This year’s economic headache – the rising cost of living
January 18, 2011
All the upbeat talk is of the UK economy being ‘out of the danger zone’. Credit is certainly due to the Chancellor for recognising the serious state of the public finances and setting out a long-term deficit reduction plan.
However, the sombre truth is that for so long as Central Banks maintain a virtual zero interest rate policy, UK and European economies will remain on a taxpayer-induced life support machine.
There is little sign of this changing in spite of dark inflationary clouds gathering. The Treasury and Bank of England are well aware that we are entering a very dangerous period. By rights given its express inflation targeting obligations, the Bank should already have raised interest rates well beyond 0.5% some months ago. Whilst it also has a less high profile duty ‘protecting and enhancing the financial system of the UK’, the inflation we are now witnessing comes as some of us feared as a direct result of the prolonged policy of Quantitative Easing (printing money).
At the end of last year Lord Young controversially observed that for the overwhelming majority the recession was ‘happening to someone else’. By contrast, nothing will bring home more to the majority of Britons that their own economic reckoning is underway than a marked rise in their mortgage repayments. The extra £20 or so taken up by the weekly shop or filling the car with petrol will be as nothing to the impact of rising interest rates and the cost of borrowing returning to normal. Remember this would already have happened if the Bank of England was obeying its inflation targeting responsibilities to the letter.
So the story of 2011 as the year unfolds will almost certainly be one of a rapid rise in the cost of living as both global commodity prices and taxation spike upwards. The cost of oil has been highly volatile in recent years, but the 50% rise in price over the past six months may prove more difficult to reverse. The exponential growth in demand from emerging economies (also affecting copper, steel, cotton etc.) may be compounded if political unrest in the Arab world spreads beyond Tunisia. Then there is a global shortage of wheat as a result of failed harvests in eastern Asia, whilst the effect, for example, of the Queensland floods on the price of iron ore, coal and other minerals will only be clear in the months ahead.
This impact will be compounded if interest (and mortgage) rates were to rise to ‘proper’ levels. Understandably policymakers are fearful both of stoking up inflationary expectations or choking off early signs of sustainable economic recovery if they raise interest rates.
The prolonged near-zero interest rate environment has enabled banks to continue holding toxic assets without realising their losses. Similarly there has been no incentive for banks to foreclose on many struggling businesses and indebted individuals. The impact of even relatively modest interest rate rises would undoubtedly be for creditors to cut their losses. The Council for Mortgage Lenders calculates that the impact on homeowners already perched on the edge of insolvency of a rise in base rate to 2.5% would be devastating to some three million borrowers. It would also lead to a confidence-sapping depression in both house prices (and more accurately still, house values, for those who have become accustomed to borrowing against the rising value of their main asset).
In truth, the continued failure to raise rates is an implicit recognition by the Bank of the underlying weaknesses of UK plc after three years of patchy or negative growth. Yet the political pressure to keep rates down may test to breaking point in the year ahead the independence of the Bank of England over monetary policy.
The coalition government’s policy of a dash for growth (another reason why the rapid rise in imported commodity costs is so worrying) reflects the fact that the deficit remains uncomfortably high, especially as tax receipts plunge. Indeed it now looks quite likely that we shall collectively borrow more in 2010-11 than in the final year of the Labour government. Moreover, in the first six months of the coalition government, current spending has risen by 7% year-on-year, such are the upfront costs of the radical reforms we seek to make to the public sector.
The key challenge now is to tackle inflation without adversely choking off growth or economic confidence. As you may have gathered from the foregoing, I believe that in current circumstances it is impossible to see how we can achieve both.
But I am also pretty confident that the Treasury and Bank have made their choice. Despite its effect on savers and those on fixed incomes, my prediction is that interest rates will not stand higher than 1% by year-end. The calculated gamble by policymakers is that a little inflation in the system is now more desirable than the alternatives.
History teaches us that once in the system, inflation is difficult to control.
The Treasury has skilfully succeeded in persuading the markets of the government’s intent to control the deficit, in spite of public spending projected to be higher in 2014-15 than in the last financial year. If there is any element of Gordon Brown’s legacy that is worth emulating it is his record of consistently low inflation (admittedly achieved in far more benign economic conditions).
The financial markets may soon need convincing of the resolve to keep the cost of living down, especially as the biggest beneficiaries of inflation are debtors…..and government is the biggest debtor of them all.