UK Inflation – short term up, medium term down

I understand why many of you are worried by inflation – food prices are leaping up, and the government has just increased the price of petrol sharply through the duty increase and the ad valorem tax increase on the back of the increase in oil prices. It is quite likely our inflation rate on the government/Bank’s measure of CPI will go back above the target of 2% in the next couple of months. If you add mortages in to the full RPI the figure is much worse, given the rate rises we have experienced. There is a real squeeze on disposable income. People may try to have a good Christmas and New Year at the shops, but that will just lead to slower sales thereafter.

The Bank, the MPC and the government should be focusing on the medium term picture – there is nothing they can do to stop the food price inflation in the pipeline, and they seem unwilling to solve the petrol inflation problem by cutting the tax rate as they want to pocket the extra money. I remain of the view that inflation is not the problem over the next couple of years – the problem is deflation from the credit crunch.

We now see that UK commercial property prices have fallen and may well fall more. Experts are arguing over whether they have fallen a few percent or whether it is already by more than 10% in many districts. Residential property prices are falling in most parts of the country outside the expensive districts of central London, where foreign demand seems to be keeping the market lively and detached from the rest of the country.

For the first time for several years the government is keeping public sector wage increases down – save for the top officials and managers who escape the squeeze. THere is no sign of a priivate sector wage lift off either.

Evidence is coming in from the banks that they now want to show more cash on their balance sheets, and are far more reluctant to lend. This will have an impact on retail spending patterns as people find it more difficult to obtain unsecured loans. The slow down in the volume of housing transactions will also reduce spending, as substantial big ticket and housing related expenditure occurs when people move, when a larger mortgage helps.

Keeping the pound high against the dollar by keeping money markets tight is extering downward pressure on manufacturers’ selling prices as they have to try to stay competitive against US exporters.

The Bankl and the MPC should not be misled by short term strength in inflation into making the credit crunch worse. If the government wanted to help they should cut the tax rate on petrol now, to control the short term increase in the CPI. Then the Bank could cut interest rates, lwoering RPI inlfaiton in the process and starting to relax the squeeze.

The authorities have to decide how far they want property and other asset prices to fall before they think they have done enough to make their point. If I were them I would not leave it too late. The US faces a bigger inflation threat than we do owing to the big fall in the dollar, but they decided on two cuts in interest rates to try to stop their residential property price collapse spreading and worsening, with the risk that it could tip the whole economy into recession if the authorities stood idly by.

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7 Comments

  1. Tony Makara
    Posted November 13, 2007 at 10:26 am | Permalink

    The inflation debate hinges on the strength of sterling. So long as sterling is overvalued inflation will remain unseen. However this will do nothing for our ability to export and will stall growth. We have become very dependent on imports, much of which is foodstuffs, and this will manifest into inflation as and when the pound depreciates, sterling won’t act as a magnet for short-term cash forever, just as the slide of the dollar will be reversed before too long. So everyone should be ready for the great currency gear-shift when it comes.

  2. Cliff
    Posted November 13, 2007 at 12:20 pm | Permalink

    It seems to me and I am not an economist, that the government’s mantra of keeping settlements for wage increases low in order to keep inflation down is only one side of the equation. On the other side, I would suggest that the government needs to keep the increase in “tax grab” low.
    I have noticed that recently food prices have jumped up fairly sharply, especially bread, milk and butter for example. I am advised that this is due mainly to the increase in fuel prices. It seems to me that some of this increase is down to tax increases on the fuel price. These increases are passed on to the consumer and thus inflation soars, the “independent” BoE will then use the only tool it has to keep inflation low namely by keeping interest rates artificially high.
    I have recently looked in to the question of the independence of the BoE as I could not see how a bank could be independent if it is told that it must keep inflation at a certain level and if it goes above that level, it MUST raise interest rates to counter act this rise. On other blogs I am advised that “every other country that has an independent bank has our model” so that’s all right then,(sarcasm intended) I just can’t see why it is called independent that’s all.
    I also question the bank’s true independence by the way the officials of that bank are appointed, namely by government, again hardly independent in my view. Is it not just a case that a chancellor can say,”It isn’t me ripping you off through interest rates, it’s the independent bank.”?

    Reply: The Bank is not independent, as explained on this site as the Northern Rock crisis unfolded.

  3. Tony Makara
    Posted November 13, 2007 at 3:20 pm | Permalink

    It will be interesting to see just how independent the BOE is if we reach a situation in which the pound starts to plummet against major currencies and if the BOE deem it unnecessary to raise interest rates to support the currency. In such a scenario Gordon Brown would certainly enact the emergency powers he outlined to the BOE in his open letter of May 1997. Gordon Brown needs to see that the pound remains overvalued because his whole anti-inflationary strategy depends on it.

  4. Derek
    Posted November 13, 2007 at 9:43 pm | Permalink

    Unfortunately, I can't see anything on the horizon, in the medium term to ameliorate inflating retail prices in shops. I think the storms will have to be very deftly navigated to avoid stagflation. I still think the authorities will struggle to keep a lid on shop prices without unleashing property price appreciation or vice versa. Meanwhile there's still been no discernibly viable solution to the credit crunch and undiscovered poor quality debt. The general ethos still appears to be, there's some bad apples in the barrel we'll just throw some more in and hope it sorts itself out. Surely if a serious, and likely very painful, effort was made to unravel the true exposure to bad debt, the authorities would be far better placed to take the right action to keep the economy healthy. At present everything seems little more than a rolling reactive response to events rather than a pro-active grasping of the reins.

    Reply: Bad debts are created by credit squeezes. Higher interest rates make more defaults on loans likely, and less credit means fewer jobs and lower incomes. The problem in the UK now is not the likelihood of a property price escalation, but the extent and speed of the fall in property prices, exposing more loans based on property values.

  5. Steven_L
    Posted November 14, 2007 at 12:44 am | Permalink

    “… sterling won’t act as a magnet for short-term cash forever, just as the slide of the dollar will be reversed before too long. So everyone should be ready for the great currency gear-shift when it comes.” (Tony Makara)

    I was prophecising about the collapse of the pound against he dollar/euro too a while back, and the associated inflationary pressures, but now I’m not so sure.

    I’m now minded that the Arab states talk of shifting their dollar pegs to the IMF mixed basket and China beginning to allow the strengthening of the Yuan, and their proposed diversification fo foriegn currency reserves will steer us clear of an all out crash.

  6. Steven_L
    Posted November 14, 2007 at 1:25 am | Permalink

    "If the government wanted to help they should cut the tax rate on petrol now, to control the short term increase in the CPI. Then the Bank could cut interest rates, lwoering RPI inlfaiton in the process and starting to relax the squeeze." (JR)

    I'd just like to say "I told you so".

    I seem to remember commenting on the arrival of $95 oil and the need for cuts in Uk fuel duty on 1th August this year.

    'So going back to this theme of listening to what clever people are saying in the financial press, there is a guy who works in commodities called Jeffrey Currie said that $95 crude was quite likely this year unless OPEC unexpectedly increased production and that declining inventories were raising the chances for $100 oil.

  7. Mike10613
    Posted November 14, 2007 at 12:19 pm | Permalink

    I have just paid for the tax disk on my car.

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    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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