Investment Week – Inflation
29 December 2009
Given the choice between two evils, economists would generally rather confront an inflationary threat than one of deflation. That’s because they have had more experience in tackling inflation and feel that they have the appropriate policy tools to do so. Periods of deflation are much rarer, and have proved to be more intractable – witness the difficulties that Japan had in escaping from deflation through the 1990s. So, when the UK financial system creaked and threatened to fall apart last year, the authorities, fearful of potential deflation, mobilised a major policy response. Interest rates were cut to historically low levels and the system was flooded with liquidity, to help it to re-capitalise and avoid total collapse. If there were any inflationary consequences, then that was a risk that they were prepared to take, confident that they could manage that risk.
Having succeeded in underpinning the economy, and driven away deflationary fears, there are some who now see that inflation risk as a reality, especially as most of the fire-fighting policy measures are still in place? That anxiety is heightened by the fact that inflation in the UK has proved to be ‘stickier’ than in most other economies through this economic downturn. It should be remembered that this is not necessarily a binary event – more often than not, economies face neither an inflation nor a deflation ‘problem’.
Let’s consider the situation today. Yes, a lot of money has been pumped into the system but no, it has not so far put upward pressure on consumer prices. What it has done is to stabilise the banking system. That’s not to say that it will continue to have a benign impact. However, both the authorities, and informed observers, are convinced that liquidity can be readily drained, and interest rates hiked, in the event of a sustained broad build-up in inflationary pressures. Others are not so sure, and are unconvinced by the Bank of England’s view that after a brief, sharp pick-up in inflation over the next few months, the rate will fall back towards the target rate by end-year.
At the end of 2008 the annual rate of inflation benefited as the previous sharp increases in food and fuel prices unwound. Now, as these beneficial effects themselves fall out of the calculation of the twelve-month rate of change, so the year on year rate would rise even if the index reading is unchanged from month to month. Together with the impact of the government’s decision to raise the VAT rate back to 17.5%, reported inflation is likely to top 3.0% early this year. However, that is probably as bad as it gets for 2010, as several months of sharply rising inflation then fall out of the twelve-month figure. In the February to June period of last year, inflation rose at a monthly rate of almost 0.5%. So, as long as we don’t get a repeat next year, the inflation number should be heading back towards 2.0% in the second half of next year.
The major driver of longer-term inflation trends, wages and other labour costs, has been encouragingly subdued. For most of the last decade average earnings have hovered between 3.5% and 4.5%. During the recession, that number has plummeted to 1.6%, as more than half of all workers have been prepared to compromise on wages in order to preserve their jobs. Wage freezes and cuts have become relatively prevalent – at least in the private sector. There has also been a surge in the numbers working part-time, which is now approaching one million. These disinflationary trends won’t last forever. However, even on the Chancellor of the Exchequer’s forecast of economic growth at 1.5% this year, the labour market is unlikely to tighten markedly any time soon. Couldn’t we get a rerun of last year when food and fuel prices shot up? It’s not totally impossible, but very unlikely given a global economy still hampered by a less than fully functioning financial system and fiscal retrenchment in many countries, as the authorities try to rein in budget deficits.
Fears of inflation are overdone. All we are likely to see in 2010 is an early run up in annual inflation, followed by a subsequent relapse. We are not expecting an upward trend to develop any time soon. Nevertheless, a sustained pick up in economic growth could eventually put some upward pressure on prices if resources, such as labour and raw materials, get to be in short supply. However, we are nowhere near there. Barring a policy error (failing to remove accommodative policy measures in a timely and appropriate manner), it’s unlikely that demand will be sufficiently strong as to reignite inflationary pressures. It seems that we are set for another period in which neither deflation nor inflation is a major concern.
Douglas Roberts, Senior International Economist, Standard Life Investments
This article was first published in Investment Week on Monday 1st February 2010.
