Inflation in a credit crunch – high interest rates will make the crunch worse

Inflation is too much money chasing too few goods. Today inflation in the UK and the US is being driven higher by increases in the prices of energy, raw materials and basic foodstuffs, and in the UK by the costs of government. Much of the international inflation comes from excess liquidity in the oil exporting economies and from the demands of Asian economies which have built up large surpluses through successful exporting. The US and UK economies have bigger problems from the way credit has dried up, leading to job losses in the US and a sharp slowdown in the UK economic forecasts.

This makes high interest rates in the US and UK economies an inappropriate response to the inflation – something the US authorities have understood. There is clearly no excess liquidity in the US or UK private sectors. Asset prices on both sides of the Atlantic are falling. US house prices, shares and commercial property are either in freefall or are showing signs of distress. UK commercial property has fallen sharply, UK shares are down and most residential property prices are now static at best.If we had too much domestic liquidity you would expect some or all of these values to be rising, not falling.

Energy prices have risen partly because the emerging economies have need more and more of the limited supply, partly because the dollar and the pound have been weak currencies, and partly because despite global warming theory it has been a very cold winter in many parts of the northern hemisphere where much of the effective demand for energy resides. Food prices, especially grains, have soared. This is partly because the Asian customers want more and better food, but partly because the weather has been so bad affecting crop yields and partly because some global warming theorists have favoured using grains for fuel, diverting them from food.

The big pools of liquidity built up in Asia, Russia and the other commodity producing areas have helped power the prices of precious metals and other commodities, both to fuel demand for industrial products, and to satisfy new holders and hoarders of them.

The UK’s inflation rate has been increased by the inefficiency of the public sector, and the liberal use of higher charges and taxes to tackle what is more truly a problem of spending badly.

The correct response to the commodity price inflation in the west should be to ignore it, all the time there is no transmission from the higher metals, energy and food prices to wages and asset prices. So far there is some sign that some of the extra costs are being passed on by business, but no sign that either the US or the UK is about to have a worrying round of wage inflation. Passing the price increases on just shifts more of the pain from companies to the individuals who buy the products. It looks as if this inflation is going to lead to a reduction in the spending power of consumers in the UK, as neither the government nor the business sector are willing to take the hit. Indeed, the government is keen to divert attention from its own role in the inflation, by calling in parts of the private business world for punishment talks when their prices have gone up, as it is currently doing with the energy suppliers.

In the UK everything points to the need to cut the costs of government, not by doing less in the services that matter but by doing things better where they need doing. I set out in yesterday’s blog the need to cut UK government borrowing as part of our response to the present economic crisis. Today the message is reinforced by the inflation figures. The government has done the right thing in at last telling the public sector – including MPs – that this year’s pay rise has to be below inflation. It needs to do much more to get value for all the spending it is committing.

Today’s gales may be the last fling of an unpredictable winter in the UK. The parallel squalls on the markets need the authorities to realise they have a serious problem and get to grips with it if they wish to create calmer conditions.

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10 Comments

  1. Posted March 10, 2008 at 1:01 pm | Permalink

    Inflation must not be ignored. I sense an attitude that inflation is less concerning than the "credit crunch". Previous experience shows that inflation is insidious and will eventually wreck the economy. Is it realistic to expect that the massive increases on the basics of life, such as food and energy will be accepted without high wage and salary demands following? Once that happens the whole thing will get out of control. The experiences of the 70s and 80s seem to have been forgotten. I wrote to you previously about the worrying similarities to those days and see no reason to fear that we are in grave danger of returning to those abysmal times.

  2. Posted March 10, 2008 at 2:48 pm | Permalink

    Speaking of energy prices, do you think Mr Darling after careful deliberation may have decided that the most pressing problem in the UK economy today is that petrol is just too cheap?

    I think he maybe almost alone in such a conclusion.

  3. Posted March 10, 2008 at 3:46 pm | Permalink

    Today’s gales may be the last fling of an unpredictable winter in the UK.

    I quite agree!

    I concur with your last post too, although I fear it's too late to change course on Northern Rock.

  4. Posted March 10, 2008 at 5:58 pm | Permalink

    You are, as ever, totally right in your analysis. The Telegraph today had two superb articles saying the same thing: Janet Daley and the Leader.
    And do you think the leopard will change his spots?
    I think, myself, that we are faced with a government which is very clever but totally stupid. All it wants is re election and to cling on to power for as long as it can. It will do this by buying votes out of our money through hand outs to its clients.
    So, truthfully, I think you are going to be appalled by the budget, prepared, remember, by an Edinburgh lawyer who knows little or nothing about the Treasury for a man who has spent the last decade arranging for the debacle.

