Tuesday, February 16, 2010

Does Anyone Know How To Fly This Thing?

Ladies and gentlemen, this is your Captain speaking. You may have noticed we're currently flying through an area of turbulence. There is absolutely nothing to be concerned about, and we will soon level out. Althoooough... just as a precaution you might want to return to your seat immediately and assume the brace position. And if there are any pilots on board perhaps they would make themselves known to a member of the cabin crew. Priests too... we could probably use a couple of them up here...


This is getting scary. CPI inflation has jumped to 3.5% - 1.5% above the 2% target; RPI inflation is up to 3.7%, and RPIX inflation (ie RPI excluding mortgage costs) is up to a belting 4.6%.  Yet according to the Governor, there is no need for alarm. According to him, this is a temporary spike caused by the reversal of the VAT cut, a 70% year-on-year hike in oil prices, and the depreciation of sterling in 2007 and 2008.

Indeed, rather than focusing on the upside risks to inflation, his letter is much more concerned to assure us that he stands ready to refire the printing press should inflation fall too much.

The trouble is, the rest of us - especially those dependent on pensions and savings - are not at all comforted by the Governor's assurances.

Let's just remind ourselves of the Bank's inflation record since the 2% CPI target was set in December 2003. The following chart shows the rolling 12 month CPI inflation rate against the 2% target and the 2.4% average inflation rate actually achieved by the Bank over the period as a whole. Yes, that's right - despite all that alarmist talk about deflation, the Bank still failed to hit its 2% target, overshooting by an average 0.4% pa.

This is not a great record. As we can see, the Bank's grip on inflation has been far from secure. They got so lax in the run-up to the Crash that in September 2008 inflation broke through 5% - two-and-half times their 2% target. Indeed, there are those who argue that if the Crash had not come along at that very moment, the Bank would have had considerable difficulty getting back on track.

And remember too that this period was fairly benign in terms of the global background. For example in the Eurozone inflation averaged just 2% pa.

What's going to happen if, driven by China and the other BRICS, world commodity prices remain under upward pressure. And what if a deeply indebted US government carries on running the dollar presses, just as it did to finance its Vietnam/Great Society spending splurge in the 70s? And most of all, what's going to happen if the markets take fright and whack sterling again?

I'll tell you what's going to happen - far from behaving in the orderly way that the Bank and Will Hutton describe, our inflation rate will lurch upwards.

The stomach knotting truth is that the Bank is losing its commitment to low and stable inflation. Given all the uncertainties, it is much more willing to see inflation overshoot than to risk being accused of nuking GDP growth.

But as we've blogged many times, in anything other than the short-term, you cannot sustain GDP growth by cranking the printing presses. We remember the 1970s; they got very bumpy indeed. And the big lesson was that inflation really does matter. Not only does it rip the faces off pensioners, widows and orphans: it also undermines confidence and investment, with devastating consequences for growth.

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