TAKE your pick. Is inflation four per cent a year, as the official, consumer price index measure suggests, or 5.1 per cent, as the older, broader retail price index would have you believe? My own favourite measure of how the cost of living is going up is the tax and price index, which has surged a crippling 5.5 per cent; it adds changes to direct taxes such as income tax and national insurance to the mix.
Wealth is being eroded by stealth: if you were to keep £100 in cash under your pillow, it would be worth just £69.31 in today’s money in five years’ time if prices continue to go up at current rates. After ten years, thanks to the power of compounding, inflation would have slashed the value of your £100 to a pathetic £29.19: sterling’s purchasing power would have been cut by over 70 per cent.
But all of these figures are just for a hypothetical average person. Many readers of this newspaper will be facing even bigger knocks to their take-home pay, especially if they commute or are being hammered by tax hikes.
For some, cuts to real incomes of six, seven or even 10 per cent will not be out of the question, assuming unchanged pre-tax income and patterns of consumption. With compensation creeping up by just 2.1 per cent on average, real, post-inflation and post-tax pay is being slashed by at least 2.4 per cent.
Either pay deals will remain subdued, reflecting the current tough climate – or salaries will surge, triggering an inflationary spiral as firms put up prices in a desperate bid to recoup costs. The only good news is that falling wages will help unemployed workers to start finding work again.
In his letter to the chancellor, Mervyn King warns that even on the consumer price index inflation could soon hit five per cent; even more depressingly, he argues that it could be “two to three years” before inflation returns to target. It is an astonishing loss of control. His argument that “attempting to bring inflation back to the target quickly risks generating undesirable volatility in output” won’t stop rates from going up – a hike of 0.75 percentage points this year now looks like the most likely outcome.
The Bank’s mandate is to keep consumer price inflation at two per cent, though a deviation of one per cent either side is permitted – regardless of whether the surge in prices is caused by imported commodities, bad luck or (in theory) sunspots. The government may of course be secretly happy that the Bank is failing to meet its target: higher inflation means faster real term cuts to public sector spending and wages, facilitating fiscal consolidation while allowing the Treasury to spend more in cash terms. While painful at first, it could actually reduce the perceived impact of the cuts.
But one of the great lessons of economic history is that when it comes to inflation, trying to con the public, companies and the foreign investors who finance the UK’s massive budget deficit never works for very long. People are not that stupid. The government has two options: it could scrap or suspend its inflation target and humiliatingly admit that the UK – unlike every other developed country except Greece – has given up on price stability. A less disastrous idea would be for David Cameron or George Osborne to go on the record backing a more vigorous anti-inflation policy – and make it clear that they support higher interest rates. The current timidity isn’t helping anyone.
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