Readers of this site will know that I have disagreed with the analysis and policy of the Bank of England ever since I set the blog up. I have watched them lurch from too easy to too tight and then back to super easy. Current policy was bound to produce high inflation by western world standards. The combination of printing money and setting official interest rates at 0.5% was bound to give us what we now have.
There are two official explanations for RPI inflation at 4.7% and CPI inflation at 3.3%. They tell us retrospectively that it is the result of the fall in the pound last year, and they tell us it is the result of rising world commodity prices. They point out that inflation may get worse before it gets better because the VAT rise kicks in in January. All of these items are said to be temporary or one-offs which we should not worry about. The world, they suggest, is really deflationary underneath.
That is not the world I see around us. Asia and Latin America are experiencing strong inflationary pressures. Indian inflation is around 8%, and the official figure of around 5% for China probably understates what is going on in the shops. High and rising inflation in the faster growing parts of the world create price increases within the world supply chain, and spills out into western markets through price increases for traded goods and components.
There is plenty of asset price inflation around, though the Bank usually turns a blind eye to that. Commodities, fine wines, art works, shares and even properties in the main centres are all on the rise. There is plenty of cash around in the hands of the successful global entrepreneurs, amongst the newly rich business classes in China and India, and in the hands of oil oligarchs. Gold and silver prices reflect investor wishes to hold an inflation hedge as well as conspicuous consumption in the jewellery shops.
The Bank holds to the view that because the UK economy lost a lot of output in the slump, there must be plenty of spare capacity around now. So, they argue, there cannot be price inflation as companies will wish to fill their factories and offices before they put prices up. This is the biggest misunderstanding they seem to have. Talk to almost any industrialist and he will tell you his company is having a good year. Final demand has picked up from the low levels of 2008-9, and there has been strong demand to restock.
During the slump in the UK manufacturing laid off a lot of labour and closed more factories. Companies did not have the cash to carry on spending on new mahcinery. There is much less spare capacity around than the Bank thinks. Businesses are held up for shortages of skilled labour, for lack of specialist materials and components, and for delays in the supply pipeline from Asia. Global businesses are affected by the inflationary pressures on the other side of the world. Many UK companies decided to take some or all of the benefit of lower sterling in form of higher margins rather than higher volumes, keeping prices up.
The government’s decision to switch public sector index linking to CPI from RPI has so far worked to cut the public sector cost increases, leaving those who will receive less feeling bad about it. A better solution for the government is to encourage the Bank to get inflation down to target or below. As I have often argued, given the public spending pattern set out for the five years of this Parliament, we cannot afford much inflation. If we could get to zero inflation in the public sector then we could preserve all valuable public services without cuts. It will not be possible to get public sector inflation down to zero and keep it there if general inflation is going to continue in the 3-5% range.
So what does the Bank have to do? It needs to reassure us all that there will be no more quantitative easing. US QEII seems to have gone straight into commodity and asset price inflation. China thinks the US policy is destabilising its efforts to curb its credit and inflationary pressures.
The Bank also needs to take heed of the rising interest rates for government bonds which the markets are now imposing. The official 0.5% rate is looking increasingly detached from market realities. No-one in the private sector can borrow for anything like 0.5%, and savers are increasingly angry that the returns on their money are so far below the inflation rate. Even the government now has to pay well over 0.5% for its money for any sensible time period. The monthly ceremony to settle the rate is no longer commanding the markets or informing lenders and borrowers how to price their transactions. It is time for a reality check in Threadneedle Street.