George Kerevan: Inflation looms large on horizon
Changing the remit of the Bank of England could be a signal that high price rises will be returning to a shop near you, writes George Kerevan
Wednesday’s Budget was small beer – fiscally speaking – down to the pathetic cut of a penny in the price of a pint, as a sop to ex-Tory Ukip voters. As he has said often enough, the Chancellor is not for turning. However, there was one revolutionary aspect of the Budget – the decision to change the remit of the Bank of England regarding inflation.
Do you remember inflation? Probably not, if you’re under 30. Back in the 1970s, when America was printing dollars like confetti, and the UK banking system was near collapse – it’s a regular occurrence – we had spectacular inflation. For the years 1974, 1975 and 1976, prices went up 24 per cent, 16 per cent and 17 per cent respectively. Compounded, that means your savings, pension or salary declined by a massive two thirds in real terms. The Cypriot bank levy has nothing on this.
We had another round of inflation after Chancellor Nigel Lawson got his sums wrong in the late 1980s. Prices went up by a fifth between in 1989 and 1990. Again, if you were a student or OAP on a fixed income, or if your wages were not going up in line with inflation, you suddenly got much poorer.
After that, governments decided to get inflation under control. Not that politicians dislike inflation: it has the wonderful side-effect of reducing the real value of government debt, meaning they can borrow even more to bribe the voters. However, uncontrolled price rises send the financial system into chaos: workers strike for higher wages, the currency gyrates and firms stop investing because they can’t calculate the future value of anything.
So in 1997, Chancellor Gordon Brown gave the Bank of England the job of curbing inflation free from interference by politicians. Unfortunately, the brooding Mr Brown came to regret giving away this power and lent heavily on Mervyn King, the Governor of the Bank of England, to keep interest rates lower than they should have been. This produced the financial bubble of 2003-2008 – in other words, asset inflation – that subsequently exploded, creating the mess we are now in.
In 2009, something happened we had not seen since 1933 – prices actually went down, as the economy imploded. In response, the Bank of England (with the connivance of the Treasury) started to print billions of pounds and use them to buy Government debt at an artificially high price. Cutting a complicated story short, this gives George Osborne ready cash and, at the same time, keeps official interest rates artificially low.
These low interest rates are bad for savers but good for small firms and mortgage holders. Without them, the big banks would probably collapse under the weight of bad debts. But it is an economic house of cards that will collapse some day unless – magically – growth reappears. But, as we know from the new forecast from the Office for Budget Responsibility, growth is not on the horizon.
So, on Wednesday, George Osborne changed the official mandate of the Bank of England. Henceforth, the Bank is responsible for promoting economic growth as well as curbing inflation. It will now be free to make “trade-offs” between curbing inflation (through higher interest rates) and promoting growth (through lower interest rates). And the Chancellor now has someone to blame if growth does not appear.
The flaw in this clever scheme is that the Bank has already been making this inflation-growth trade-off, with little impact on the economy. The Bank is supposed to hold inflation at 2 per cent, yet prices have been accelerating faster than that for four years. Prices are going up because interest rates are artificially low to stimulate growth. The Chancellor and the Governor know this. But so do the financial markets.
Here is the dilemma. As long as Mr Osborne and Mervyn King pretended that the Bank was the goalkeeper against inflation, the markets could pretend that price rises were only temporary and so ignore them. Now, by publicly changing the Bank’s remit, Mr Osborne runs the risk that the markets will conclude he is willing to tolerate higher inflation in the long run. But if the markets conclude inflation is here to stay, hold on to your hats. Investors will only lend to the government (or firms) if they get increased interest rates to protect them from runaway inflation. That will put the final damper on any return to growth.
There are good reasons to broaden the Bank of England’s remit. Other central banks – the US Federal Reserve, for instance – have both price and employment targets. However, Osborne has chosen to make this change precisely at a time when it is obvious he prefers growth to price stability. He went out of his way to hire Mark Carney as the new Governor of the Bank of England. Carney is known to be a growth man. All this points to Mr Osborne being willing to see inflation rip. Note that the only other big thing in the Budget was a scheme whereby the government will underwrite £130bn of private mortgage loans. That helps folk to buy houses, which is good. But it will also drive up house prices, which is inflationary.
True, higher inflation might have beneficial consequences. By eroding the burden of debt, it could boost consumer spending. However, I suspect the negatives will outweigh the positives. After five years of austerity, higher inflation will likely stimulate wage demands. It will also drive down the pound as investors flee overseas where the value of their money is not being eroded. That will send the cost of imports sky high, curbing consumer spending and killing recovery.
One City trader responded to Wednesday’s Budget in apocalyptic terms: “The new BoE remit changes consolidate the current mix of tight fiscal and loose monetary policy, the classic death knell for any currency.” Let’s hope he’s wrong. But the jury is out on whether George Osborne’s Budget was merely boring – or else harbinger of the return of the inflation monster.
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Wednesday 19 June 2013
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