Jeremy Beckwith: Bank is having to cope with 'wrong sort of inflation'

Central banks may be about to use the same sort of excuse for inflation rates in the UK and Europe which are above the targets set for them. One would expect some rather more opaque language than "the wrong sort of inflation" from central bankers, but it would be a fairly accurate description.

For the past 25 years, central bankers in the US, the UK and Europe have been very successful in their policy actions when they have wished to reduce inflation. Over this period, the global expansion of free trade and the opening up of the Chinese and Indian labour markets to multinational companies have produced structural downward forces on the rate of inflation. Occasionally, the credit-fuelled western consumer has been so desperate to consume that global demand for consumer goods and services ran ahead of global supply and prices moved up at a rate which alarmed policymakers.

At such times, 1989-90 and 1999-2000, interest rates were raised, reducing the disposable incomes of those on floating-rate mortgages, and so forcing them to reduce their consumption and allow the forces of demand and supply to come back into balance. At which point the rate of inflation fell back, usually to lower levels than had existed in the previous cycle.

Central bankers could then reduce interest rates again until the next imbalance occurred. The crucial part of this process was that the policy tool of interest rates used by central bankers acted directly to mitigate the inflationary cause, namely excess consumer demand.

Turn now to the present day and the concerns about inflation in the UK economy.

The cause of the inflation is clearly not excess consumer demand, rather it could be argued that the UK economy has insufficient consumer demand. Today's inflation is caused by two factors, government taxation policy and rising commodity prices. UK CPI inflation excluding indirect taxation is currently running at about 2 per cent - in line with the target for the monetary policy committee, compared with the actual CPI inflation rate of 4 per cent - the difference is essentially the increases in VAT from 15 per cent to 17.5 per cent last year and to 20 per cent this year.

This was part of the UK's fiscal consolidation, which consists of 80 per cent spending cuts and 20 per cent tax increases. Had the government chosen to increase income tax instead of VAT, then this tax increase would not have had any effect of the inflation rate (it may even have reduced it).

The next most significant effect on the rate of inflation has been the oil price, which began 2009 at about $40-odd per barrel and has since risen steadily to the current $100 or so per barrel.This causes significant and unavoidable cost increases in the economic value chain both as a direct energy input and also for transporting goods from producer to consumer.

In economist parlance, we are witnessing "cost-push" inflation now rather than the "demand-pull" inflation of the last 25 years - and the interest rate tool that the central banks have is very effective for the latter but works as a very blunt instrument on the former. After all, raising interest rates is not going to change government tax policy or the globally-determined oil price.

Indeed, raising interest rates to deal with this sort of inflation will hurt consumer incomes in the same way as previously and probably lead to an economic downturn, which will tend to bear down on inflation, but the government could decide to raise VAT further and the oil price could continue to rise which would leave the inflation problem unsolved.

This is a tough time for central bankers - in the US they are criticised for being too loose, in Europe for being too tight and in the UK for not forecasting government tax policy and the oil price, and yet they all have interest rates at historic lows.

• Jeremy Beckwith is chief investment officer at wealth managers Kleinwort Benson.