The Daily Telegraph
Bank policymakers must tackle inflation by slowly raising rates
The rate of inflation jumped sharply last month and is now back above the Bank of England’s 2pc target. We should not be surprised. Inflation is rising in major economies around the world. In the eurozone it has risen to 2pc from minus 0.2pc this time last year. In the United States, inflation is even higher than the UK – 2.7pc, again a big rise from the 1pc recorded just a year ago.
Higher energy and food prices are part of the story. But even if they are excluded, the UK CPI inflation rate has picked up from 1.2pc in February last year to 2pc, according to the latest figures. There is a more general rise in inflation taking place, and in the case of the UK it is being aggravated by the current weakness of the pound – which pushes up the prices of a wide range of imported goods.
The pick-up in UK inflation from 0.3pc to 2.3pc over the course of the past year is the biggest increase in a 12-month period since 2010. But then, a rise in the VAT rate – returning from its reduced level of 15pc back to 17.5pc – was an important factor. We have to go back to 2008, when the oil price nearly hit $150 a barrel, to find a bigger surge in inflation over the course of 12 months which was not influenced by tax changes.
Nor is this the end of the story. Further price rises are coming through the pipeline. Manufacturers are seeing an increase in the price of energy, commodities and components of around 20pc on last year. The prices of goods leaving UK factories are 3.7pc up on a year ago, the highest rate of increase since 2011.
Most economic forecasters expect inflation to rise to around 3pc by the end of this year and to remain relatively high through next year. PwC’s latest forecast is for inflation to average 2.8pc during 2018 – but inflation could easily be above 3pc in some months later this year or next.
The Retail Prices Index (RPI), which is still used as a reference point in many contracts and wage negotiations, is already 3.2pc up on a year ago. The old target measure of inflation used by the Bank of England until 2004 – RPIX – is even higher at 3.5pc.
So we are facing a significant surge in inflation which could persist for a number of years. The last time we saw a big drop in the pound in the global financial crisis, it took several years to feed through into inflation. Inflation peaked at over 5pc in the autumn of 2011 and then subsided over the course of the next few years.
The reaction of the Bank of England’s Monetary Policy Committee (MPC) at that time was to set aside concerns about the rise in inflation and to treat it as a temporary phenomenon. But the situation now is very different.
First of all, the jobs market is now much stronger than it was in 2010-11, when the unemployment rate was over 8pc. Unemployment is now below 5pc, the lowest level we have seen since the 1970s.
As I argued in last week’s column, we are close to full employment, with nearly the highest level of job vacancies we have seen this century. If immigration subsides due to Brexit concerns, that will reinforce the tightening of the labour market and add to wage pressures.
Second, the world economy now looks in much better health than it was in the early years of the economic recovery. This year, we are likely to see reasonably healthy growth in the three main regions of the global economy – Europe, North America and Asia.
The eurozone economy in particular is now looking in much better shape than in 2011. Economic growth in the economies using the euro was 1.7pc last year – the highest since 2010 – and is likely to continue at a similar rate in 2017 and 2018. As Europe is our largest export market, this is an important underpinning to UK economic growth.
Set against these positive factors, however, other influences are likely to dampen economic growth.
Uncertainty about Brexit already appears to be affecting business investment, which fell by 1.5pc last year, for the first time since the financial crisis.
Consumers will also feel the squeeze from the rise in inflation – and that is already evident in the latest retail sales figures.
UK economic growth is therefore likely to slow somewhat over the next couple of years – but the latest PwC projections still suggest that GDP will rise at around 1.5pc in 2017 and 2018. This will be disappointing relative to the period 2013-16 when the UK economy grew by around 2pc to 3pc a year, but it is still quite respectable in the post-crisis “new normal”.
This slowdown in economic growth should not therefore deter the MPC from doing its job – which is to take policy actions to keep inflation in line with the 2pc target.
The Bank of England is now forecasting a prolonged period of above-target inflation over the next three years. A major contributory factor to higher inflation is a weak pound. And the weakness of sterling partly reflects the market expectation that the MPC will be reluctant to raise rates and follow the lead taken by the US Federal Reserve.
It is time for the MPC to change these expectations and show it is willing to act to counter inflation by gradually raising interest rates.
If this is done slowly and carefully – as has been the case in the United States – it should not seriously dent economic growth. Instead, it might boost the credibility of the Bank of England and confidence in the UK economy, as well as taking some of the pressure off consumers by supporting the pound.
We are fast approaching the 10th anniversary of some of the key events of the financial crisis – the collapse of Northern Rock in autumn 2007 and the failure of Lehmans a year later.
Some action from the MPC to raise interest rates is long overdue – and the prospect of a sustained period of above-target inflation should spur the committee into action.
‘If done slowly and carefully – as has been the case in the US – it should not seriously dent economic growth’