Inflation: Balancing the risks

Dr Martin Weale Image copyright Other
Image caption Dr Weale says rates should go up, even if inflation forecasts are right

Hold the front page: the annual rate of inflation did not go up last month.

It merely stayed at 4.5%.

That headline figure has not gone below 3% since December 2009, and it has now been above target for 34 of the past 40 months.

Neither the Bank of England nor any City commentator expects it to fall in the next six months.

In fact, all the betting is that it will be significantly higher at the end of the year than it is now. The only debate is over when, and whether, it will go well over 5%.

We shouldn't forget to be disturbed by this turn of events.

Only four years ago, the Bank of England could hold its head high in the premier league of central banks. In its first decade of independence, Consumer Prices Index (CPI) inflation had averaged 1.6%.

Now you have to say it's facing imminent relegation. If it's not in the Championship already.

Since May 2007 the average monthly inflation rate has been 3.5%. Our central bank has neither prevented nor even predicted this prolonged period of excess inflation, which has so devalued the average pay packet.

There aren't many Western central banks with a worse forecasting record during this period than the Old Lady of Threadneedle Street.

As a recent paper from the Centre for Policy Studies pointed out, between August 2007 and May 2010 the Bank's average forecast for inflation a year ahead was 1.9%, but the average outturn was 3.2%.

So, on average, their forecasts were 1.3 percentage points too low. That's a large error when your target is just 2%.

By contrast, the forecasts between August 2001 and May 2004 was out by an average of just 0.1 percentage points.

There's plenty to debate about this past record - and how much the Bank could or should have acted differently. I've debated it many times on these pages.

But one point on which there can be little debate is that the UK is an outlier.

The past few years for UK inflation has not only been radically different from what came before, they've been radically different from any other major industrial economy.

Between 2009 and 2011, the Organisation for Economic Cooperation and Development expects consumer prices inflation in the eurozone to average 1.3%, with average inflation across all the OECD countries forecast to be 1.5%.

The average figure for the UK is expected to be 3.4%.

As I've discussed many times, the Bank of England is betting that this period will turn out to be truly exceptional - and temporary. So, in many ways, is the Treasury.

In effect, the UK authorities and many City forecasters are all hoping that the global forces pushing up inflation will eventually subside, and that there has been no lasting change in either UK trend productivity growth or the underlying trade-off between inflation and growth in the UK.

Trust me. You want them to be right.

Because if they're wrong, the next few years start to look even bleaker than we thought.

Our potential growth rate will be even slower, unemployment will be higher, and the structural hole in the public finances will be even larger, requiring the government to impose even greater tax rises and spending cuts to bring the national debt onto a downward path.

Martin Weale took the gloomier road in a speech last night, explaining why he thought interest rates should go up, even if the Bank is right in its current forecasts for inflation.

On the basis of the past few years, he thinks the trend rate of productivity growth - and thus the economy's potential growth rate - is lower than we thought before the crisis.

That's to say, it's not just the starting point that's fallen, but also the rate at which we can safely make up lost ground.

He also thinks there is more domestically generated inflation out there than a simple look at wage settlements would have you believe.

Here's what he says:

"I have, of course, been pleasantly surprised that wage settlements in the private sector have remained low and that private sector regular weekly earnings are rising by less than 2.5% per annum.

"But a more general picture of unit domestic costs excluding taxes can be obtained by looking at the gross value added deflator.

"This rose by 1% in the first quarter of the year and by 2.4% compared with the first quarter of 2010. So it is consistent with the view that, even after excluding import costs and taxes, there are at present substantial cost pressures in the economy."

All this has Dr Weale believing that the risks of inaction are greater than the risks of action.

As we know, a majority of his colleagues on the Monetary Policy Committee disagree.

Month after month, in this period of above-target inflation, they have concluded the risks - to growth, and to the medium-term inflation target - of acting now are greater than the risks of staying put.

The City expects this to continue for a long time to come.

Astonishingly, the markets now seem to be betting that the MPC will not raise rates until next year.

But the longer this "exceptional" period of above-target inflation continues, the more we all have to worry that the "exception" has become the rule.