Inflation is only going one way. Let's hope interest rates don't follow | Larry Elliott

The question is not whether inflation will continue rising in 2017 but how high it will go. At least 3%, maybe even higher …

It seems so obvious. The Bank of England sets interest rates to hit the government’s 2% inflation target. Inflation is currently 2.3% and – despite holding steady in March – is certain to go higher over the coming months. Higher borrowing costs choke off inflationary pressure. Therefore interest rates should now be going up.

In reality, it is a bit more complicated than that. The first thing the nine members of the Bank’s monetary policy committee have to decide is whether the above-target inflation seen in the last couple of months is a temporary blip. It’s quite clear it isn’t. Food is going up, energy companies are raising their tariffs, retailers are passing on the higher costs of imports caused by a weaker pound.

Last month’s inflation figure was flattered by the timing of Easter, which led to a sharp fall in the annual cost of air fares. That one-off factor will be reversed in April. The question is not whether inflation will continue rising in 2017, but how high it will go. At least to 3% is the answer, perhaps a bit higher.

The next thing for the MPC to consider is whether there is a risk of inflation becoming entrenched. That would happen if rising prices led to workers successfully negotiating higher wages to compensate them for the hit to living standards. There seems little sign that inflation will feed on itself, as it did in the 1970s.

Paradoxical though it sounds, a combination of higher prices and stagnant wages is actually deflationary for the economy. That’s because living standards come under downward pressure, leading to consumers tightening their belts and companies investing less. The Bank doesn’t need to raise interest rates to bring down inflation. If it shows a bit of patience, inflation will come down of its own accord.

That is provided there is not another downward lurch in sterling, because that would further raise the cost of imports and push the inflation rate closer to 4%. If the MPC sat tight under those circumstances, the financial markets might decide that the pound was a one-way bet and carry on selling.

That would be the nightmare scenario for the Bank. Rising inflation would intensify the deflationary squeeze on living standards but make it nigh-on impossible to ignore the case for an interest-rate rise that would risk tipping the economy into outright recession.

So what does the MPC do? Simple. Members of the committee make hawkish speeches in which they explain how serious they are about hitting the inflation target. A couple of them even vote for a rate rise, in the hope that the pretence of an early increase in borrowing costs supports the pound. Meanwhile, the MPC keeps its fingers crossed and hopes for the best.

Productivity slump linked to research investment failure

The impact of the financial crisis that began almost 10 years ago is well documented. Banks made reckless decisions and some of them nearly collapsed as a result. Lenders became risk-averse and stopped lending. The lack of credit stopped the economy in its tracks.

The story of how RBS and HBOS teetered on the brink of disaster after the collapse of Lehman Brothers in the autumn of 2008 is by now familiar. Less well explained is the link between the credit crunch and productivity recorded since the slump. Output per worker in the UK is around 15% lower than it would have been had the pre-crisis trend continued, and nobody really knows why.

Maarten de Ridder, an economist at Cambridge University, thinks he has at least part of the solution to the productivity puzzle: companies that wanted to invest in research and development struggled to obtain funds from the stricken banks, resulting in a 32% fall in R&D investment in 2008-09, the years when the economy was in recession.

Innovation takes time to bear fruit so de Ridder – in a paper presented to the Royal Economic Society’s annual conference – compared sales in the US between 2011 and 2014 for firms that relied on the most credit-constrained banks and those that fared better during the financial crisis. He found that the most severely affected firms fell 12% behind those with the least exposure, with dramatic results for the wider economy. His results are even more relevant to Britain, where the post-crisis productivity slowdown has been even more pronounced. Had cash-starved UK firms been able to find the necessary finance, the economy would now be 5% bigger.

Britain’s R&D is, according to the latest official figures, on a gently rising trend so it may be firms that want funds for investment are now able to get them. But de Ridder says that in the event of another financial crisis the state should itself make credit available to ensure companies can carry on investing. That sounds eminently sensible.

Contributor

Larry Elliott

The GuardianTramp

Related Content

Article image
The Brexit economy: looming rate rise clouds outlook as inflation dips
‘The beast from the east’ blew the UK economy off course, further complicating an already complex picture

Richard Partington

26, Apr, 2018 @12:21 PM

Article image
British consumer keeps UK plc afloat as key sectors start to sink
As a no-deal Brexit looks increasingly likely sterling is starting a steep slide and growth is stalling

Richard Partington

31, Jul, 2019 @5:00 AM

Article image
Rising food and fuel prices hoist UK inflation rate to 2.3%
Standard of living fears build as wage growth slows and inflation leaps from 1.8% in January to highest level since September 2013

Katie Allen

21, Mar, 2017 @11:27 AM

Article image
How has Brexit vote affected the UK economy? July verdict
Each month we look at key indicators to see what effect the Brexit process has had on growth, prosperity and trade

Richard Partington

31, Jul, 2019 @5:00 AM

Article image
Brexit could lead to recession, says Bank of England
Central bank issues unprecedented warning over EU vote, claiming exit could depress pound and raise unemployment

Katie Allen

12, May, 2016 @5:18 PM

Article image
Bank of England warns households to expect sharp rise in inflation next year
Monetary policy committee predicts inflation will rise from 1.3% this year to 2.7% in 2018 and drops plans for further interest rate cut

Katie Allen

03, Nov, 2016 @6:15 PM

Article image
How has the Brexit vote affected the economy? March verdict
Each month we look at key indicators to see what effect the Brexit process has on growth, prosperity and trade in the UK

Richard Partington

27, Mar, 2018 @12:27 PM

Article image
Bank of England warns of one in three chance of Brexit recession
MPC votes 9-0 to keep interest rates at 0.75% as uncertainty drags down the UK economy

Richard Partington Economics correspondent

01, Aug, 2019 @11:14 AM

Article image
No UK interest rate rise but plenty of no-deal Brexit warnings
The Bank of England warning aims to focus politicians on getting a Brexit deal done. Project Fear Mk II might just work

Larry Elliott

01, Nov, 2018 @12:31 PM

Article image
UK households face squeeze after surprise inflation jump to 2.7%
Dearer autumn clothing ranges boost CPI to six-month high despite a forecast fall

Richard Partington Economics correspondent

19, Sep, 2018 @10:00 AM