  5. Posted March 10, 2008 at 7:29 pm | Permalink

    I can only add an individual perspective of someone exposed to the chill-winds currently blowing in the global economy. Circa 2001 the technology industry faced a downturn that essentially started within this industry and frugality of a degree that I suspect is unknown in the public sector has been the norm ever since. The problems this time originate in the finance industry but I actually feel prospects for UK employment in the tech-sector are as grim as during the .com bust. This is because;
    (a) From the perspective of decision-makers in Silicon Valley boardrooms the UK is a market overweight in financial sector customers and these are precisely the companies cutting back the most now.
    (b) Prior to ~2000 the UK was perceived as being a relatively low-cost place (compared to the US) to find skilled employees. The last few years have seen (i) a huge recruitment of talent in Asia and (ii) a dollar decline such that the UK is now expensive compared to the USA let alone China or India. If high UK interest rates were to push the £ towards $.250 the outlook for UK employment would be ominous.

    Unless things pick-up in the US pretty soon I fear the UK payroll of global companies could be reduced to just those functions (e.g. sales, customer support) that absolutely must to be performed locally with ostensibly higher-value functions relocated to Asia simply because they can (in theory) be performed anywhere. Should Britain lose a significant proportion of the FDI it has attracted in the past the loss of tax revenue would ultimately be felt by those on the UK state payroll so public sector frugality is very much required now in Britain. It may indeed already be too late.

  6. Posted March 10, 2008 at 8:39 pm | Permalink

    Am I right in thinking that slow inflation always leads to rapid inflation unless something is done about it?

    Reply; NO. IT DEPENDS HOW MUCH MONEY IS CHASING HOW MUCH GOODS.

  7. Posted March 11, 2008 at 2:20 am | Permalink

    Well I think the DOW and probably the FTSE are well and truly in bear market conditions now. I expect to see more falls over the course of the year, accompanied by enough volatility to burn the fingers of anyone who goes near shares or their derivatives hoping to profit from the conditions.

    I expect house prices to fall this year, and the pace of the fall to gather momentum. I expect more personal and corporate insolvencies and more reposessions.

    I expect New Labour to stick with the old plan of borrowing money, chucking it around the economy in the form of tax credits and pointless government initiatives and hoping nobody notices how much they've run up the national credit card.

    I expect the overall tax take to rise. There will be a round of taxes on all the things they can get away with taxing, such as alcohol and motoring.

    A keep hearing people say that in the second half of the year everything will get better, there will be loads of cheap blue-chips worth buying, house prices will be back on the increase and everything will be hunky-dory. I disagree, I think the next few years will be very painful for many people in the UK.

  8. Posted March 11, 2008 at 10:58 pm | Permalink

    John its good to see you have understood your basic economics.

    However Adam Smith lived and wrote TWON a long time ago.

    But you forget John that Adam Smith believed in sound money backed by a Gold Standard. Not the almost infinitely corrupted type of funny money we have had since the end of the first world war.

    There are other things that drive inflation now days apart from wars. Caused mainly by YOUR political class cooking the books. But also by other nations people not wanting to eat grass while working 90 hours for $30 a week forever.

    You may well be able to ignore inflation, like myself. But those who barely get though the week as it is, while working full time, may have a very different way of seeing things.

    The poor bastards were constantly told, that there would be NO MORE BOOM AND BUSTS. Very unfortunately too many of the silly buggers believed their Labour politicians and even more The Labour Parties obviously fascist British establishment Broadcasting Corporation.

    However as you most likely have noticed I hope, you Mr John Redwood MP are a Conservative politician. So why have you and your party not spent more time and effort for the last 11 years WARNING ordinary people that no more boom and bust, is literally IMPOSSIBLE under our present corporate capitalist system?

    Not just because Labour politicians are all a corrupt bunch of lying con men on a gravy train mission from hell.

    But because the people that run the worlds banking system design booms and busts to ALWAYS happen, as the primary way that they stay running the worlds banking system, not to say the entire world, very profitably.

    OK some of the minor league players lose vast amount of created borrowed money every now and again, but over time the big league players get it all back. Especially when the Tory party are allowed back in, for the the main purpose of paying off the bills.

    The people that lose are us THE ORDINARY PEOPLE, that actually produce ALL the REAL wealth, love and human compassion on the planet. It is us who's marriages, homes, small businesses, and futures, go down the river. It is us that are left down the creek without a paddle or even our own life raft. Not those of the political class, the ruling class, and certainly not your mates in the City of London.

    I will vote Conservative at the next election. But not because The Conservative party are any less part of the scam then the Labour Party, or indeed the Lib/Dems are. But because I know the bills have to be paid back one day, and the quicker the better.

  9. Posted March 17, 2008 at 6:59 pm | Permalink

    what is the inflation rate in the uk at this moment in time

    CPI about 2% RPI about 4%

  10. Posted March 29, 2008 at 12:25 pm | Permalink

    What I would like to understand is how much inflation is being stoked up by the rapidly easing money supply being generated by the central banks ? Is someone looking the other way ?

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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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