Still choppy

The inflation overshoot

Still choppy

The economic conditions are not ideal to launch a British version of QE2

Nov 18th 2010

THE routine has become familiar. Inflation surprises on the upside. It is high enough to warrant another note from Mervyn King, the governor of the Bank of England, to George Osborne, the chancellor of the exchequer, to explain what is going on. That note says, in essence, that the overshoot was caused by temporary factors and that inflation will eventually subside because of spare capacity opened up in the recession. But will it?

This week’s letter from Mr King was the fourth he has had to write this year as inflation has persistently strayed more than a percentage point above the 2% target. It was prompted by official figures showing that consumer prices rose by a higher-than-expected 3.2% in the year to October (see chart), up from 3.1% in September. Indeed, in nine letters since April 2007, Mr King has been obliged to explain why inflation has been above 3%. 

That inflation has remained stubbornly high in the wake of the most severe recession since the second world war is odd. In this respect, Britain is unusual among advanced economies, as other figures also published this week highlighted. Inflation in the euro area in the year to October ran at 1.9%; in America it was 1.2%.

The main reason why Britain has been the exception is the steep fall in the pound, whose trade-weighted value slumped by some 25% between mid-2007 and early 2009. Even though the effects on inflation through higher import prices should be waning now, there have been other adverse temporary influences, such as past rises in oil prices and the return of the main rate of VAT, a consumption tax, to 17.5% at the start of 2010, after 13 months in which it was set at 15% as part of the previous government’s fiscal stimulus. 

The difficulty for the bank’s monetary-policy committee (MPC) is that there will be yet more temporary factors pushing inflation up over the next year. In January VAT will rise again, to 20%, an increase that is expected to be passed through in full to prices, whereas only half of its preceding fall and rise are reckoned to have been passed on. Moreover, world food prices have been climbing steeply. 

In January Mr King said that “in both of the past two years inflation picked up as a result of temporary price-level factors and then fell back, as the MPC had predicted.” But the bank’s own central forecast, published on November 10th, shows that inflation will reach 3.6% in the first quarter of next year and will not fall below 3% until early 2012. Just what “temporary” means in the bank’s lexicon is unclear.

The risk in this, as the governor acknowledged in his latest letter to Mr Osborne, is that people start to expect higher inflation. The bank argues that expectations remain consistent with hitting the inflation target in the medium term. However, two out of three household surveys show that expectations of inflation one year ahead have been moving up. 

The big picture, as Mr King sees it, is that the slack in the economy following the steep recession will eventually pull down inflation. This remains plausible. Average earnings are growing at only 2% according to official figures out this week; the unemployment rate is a still-high 7.7%. But financial crises tend to inflict a lot of damage on capacity. That could mean that the margin of spare resources is not that large, which would chime with surveys of businesses. 

Mr King is still being given the benefit of the doubt, but he must be chary of his stock of credibility. The inflation overshoots make it more difficult for the bank to follow the United States, where the Federal Reserve has launched another bout of quantitative easing nicknamed QE2. That lifeboat won’t be launched in Britain in the near future, unless there is very clear evidence that the recovery is foundering.

Britain 

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