Why sterling’s decline could push up inflation once again

Allister Heath
THERE was a time when a weaker pound used to boost exports. These days, it doesn’t appear to make a noticeable difference, in the short term at least. Last year’s brilliant growth in car exports – the UK sold more cars abroad than ever before in its history, one of the most cheerful news stories of the year so far – wasn’t noticeably impacted by the level of sterling. Of course, large, permanent movements in the pound will have an impact on the competitiveness of goods and services sold abroad, but most these days seem to be relatively price-insensitive. This is because the mix of UK goods and services exported has changed; most are now very high valued added premium products.

The biggest impact of a weaker pound these days is its effect on the price of imports, which are inevitably pushed up. That is why I’m worried about sterling’s recent decline: it fell below €1.20 and $1.60 yesterday, for the first time since March 2012. As PwC’s excellent Andrew Sentance has pointed out, sterling’s sustained sub €1.20 level in 2011 contributed to the last big inflation spike (to over five per cent). Even a minor rise in inflation would hurt: the consumer price index is still growing too quickly at 2.7 per cent, and the retail price index is doing even worse at 3.1 per cent. There seems little hope that this will fall sustainably if sterling continues to weaken, though of course there are always long and variable lags in monetary policy.

It is important to remember the extent of the inflation overshoot of recent years. The CPI measure of the price level is 8.4 per cent higher than it would be had annual inflation been kept to two per cent, the central value of the official target, since the year that ended in March 2007, when the rot started, according to calculations by Europe Economics. In other words, the cumulative miss has slashed the purchasing power of the pound by almost an extra tenth, on top of the inflation allowed under the target.

This is not something that can be laughed off as irrelevant. It represents a very serious reduction in real values and especially of real wages and savings. There are, of course, advantages to inflation; an over-indebted society can effectively default quietly and in a more controlled manner by inflating. One reason why employment has done so well is that the real, inflation-adjusted cost of employing somebody has dropped, boosting the demand for labour.

But over time such benefits are far outweighed by the costs of inflation. If the past few thousand years teach us anything, it is that price stability and sound money are the answer, not inflation, and that it is nigh-on impossible for central banks to generate controlled bursts of inflation. We finally understood this in the UK in the 1970s; but even though price stability (or something close) was supposedly enshrined in the rules at the heart of Gordon Brown’s monetary policy reforms of 1997, that experiment failed lamentably.

Let us hope that the new rules Mark Carney, the incoming Bank Governor who starts in six months’ time, and George Osborne agree to will not turn out to be yet another ruse to allow inflation through the back door.

The tragic hostage crisis in Algeria, as well as the horrific events in Mali remind us that geopolitical shocks remain the greatest of Black Swans. Such events have a tendency to spiral out of control. Few in London would have thought Mali would turn into such a flashpoint; there is nothing more dangerous than what Donald Rumsfeld called the unknown unknowns.

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