Tuesday, June 17, 2008

Inflation has risen above the 3% mark, and Bank of England governor, Mervyn King, will have to write a letter of explanation to the Chancellor of the Exchequer, Alistair Darling. Indeed, the increase, to 3.3% is higher than most pundits expected. It is not too difficult to find explanations, but it is somewhat harder to find fixes. As we all know, prices of oil and foodstuffs have risen dramatically owing to international conditions.

The policy tool that is available to the central bank is the headline rate of interest. Hiking the rate of interest reduces demand and so puts downward pressure on prices. The trouble is that the general condition of the economy is not one in which interest rate hikes are a particularly attractive option. This is because, by reducing demand, they would make a recession - which already looks to be more than a remote possibility - increasingly likely, and all the more severe.

Faced by the threat of both inflation and unemployment, government needs to use more than one policy tool. The obvious second tool to use is fiscal policy - interest rates could then be used to control inflation while raising the government's budget deficit could ensure that the consequences for employment and growth are not too adverse.

The problem with this is that the government's budget deficit is already large. Indeed, as a share of GDP, it is larger than that of any other major country except Hungary and Pakistan. The scope for extra borrowing to be effective is limited therefore. People would know that the borrowing would have to be paid back out of future taxes, they would start saving up for those heavier tax burdens, and the demand taken out of the economy by these extra savings would cancel out much of the benefit of the extra demand generated by the borrowing. That said, the government did recently inject an extra £2.7 billion into the economy as a means of defusing the political revolt over the abolition of the 10% rate of income tax.

A stronger candidate for second policy tool, as things stand, is for the government to operate directly on people's expectations of inflation. The price increases of the last year have been pronounced, but they will become truly inflationary only if wage settlements are raised in line with (or ahead of) the increases in prices. To keep inflation down, wage deals need to be kept at levels that are sufficiently modest to ensure that we do not enter a wage-price spiral.

I am not advocating an incomes policy here. Such policies have, in the past, tended to be ad hoc and so have typically failed after a couple of years. But there is much to be gained from senior and credible politicians stating the facts clearly. Prices have risen. This is because there are now more people competing to consume the finite supplies of oil, and there are more competing uses for the produce of agriculture. We can catch up with the purchasing power that we had a year or so ago by becoming more productive. We can't catch up by giving ourselves pay deals that just wind up pushing prices up further. In particular, a monetary policy that simply involves printing more money to accommodate inflation - repeating the mistakes of the 1970s - is (or at least it should be) a non-starter.

It's time for the politicians to talk tough reality.