Inflation moves from novelty to normality
The period of falling prices and low inflation was novel but all good things come to an end: from now on it looks like business as normal as prices rise again. And why would any government or central bank want otherwise?
Inflation in the year to October rose from 1.1 per cent to 1.5 per cent, heading back towards the 2 per cent target for the consumer price index that the government has told the Bank of England to achieve. The RPI, which includes housing costs, has moved from September’s 1.4 per cent decline to a fall of just 0.8 per cent – almost back into positive territory.
The Bank governor has warned that inflation will not only return to the 2 per cent target but shoot through it, suggesting the Bank is no longer in control of prices. But the truth is, that while low inflation seemed a good objective in the 1990s after the previous decades of rapidly rising prices – more than 25 per cent a year at times – governments have a vested interest in high inflation.
Financing the rescue of the banking system and plugging the deficit between rising spending and falling tax revenues has meant the government taking on huge amounts of debt. The idea of state borrowing not exceeding 40 per cent of national income has been abandoned. But that debt must be steadily repaid, and by far the easiest way to reduce borrowing is by letting inflation erode it.
With nil inflation, £100 borrowed now costs £100 to repay in five years time; with inflation, the £100 repaid in 2014 will be worth only, say, £80 or £90 in today’s money. The higher the inflation the cheaper it is to repay the debt.
And not only government benefits. All borrowers, corporate or personal, will see the purchasing power of their loans fall as prices rise. Homeowners who stretch themselves to borrow £200,000 now will find the burden fall as their income rises. Freezing pay simply adds to the burden.
The Bank’s uncertainty about future inflation is no doubt because it is one of the biggest borrowers of all through its quantitative easing programme and it has borrowed this money from itself. QE means creating money and using it to buy bonds from clearing banks, but ultimately this £175bn will have to be “repaid” to the imaginary account it came from. That means reselling the bonds into the market.
QE is intrinsically inflationary. When recession was causing prices elsewhere in the economy to fall, the QE counter-effect could be absorbed, but now fuel prices and other commodity-led increases are causing inflation to rise again, the effect of QE is stoke an already glowing fire.
Higher inflation will lead to higher interests rates, but it will get the Bank and the Treasury off the hook. So why expect them to keep prices down?
