per cent at the moment. I’m certainly not advocating this, just pointing out that we are facing a potential catastrophe if inflation continues to rocket. In fact, real interest rates always have to overshoot in situations of elevated inflation – so if prices continue to accelerate, we could even end up with rates of 10 per cent.

Let us hope that the Bank of England’s gamble pays off and that such crippling interest rates are not needed. The UK economy is unlikely to be able to cope with rates much above five to six per cent, which implies that inflation above three per cent becomes dangerous. A return to double-digit interest rates – last seen in the 1990s – would guarantee that large numbers of people would go bust, lose their homes and default on their debts. Could you cope, dear reader? There would be another house price crash, banks would be hit and the economy would undoubtedly be tipped into recession. It does seem that inflation is at close to a peak – so some optimism may be in order. But the lesson of economic theory as well as history is that a temporary, controlled bout of inflation that goes away of its own accord is a rare phenomenon indeed.

Inflation on the official consumer price index (CPI) measure jumped to 4.4 per cent in February, from 4.0 per cent in January, 0.2 points above the average, consensus view in the City. Retail price index inflation was 0.3 per cent above consensus, rising to a 20-year high of 5.5 per cent, up from 5.1 per cent. As Michael Saunders of Citigroup points out, this is the 24th time in the last 35 months that the CPI has overshot the pre-release consensus (with 25 overshoots for the RPI). No other major industrial country has seen such repeated inflation overshoots in recent years. The City’s forecasting record has been very poor. The Bank of England also keeps getting it wrong: first quarter inflation is likely to be 4.2-4.3 per cent, more than three per cent higher than the MPC forecast a year ago and still 0.2 per cent above its 11 February Inflation Report forecast. This will be the eighth time in the last nine quarters that inflation has overshot the MPC’s prediction made at the start of the quarter. Not great.

As far as consumers are concerned, the pain is even worse than these figures suggest: the tax and price index (TPI), which adds the impact of direct tax hikes to inflation, hit six per cent in February, its highest rate since 1991. With wages rising by 2.3 per cent a year, the average Brit has just suffered a 3.7 slump in real take-home pay. No wonder the UK Misery index – which takes account of inflation and unemployment – has just hit a 20-year high. Over to you, George Osborne.

allister.heath@cityam.com

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