The high-wire inflation act

Inflation has come in significantly higher than expected. No crisis yet, but it’s a window on a complicated world of post-election monetary policy. At 3.4 per cent it was last month well above target, but we are still told that this is a temporary ‘blip’ caused by the remnants of the VAT rise, and fuel prices, and a weak sterling amongst other things.

The Bank of England will “look through” these accelerating prices and not yet start to raise interest rates from their record lows. However, the longer the Bank of England tolerates higher-than-target inflation, the greater the risk that its inflation-busting credibility is undermined.

There is some evidence of inflationary pressure building up in the world economy. Steel prices have surged and energy prices are a wildcard. The rise in the petrol prices to record levels is very real for millions of drivers. If, as many economists suspect, VAT is likely to go up, then there is another significant upward pressure on the inflation numbers.

A question in the markets is whether a period of slightly higher inflation is being tacitly accepted by the Bank of England to help the economic adjustment.

It is a strategy suggested by the IMF chief economist, which was rejected in an important speech by Deputy Governor Charlie Bean.

The Bank of England vehemently deny they are any less intolerant of inflation, there are sound economic reasons to look beyond the current high inflation rate. We will see some of this when the minutes for their latest decision are released tomorrow. But it’s not just rate rises, there’s also the challenge of reversing quantitative easing, something I referred to as quantitative tightening.

“Early policy tightening is likely to be required to stabilise market expectations and re-establish inflation-fighting credibility,” says Simon Ward, economist at Henderson, pointing out that market expectations of inflation have crept up half-a-percent since February.

Almost everybody I talk to in banking or economics believes that Britain’s day of reckoning for a decade of over-indebtedness will come when rates start to rise. The first time buyers that the government want to tempt back into the market on “bargain” tracker rates of 4.5 per cent — well that equals base rate plus 3.99 per cent, and I wonder how many of those guys are stress-testing their finances against a mortgage rate of 8, 9, or 10 per cent.

But what about savers? High inflation means that savers need to find deposit rates of between 4-6 per cent just to keep the value of their savings from being eroded. And then there are the ‘savers’ who are lending money to our government to fund the deficit.

Even a moderately enduring period of higher than average inflation can serve to erode the value of gilts, i.e. help the government to inflate some part of our national debt away.

From what I hear from the people who will buy government debt, they fear this far more than perceived risk of a hung parliament equivocating over spending cuts. So it’s a high-wire act for Mervyn King over the next two years. Today’s inflation figure means that act got a little higher.