Now we must pay for the great inflation deception

Published on Saturday 12 January 2008 16:20

A BRUTAL truth of economics is that policy choices range from the unpalatable at one extreme to the downright painful at the other. This should not mask a more brutal truth that this present paucity of choice stems from a deception of our own making and which we seem determined to sustain.

The proximate cause of the problems that confront the economies of both the US and the UK has been a prolonged period of excessive borrowing funded on low interest rates that were unsustainable. As the credit bubble burst and banks have been forced to rein in borrowing, both the UK and US face an economic slowdown that looks increasingly likely to turn into recession.

But since excessive borrowing was the problem (remember all that anguished hand-wringing over Britain's 1.3 trillion personal borrowing mountain?), lower interest rates – the means by which this excess was encouraged – can hardly be credibly advanced as the solution. Yet this is exactly what central banks are now under pressure to do. As banks are faced with mounting defaults and crippling loss provisions – Merrill Lynch alone is now set to write off no less than $15bn stemming from wrecked mortgage investments – the lending taps are being turned off, household and business borrowing are being squeezed and the slowdown is increasing in intensity. Central banks must be seen to be doing something, even if lower interest rates may not in fact 'fix it'.

The dilemma is that the immediate fear of recession is now set to override the longer-term fear of re-inflating the credit bubble. One worrying consequence of this is that confidence is hard to re-establish, however much central banks cut interest rates.

For existing borrowers, the income freed up by lower borrowing costs is now more likely to be saved than spent. So the stimulus effect of lower interest rates may prove more muted than hoped. Rates may then have to be cut dramatically. This can result either in little effect (as in Japan from 1989 after the collapse of property prices) or an inflationary spending and borrowing wave. This is broadly where we are now caught.

Nowhere is this sense of entrapment more keenly felt than in millions of households. Income, faced with intensifying pressure from higher prices (foodstuffs, oil, energy and heating bills), is being squeezed. Now there is a reduced ability to borrow out of this squeeze, spending is cut. Little wonder retailers are squealing.

Yet the surprise is less the sudden onset of this squeeze than that consumer spending growth has held up for so long, looking at the way in which inflation and taxes have been eroding households' spending power. Between the first quarter of 2006 and the third quarter of 2007, real household income grew at a quarterly rate of just 0.4%. But at the same time real household spending increased at an average quarterly rate of 0.9%.

How this was bridged – the resort to ever-higher levels of secured and unsecured lending – tended to obscure the most unpalatable fact of all: that this pace of growth in consumer spending was unsustainable. And given that domestic consumption accounts for some two-thirds of UK GDP, the entire basis of the UK's economic expansion of the past five years, and with it the growth of Government tax revenues and Government spending, the core claim of the Brown chancellorship to prudence and stability has now come to look quite the opposite.

Indeed, it has spent to the hilt, with borrowing ceilings now in danger of being breached, and with nothing in reserve to cut taxes in a downturn. The Chancellor's cupboard is bare.

But why did the penny not drop sooner? A major contributor to this illusion of sustainable growth has been the setting of an inflation target for interest rates consistently below the level of real inflation in the economy. It is a truth universally acknowledged by every household in Britain that real-world inflation – what we experience in our shopping basket, utility bills, taxes and service charges – has been running consistently higher than the 'doctored' official measure of the Consumer Price Index (CPI). There's real-life inflation, and inflation as the Government defines it, which strips out the effects of central government and council taxes and housing costs.

Currently, this official measure of inflation is running at 2.1% – close to the target level of 2%. But the All Items Retail Price Index is running at 4.3%. Some credible measures of 'frequent purchases' inflation suggest a level even higher, at close to 6% – not at all improbable given that food inflation is running at 5.3%, housing items expenditure at 9.9% and fares and travel costs at 4.8%.

Everyone was a winner, for a time, in the great inflation deception. Households were able to borrow at interest rates lower than they would otherwise have been. Mortgage costs were kept down. The Bank of England was more able to hit the less-demanding CPI target. And the Government basked in the illusion of prosperity and stability. That long era of uninterrupted growth was built on an illusion that was unsustainable.

Today, with food price inflation, higher utility bills and petrol costs continuing to hit consumer pockets, inflation is well above the 'doctored' rate and biting into spending power. The 'solution' – lower interest rates – may well cushion this squeeze and prevent the onset of recession. But it is a weapon of enfeebled power and runs the risk of adding to inflation pressures. And there is little that interest rate policy can do to abate price pressures arising from China (which has turned from an exporter of deflation to an exporter of inflation) and a falling pound.

Indeed, the pound now looks like the new dollar: the more that interest rates are cut, the further the pound is likely to fall, and this on top of the 10% decline in its trade-weighted index since the summer. A lower pound drives up the cost of raw materials and finished consumer goods, adding to the very inflation that the Bank is seeking to combat. So the Bank delays on those rate cuts and gives the unfortunate impression of dithering as the property, retail, financial and house-building sectors look increasingly set for recession.

Little wonder that on the economic gauge, the needle is starting to move from the unpalatable to the painful. But let's hear less about the British economy being hit by unexpected events beyond our shores. It is time to face a telling if uncomfortable truth: we have been caught out in a deception of our own making, for which we have ourselves to blame. Some of the pain is a necessary cure, and the touted remedy – lower interest rates – does not address the underlying problem of unravelling credit risk. This is going to take a lot of time to sort out, and pain to absorb.