The New Statesman recently declared: "The inflation hawks were wrong." ConservativeHome's The Deep End tried to excuse them, declaring: "The inflation hawks were wrong, but for the right reasons". But they didn't need any excusing, because they weren't wrong.
What are they accused of being wrong about? George Eaton in the New Statesman quotes Andrew Sentance saying, in early 2011: "if we do not start to raise UK interest rates gradually soon, we risk having to do so more aggressively in the future". Which bit of that has been proved wrong? The Spectator is quoted as saying: "Inflation is back with a vengeance…Britain is once again in an inflationary cycle…For how much longer can high inflation be described as a blip?" And that wasn't right because…?
The New Statesman seems to believe that just because inflation has momentarily dropped back to "only" 0.2 percentage points above target, that means there wasn't any inflation. But the policy index, CPI inflation, has not been below its 2% target now since November 2009. Twice in the past four years CPI inflation has reached 5.2% – not simply above target but so far about the previously-permitted 1% tolerance threshold around the target that they've redefined the target to abandon the tolerance threshold! Just since November 2009 – so in less than three years – the price level has risen more than 4 per cent more than it would have done had the inflation target been met. Since the old target of 2% +/-1% was first violated in March 2007, the price level has risen more than 6% more than it would have done had the inflation target been met.
We haven't yet degenerated to a 1970s inflation problem. But there's plenty of "problem inflation" short of having two years of the stuff at above 20%! Six per cent of extra above-target inflation, over four years, when the target itself is only 2% per year, is definitely a non-trivial sustained inflation problem.
Over the past four years, whenever the economy hasn't actually been contracting, inflation has gone to 5% and rising. Each time we had real-terms growth, prices rose until they choked that real-terms growth off. Then we went into recession, inflation fell back, and we started to grow again until the inflation rose once more and choked the growth off. The British economy is exhibiting classic stop-go symptoms.
This aspect of the problem is going to get worse before it gets better. To no-one's surprise except Ed Balls', the recession has ended for now. If the euro doesn't collapse, a bit of domestic growth might release some of those large corporate cash piles so companies catch up on their investment back-logs. We might even see growth accelerate (presumably after at least a little dip next quarter). But if not actually being in recession means inflation of 5%, imagine how much inflation we'll get if the economy starts motoring along at 3% per annum?
It's at that point we'll see the consequences of the Bank of England's loss of all inflation credibility. Credibility isn't a matter of people expecting inflation to be low. Rather, credibility is about whether people believe you will keep your promises even if it is painful.
In the late 1970s, policymakers had zero credibility – rather like the Bank of England today, only they not only had no credibility, but people also believed that inflation would be high and rising. When Mrs Thatcher said she would not u-turn, as politicians had done consistently in the decades before her, the workers didn't believe her. People often criticise the unions over this, as if they ought to have believed her. But why would they? Even if they'd believed she meant it herself, they would have expected her to be replaced by someone else that would u-turn. So when inflation momentarily fell back in late 1980, from 21.9% in May to 15.4% in October, the workers didn't think "OK – so inflation will now drop down to below 5%, so we'd better be careful not to demand too high wage rises, otherwise firms won't be able to employ us and there'll be unemployment." Why would they think that? Instead, they thought inflation would shortly be rising back again to exceed its previous peak, as had happened in inflation cycle after inflation cycle in the past. So, to protect their real wages from erosion by the inflation to come, they got a 22.6% wage rise in October 1980.
Inflation actually fell back to 3.7% by June 1983. Mrs Thatcher didn't u-turn. So those large wage rises left vast numbers of workers unemployable and they duly became, and stayed, unemployed.
This history teaches us an important lesson – gives us a warning – for what's to come today. If we get growth of, say, 3%, workers are going to want wage rises. Inflation expectations have consistently been well below actual inflation for the past four years. Workers didn't volunteer for nearly as large real-terms wage cuts as have happened over the past four years. Instead, they've been scammed by policymakers who persuaded them that inflation would be much lower than it's actually been, such that they've worked for lower wages than they might otherwise have accepted – this is one factor in keeping unemployment down.
When there is growth, workers will want to catch up some of the past wage losses they hadn't volunteered for, and to participate in greater prosperity along with their bosses, and to enable them to service their mortgages as interest rates rise, and to keep pace with inflation as it accelerates.
At some point, the Bank of England and the government will want to get inflation down. They made no effort whatever to try to prevent it from rising to 5% in 2011, so we can be confident they won't make any attempt to stop it from rising to that level in 2013/4. Interest rates will be held very very low, far below inflation, until inflation returns to that. At some point perhaps a little below or perhaps a little above that level they might try raising a bit – towards, say, 2% – but make no effort to raise rates to a level that would actually get inflation down. But eventually they will act. And when they finally do act, no-one will believe them. By then inflation will be racing away and workers, having repeatedly been burnt by above-target and above-expectations inflation for years, will be demanding above-inflation pay rises just to provide a buffer against the next up-leg in inflation. When policy finally does crack down on inflation, there's every chance workers will be isolated having achieved wage rises that, had they known inflation would truly fall this time, they wouldn't have demanded.
At that point, inflation will – as has happened so often in the past – be converted into unemployment. High enough unemployment and fierce enough interest rate rises will ultimately get inflation down. Doubtless someone from the New Stateman will write an article then saying that since inflation's back to 3%, that just goes to show that all the previous concerns about the risks of high inflation were over-blown. But whoever the government is will face the well-known political popularity that comes with having presided over rapid inflation and also a rapid rise in unemployment.
Good luck with that.