You can’t fool everyone all the time

FOR months now, I have been calling for an immediate, symbolic rise in interest rates to stem spiralling inflation and to show markets the UK is serious about fighting inflation – only to be criticised as an over-excited hawk. Yet month after month, inflation has over-shot and still the chorus is that “the Bank of England should hold its nerve”. I disagree: we need some action, and fast. Merely praying that all will soon be well again is not a proper economic strategy.

The consumer price index is now rising at 3.7 per cent, the retail price index, which includes some housing costs, at 4.8 per cent; and the tax and price index, which includes direct taxes and is the best measure of the cost of living, by 5.2 per cent. Average earnings growth including bonuses is increasing but is still just 2.2 per cent. Pay growth in the private sector stood at two per cent. Workers are facing a cut in real, tax-adjusted wages of around three per cent. House prices are also falling in real terms; it is impossible for anybody paying 40 per cent or 50 per cent tax to find a single bank account with a positive, post-tax interest rate (only a few Isas will do the trick); stripping out the effects of inflation, the return on many assets no longer looks that great.

Of course, a large part of the spike in inflation is due to higher tax. But the argument that this means the Bank of England shouldn’t be doing anything is flawed, as Simon Ward of Henderson points out. CPI-CT and CPIY, which supposedly strip out the effect of tax, are running at just 1.9 per cent and two per cent. But these esoteric measures are calculated on the assumption that indirect tax hikes are passed on in full to consumers. This is nonsense. Pass-through was only one-third after the 2008 VAT cut. Assuming that one-half of the increase in indirect taxes last year was reflected in the prices charged to consumers, Henderson calculates that inflation would now be 2.8 per cent had tax rates remained stable – still too high.

Low interest rates have helped banks to recapitalise themselves and wean themselves from the public trough. But it is time to move on as the policy is now decimating two other industries: life insurers and pension funds. Because of the way the accounting is done, liabilities have surged and assets have gone down; the current monetary policy is more of a threat to the solvency of life insurers globally than a stock market or property crash would be. Corporate pension funds are also in trouble.

Of course, inflation has some desirable side-effects. The real debt burden is being eroded for consumers, corporates and the state. If these defaults were explicit, there would be panic; we are getting debt restructuring on the sly. House prices are readjusting. The drop in wages will price people back into jobs.

On balance, however, using inflation to sort out one’s problems is a mistake. It is better to do it the hard way. You cannot fool everybody all of the time. People learn and start putting up prices and wages; this begins to fuel a self-fulfilling inflationary spiral. Soon, lenders begin to slap risk premia on the interest rates they demand – so not only do nominal rates go up, real ones also rise, choking off demand. We learnt in the 1970s that inflation doesn’t sustainably boost jobs and growth but merely leads to stagflation – why has everybody forgotten?
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