Britains inflation problem Talk by Dr.

Andrew Sentance, member of the Monetary Policy Committee

On the 28th of February 2011, Dr. Andrew Sentance, a member of the Monetary Policy Committee since 2006, delivered a speech on what has recently become a growing preoccupation, namely inflation. The Consumer price index has risen by 4% in January 2011, largely exceeding the 2% target rate and any previous forecasts.

Though on the 23rd of February the MPC decided not to raise the interest rates from the historically low level of 0.5%, three members disagreed with such a decision and Dr. Sentance is one of them. On the 28th of February, he decided to tackle the question organizing his speech around three main topics: Why has inflation been so high? Outlook for UK growth and inflation Implications for monetary policy According to Dr. Sentance, inflation has been so high for five main reasons. Firstly, there are the increased global pressures. Whereas the price of the oil barrel was $40-50 in 2009, in 2010, it largely remained over $100 averaging $111 nowadays. Of course turbulences in the Middle East cannot be overlooked, but other commodities prices show the same pattern: coffees price, for instance, has reached a 14 years peak and cottons price is the highest ever recorded. The drivers of these increases are the emerging markets of the East, and particularly the G7, which includes China, Australia, Indonesia, India, Japan, Korea and Taiwan, where growth of GDP is now averaging 7% per annum. Recovery is underway in the USA with a 3% growth last year, as well as in Europe with its 2% growth. What strengthens the argument is that inflation is not a British problem. In India the figure is 10%, in China 5%, in Brazil 7% and a relatively lower 2.3% for Europe. One might then ask why Britain has been more vulnerable than other European countries. The answer is that the share of trade for Britain is over 60% of GDP, whereas the figure is only 30% for the European Union (considering imports and exports into and out of the union). More open economies than Britain, such as the Netherlands and Singapore have only done better in terms of inflation by maintaining relatively constant exchange rates. Here we come to the other reasons of high inflation: the decline in the value of the pound, the recovery of the UK demand, and a benign pricing climate. Over the past 2-3 years, the effective

exchange rate has fallen by 22-23%, and we have to go back to the Great Depression, when Britain abandoned the fixed exchange rate, to record such a sharp decline over 2-3 years time. Dr. Sentance criticized the preference of the Bank of England not to pronounce itself over the currency in order not to influence the exchange rate; he argued that the currency, being an important component of the monetary transmission mechanism, shall become one of the key focuses of monetary policy if we are to succeed in curbing inflation. The latter, according to him, is not the result of VAT increases. On the contrary, he believes that British demand has not weakened and the - 0.6% figure for the last quarter of 2010 is due to the snow effect, as well as inevitable fluctuations of a recovery. The Bank of England actually has done everything needed and a lot more if compared to previous recessions, in order to bounce the economy back. It decreased interest rates from 5% to 2% and then to 0.5% and is still keeping them at this extremely low level for the 23 rd consecutive month. Now that the recovery is taking place, inflation is becoming a problem because it decreases the confidence in the money value, increases uncertainty, price expectations, nominal interest rates, as well as squeezes living standards and raises costs to the businesses, which they in turn pass on to the consumers. Indeed the difference between the percentage of firms saying they are going to increase their prices and that saying they are going decrease them, a measure of price expectations, is 30 for 2011, whereas it was - 20 in 2009. The last argument put forward by Dr. Sentance was that the output gap, i.e. the difference between what the UK is actually producing and its potential, is relatively small compared to previous recessions. In other words, there are not many spare capacities in the economy. 800 companies, surveyed by Bank of Englands agents, declare operating close to a normal capacity utilisation in 2011, whereas in 2009 they stated their capacity utilisation was 4 points below the normal level. Moreover, unemployment is at 7.9%, which is surprising in the context of such a deep crisis. There is less pressure on wage increases in the public sector because of the expenditure cuts, but in the private one pay increases for 2010 range between 2.2% for BMW and 5.2% for the Network Rail. The question is then whether this inflation is a temporary or a persistent phenomenon. Dr. Sentance said what will influence the level of inflation in the future is: on the one hand the strengthened global recovery, the increased British demand, and on the other hand the fiscal consolidation and the VAT increases. However he added that given increases in investment, consumption, and world GDP, the British economy shall be able to withstand the latter two. Looking ahead, inflation is forecasted to remain above 4% for 2011 and then to return to 2% in 2012. In terms of growth, IMF forecasts 4.4% growth for the global economy and 2% for the UK. Given all the reasons outlined above, Dr. Sentance concluded that inflation is inflation is inflation no matter what its causes, and the duty of the BoE is to sustain stable prices in the economy, what it shall do by gradually increasing interest rates. This was an extremely interesting talk by a leading personality, with many figures and explanations of the current UK situation. Nevertheless, I have some objections that I shall now present to the reader. I believe that the British main problem is not as much inflation per se, as the fact that it is currently in a liquidity trap. Having listened to an interview by G. Osborne, the Chancellor of the Exchequer, I think there is deep misunderstanding of the problem. He said that what the British Government can do to help the independent Bank of England to tackle the inflation problem is to deal with the budget deficit in order to give the former the space to keep interests lower for longer. But the problem is that despite these low interest rates, investment has declined by 2.5% over the last quarter, the economy is still sluggish, confidence is low and to many economists, increased government expenditure seems to be the only positive growth driver (James Knightley) that could boost the economy and stimulate the animal spirits. However, what the Government actually does is to

announce spending cuts, and increases the VAT from 17.5% to 20%, thus adding to the inflation when we clearly do not need it (Brendan Barber). CPI increased from December 2010 to January 2011 by 0.1%. This is the first time since recordings began in 1997 that such a pattern occurs; indeed inflation usually falls in January because of sales and the end of the Christmas period. The only plausible explanation I see is the increase in VAT on the 4 th of January. Furthermore I would not be as optimistic as Dr. Sentance about the recovery of the British demand. As prices rise, the living standards are eroded and coupled with austerity measures such as education spending cuts, a growing anger is emerging. Though the overall unemployment rate is 7.9%, the youth rate has reached a peak of 20.5% since 1992. Those employed feel more job insecurity and unfairness seeing their purchasing power shrink. I agree with Dr. Sentance that increased interest rates will strengthen the pound. However this may be unfavourable to exports. Indeed we had a net trade deficit in the last quarter of 2010 despite the depreciation of the pound: imports grew at 3% versus 2.3% for exports. Wont an appreciation of the pound worsen the situation? Last but not least, Dr. Sentance has argued that inflation was largely due to an increased demand coming from emerging global markets, as well as increased fuel prices. In this context I think that raising interest rates may penalise British consumers, particularly those who have mortgages, while not alleviating enough the problem of inflation. Even Mr King accepted that the latter was due to factors beyond the Banks control.