Britain's inflation problem is only going to get worse

published 14 December 2010

The deputy governor of the Bank of England, Charlie Bean, said yesterday that inflation had been high "for an uncomfortably long time". The BoE's interest rate-setting committee is watching it "like proverbial hawks".

Well, they'll not be happy about the latest data. It seems that UK inflation just doesn't want to stick to the BoE's script.

This morning, we learned that annual consumer price index (CPI) inflation in the UK rose to 3.3% in November, from 3.2% the previous month. Retail Price Index (RPI) inflation generally viewed as a better 'cost of living' measure jumped to 4.7%, from 4.5% in October.

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And none of this shows any sign of changing soon.

What's behind the rise in CPI inflation?

CPI inflation hit an annual rate of 3.3% last month. That means that CPI has been above the BoE's central target of 2.0% for 12 months. Worse still, CPI has been at 3% or above for the entirety of 2010. That means that Mervyn King's typewriter has been taking a hammering with all the letters he's had to write to the chancellors (both Alistair Darling and George Osborne) this year.

What was to blame for the increase this time around? Well let's see. National Statistics reports that food and non-alcoholic beverage prices rose. There was a record rise in the price of clothing up 2% between October and November. And there was also a strong rise in the price of furniture, furnishings and even electrical goods.

Even those who believe inflation isn't going to be a problem are starting to get a little concerned. A note from Jonathan Loynes at Capital Economics points out that even core inflation (which strips out food and energy costs) remains stubbornly high at 2.7%, "way higher than the equivalent measures in the US and eurozone".

There are a number of issues here. Firstly, there are the things that are widely seen as temporary, such as sterling weakness, higher commodity prices, and rising taxes. But what if these issues aren't as temporary as the BoE would like to think?

China's inflation problem could soon be ours

China isn't exporting deflation any more as we can see by the rising cost of clothing. Bear in mind that the clothing part of the CPI basket hasn't, until this year, risen for more than a decade. That doesn't look like a temporary blip to me. That looks like a shift in trend.

And the Chinese don't seem to be inclined as yet to tackle their burgeoning inflation problem with any real vigour. Rumours that rates would be hiked over the weekend turned out to be incorrect Beijing settled for a tweak to the amount of capital that banks had to hold in reserve. China's monetary policy is its own affair of course. But if China doesn't tackle its inflation problem, it'll become our inflation problem.

As for taxes a rise in VAT might be seen as a temporary issue. But what if workers start to demand higher wages to compensate?

So far, the BoE has pinned its hopes on this nebulous idea of the 'output' gap. In essence, this is an estimate of the gap between the economy's actual growth and its potential growth. The idea is that, when demand drops during a recession, lots of people lose their jobs, and equipment is left sitting idle. So when demand recovers, there should be lots of spare capacity to pick up the slack, before you start getting inflationary pressures building.

But what if a lot of those people's skills and a lot of that equipment is simply obsolete? What if some areas of the economy are never coming back? Arguably, it'll be a very long time before we need the same number of estate agents as we did in 2006 / 07 for example.

According to one of the fund managers at our recent Roundtable discussion, many British manufacturers are now running up against skill shortages. They've rehired people who were laid off during the recession, and even backdated their wages in some cases.

The public sector may be about to feel the sharp end of the cuts. But private sector businesses who have survived this long are hoping to see a bit of light at the end of the tunnel. And staff at those businesses may well feel that they've put up with frozen wages for long enough.

Rises in living costs may act as a tax on consumers, which is of course deflationary. But once the fear of unemployment or redundancy passes, workers may well stop absorbing those costs, and start to demand higher wages to compensate. Particularly as corporate profit margins have been really quite healthy.

The BoE is clearly loath to act. But its resolve will be sorely tested in the year ahead. And as Loynes says, if inflation expectations start to pick up, the bank "may be forced to tighten monetary policy just as the biggest fiscal squeeze for decades is hitting the economy".

Is now the time to fix your mortgage?

That'd be good news for savers, and who knows? The broader economy might even be in a fit state to take the strain. But if you have a mortgage, my honest view is that it might be time to look at fixing your costs. Obviously if you have one of those dynamite cheap deals that were put in place before the credit crunch, you may still be better off sticking with it. But it's time to start thinking and budgeting as if the future for Britain certainly contains higher interest rates, rather than the threat of ongoing deflation. I can't guess at when it'll happen, but I do suspect it'll be sooner than most expect.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.