Call me alarmist – but the inflation risk is real

UK inflation just hit a four-year low. Hurrah! The Bank of England will now be under much less pressure to raise interest rates – which is good news for the UK’s highly indebted households.

Inflation is now so subdued we don’t need to worry about it anymore. The real danger is that Britain contracts a nasty dose of deflation – the Japanese-style disease of falling prices, stalled demand in expectation of a further price slide and curtailed investment. So be reassured that our central bank, having already created £375bn of virtual money, could yet unleash even more quantitative easing.

The above two paragraphs represent, more or less, the conventional wisdom on UK inflation. I find myself, yet again, disagreeing with almost every word – except for the very first sentence. UK inflation is indeed at a four-year low, according to the Office for National Statistics. In November, the Consumer Price Index was 2.1pc higher than the same month in 2012.

In a recent article for Standpoint magazine, Professor Tim Congdon, a monetary economist of international repute, dubbed me an “inflation alarmist”. It is true that back in March 2009, just as QE was beginning, this column forcefully argued that inflation was a “serious medium-term problem” for the UK. At the time, amidst crashing financial markets, and endless deflation scare-stories, this was a minority view. Yet, as regular readers may remember, throughout 2009 I did keep warning of future inflation.

Why? Because sterling was falling, making UK imports dearer. I also felt oil would quickly recover from its post-Lehman plunge and move back towards $100 a barrel. Business investment was spiraling downward and desperate firms, in a bid to survive, were selling-off capital goods. Both trends pointed to future capacity constraints once demand even partially recovered. I was also receiving numerous reports back in 2009, from Telegraph readers and other business contacts, of supply-chain price pressures that weren’t yet being captured in the official figures.

By the start of 2010, CPI inflation was indeed up at 3.4pc, way above the Bank’s 2pc target. The CPI stayed at 3pc or higher for the next twelve months and, the following year, climbed higher still. Throughout 2011, UK inflation was consistently 4pc or more and even breached 5pc during the late summer.

Since then, as average annual oil prices have plateaued around £110, and import costs have eased with a stronger pound, the CPI has admittedly relented slightly, averaging 2.8pc in 2012 and 2.7pc during the first eleven months of last year. But in December 2009, UK inflation went above the Bank’s 2pc target and has since stayed there, for 48 months in a row. So in what way were my warnings “alarmist”?

I never predicted “hyper-inflation” – as Professor Congdon claims. Having spent a fair chunk of my adult life studying and living in emerging markets, I’m fully aware hyper-inflation is generally defined as price rises exceeding 25pc a month. There was no suggestion Britain would face that. But back in early-2009, at a time when almost every City economist was calling for massive QE in order to bail-out their banking sector employers (or clients), using “deflation is coming” as an intellectual alibi, I did repeatedly warn UK inflation would remain sticky and elevated.

That’s exactly how it turned out. Real private sector wages have fallen four years in a row – thanks largely to stubborn inflation. The entire political debate is now couched in terms of “the cost of living crisis” – a theme that will no doubt resonate until the 2015 general election and beyond.

One reason for the public outcry over living standards is the big (and growing) discrepancy between official inflation and price rises experienced in the real world. The seemingly consistent under-stating of inflation by the ONS – involving the use of all kinds of statistical wheezes such as goods-basket rigging, “hedonic benefits” and (take my word for it) the selective use of geometric rather than arithmetic averages – will no doubt be the subject of a future column.

Suffice to say, for now, that I do think its weird the CPI doesn’t include council tax rises or housing cost inflation – which is now high, of course, and set to get even higher as interest rates and rents go up. It’s also deeply disconcerting that last March the government’s UK Statistical Agency announced that the far more accurate Retail Price Index, an inflation measure that’s existed since 1947, would “no longer be designated as a national statistic”. Is that because it’s produced higher numbers than the CPI in 15 of the 16 years since the CPI was introduced?

Professor Congdon will no doubt accuse me of yet more “alarmism” but, despite the good news about November’s CPI, I remain concerned UK inflation will prove problematic in 2014 and beyond. Forgive me, Professor, but you’ll find that, beyond the self-serving City number-crunchers and the groves of academe, a huge swathe of British business leaders agree.

For one thing, the low November number can  largely be explained by food prices that were down on November 2011 due to a bad harvest the summer before and recent energy price rises also weren’t included. Once higher utility bills are factored-in, the CPI will tick up.

While sterling has lately recovered, it remains 20pc down against the dollar and euro since 2007 and could yet lose more ground – not least given the UK’s huge trade deficit with both the European Union and the wider world. It’s also worth noting that inflation has remained high over the last four years despite the UK staging the weakest recovery of any major economy. Now demand is growing quickly, albeit partly due to rising consumer debt, we could easily see further price pressures.

While the CPI will oscillate from month-to-month, it also strikes me the trend in both energy and soft commodity prices remains upward, as the global population continues to escalate and lifestyles across the emerging markets modernize, so becoming ever more resource-intensive.

More fundamentally, I remain of the view that QE itself will ultimately prove inflationary. For now, much of the central bank funny money has either found its way into asset prices, pushing Western shares to over-valued highs, or is sitting on the balance sheets of banks that are pretending to be solvent. Certainly, few of the QE proceeds have been lent out, as was intended – and as the busted banks promised in return for being rescued. Business loans were down almost 4pc year-on-year in November, according to the Bank of England.

Back in March 2009, the UK was clearly in a mess. Without some “extraordinary” monetary measures, our banking system would have seized completely, resulting in economic and social chaos. Yet, the room for manoeuver afforded by the first round of QE should have been used to force insolvent banks into administration, while protecting depositors, with shareholders and creditors taking their loses. Such creative destruction and renewal is essential if capitalism is to work.

Instead of being used as a necessary emergency measure, or a crash pad, QE instead expanded grotesquely and became a comfort blanket. Billed as a £50bn initiative back in 2009, it has since doubled, doubled and almost doubled again.

This shouldn’t surprise us. This outlandish policy has friends in high places – being all about rescuing City denizens from their crazy investments and helping governments to dodge the really tough fiscal decisions. As our moribund banks slowly return to life, though, and the bulk of the QE proceeds enter broader circulation, as sure as night follows day, higher inflation will result.

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