Stop worrying about inflation

It will go away but the danger of deflation remains.

It still looks a little early to me for the majority to swing and it would bring down a torrent of criticism on the Bank's head. But if not this week, then May, when the Bank will have the benefit of first-quarter GDP figures as well as other data, is beginning to look like a racing certainty.

A rate increase in May, when the Bank of England's Monetary Policy Committee produces its next inflation report, is looking like a given, says David Smith* in the above quote from his Sunday Times column (£).

For that to happen, there would have to be a major turnaround in the economy, which does not look likely, to say the least. The problem is that consumer and business confidence has collapsed, net trade is still negative, unemployment is rising, youth unemployment is on course to hit the million mark along with falling house prices and growth was negative in the fourth quarter.

I agree with Smith, though, that there will not be a rate increase this week.

With the economy in its current state, such a move would be a disaster and would likely have to be quickly reversed, perhaps even by the Chancellor with his powers under the Bank of England Act. Far from enhancing the MPC's inflation-fighting credibility, as the MPC members Martin Weale and Andrew Sentance have claimed, there is every possibility that such a move would be a death sentence for the MPC.

Keeping rates down as low as possible and hoping and praying and crossing all of his fingers and his toes that the MPC will do more quantative easing is Osborne's only plan B. A rate increase would mean he -- and probably the coalition -- would be finished. (May, by the way, is Sentance's last meeting and Osborne is unlikely to renew him or replace him with another hawk.)

The Bank of England governor, Mervyn King, has it right. The MPC needs to focus on the inflation that it is able to impact. Contrary to what Sentance has been foolishly claiming for months, inflation today or next week or in six months time is completely irrelevant for this week's MPC decision because it takes interest-rate adjustments about 18 months to feed their way through. The current inflation forecast of the MPC is overly optimistic and may well get revised down this month in light of the bad GDP numbers. Even with that forecast, inflation is well below target. Any rate increase would, in all likelihood, push the economy to deflation. The MPC's new inflation forecast, out next week, will show that inflation will be below target at the forecast horizon.

I have considerable sympathy with Professors Arestis and Sawyer, who argued, in a letter to the Financial Times last week, that the inflation we are experiencing has not been caused by excessive demand and that it would be nonsensical to reduce demand to "solve" it. They wrote: "It has long been recognised that, at best, interest rates by pushing down demand could address demand-push inflation and that they would be helpless in the face of cost-push inflation. At the present time, demand is still low in the UK and clearly significantly below capacity. The pressures on inflation are coming from higher world oil and food prices, value added tax and other tax increases and delayed effects of depreciated exchange rate. It is then clear that raising interest rates has no role to play in bringing down inflation." "No role" may be a bit strong but they make a good point.

I would go one step further and argue that the whole idea of targeting CPI inflation has failed. At the very least, the MPC's mandate should be extended to include growth and employment. The inflation measure should include house prices or could just simply be raised to 4 per cent. As I have said many times, happiness research shows that unemployment hurts people much more than inflation, especially now.

Inflation is going to collapse in 2012 when the impact of the one-off increase in VAT, oil and commodity prices and the exchange-rate depreciation mechanically drop out of the inflation calculations. As Mervyn noted in his recent speech, these three items alone account for 3 per cent of the current 3.7 per cent CPI inflation rate.

Inflation is going to go away because of the big output gap in the economy, simple as that. The danger of deflation, however, remains. Unemployment is rising and unless things improve quickly, any increase in rates would send the economy into a downward spiral as the effects of the VAT increase and spending cuts hit home. In all likelihood, Adam Posen is going to prevail and, by the summer, the MPC will be forced to do more QE. David Smith's racing certainty is likely to fall at the first fence.

*By the way, David, what ever happened to your building skip index? Presumably there aren't many around since the house price crash and the lack of availability of credit.

David Blanchflower is economics editor of the New Statesman and professor of economics at Dartmouth College, New Hampshire

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Will Euroscepticism prove an unbeatable advantage in the Conservative leadership race?

Conservative members who are eager for Brexit are still searching for a heavyweight champion - and they could yet inherit the earth.

Put your money on Liam Fox? The former Defence Secretary has been given a boost by the news that ConservativeHome’s rolling survey of party members preferences for the next Conservative leader. Jeremy Wilson at BusinessInsider and James Millar at the Sunday Post have both tipped Fox for the top job.

Are they right? The expectation among Conservative MPs is that there will be several candidates from the Tory right: Dominic Raab, Priti Patel and potentially Owen Paterson could all be candidates, while Boris Johnson, in the words of one: “rides both horses – is he the candidate of the left, of the right, or both?”

MPs will whittle down the field of candidates to a top two, who will then be voted on by the membership.  (As Graham Brady, chair of the 1922 Committee, notes in his interview with my colleague George Eaton, Conservative MPs could choose to offer a wider field if they so desired, but would be unlikely to surrender more power to party activists.)

The extreme likelihood is that that contest will be between two candidates: George Osborne and not-George Osborne.  “We know that the Chancellor has a bye to the final,” one minister observes, “But once you’re in the final – well, then it’s anyone’s game.”

Could “not-George Osborne” be Liam Fox? Well, the difficulty, as one MP observes, is we don’t really know what the Conservative leadership election is about:

“We don’t even know what the questions are to which the candidates will attempt to present themselves as the answer. Usually, that question would be: who can win us the election? But now that Labour have Corbyn, that question is taken care of.”

So what’s the question that MPs will be asking? We simply don’t know – and it may be that they come to a very different conclusion to their members, just as in 2001, when Ken Clarke won among MPs – before being defeated in a landslide by Conservative activists.

Much depends not only on the outcome of the European referendum, but also on its conduct. If the contest is particularly bruising, it may be that MPs are looking for a candidate who will “heal and settle”, in the words of one. That would disadvantage Fox, who will likely be a combative presence in the European referendum, and could benefit Boris Johnson, who, as one MP put it, “rides both horses” and will be less intimately linked with the referendum and its outcome than Osborne.

But equally, it could be that Euroscepticism proves to be a less powerful card than we currently expect. Ignoring the not inconsiderable organisational hurdles that have to be cleared to beat Theresa May, Boris Johnson, and potentially any or all of the “next generation” of Sajid Javid, Nicky Morgan or Stephen Crabb, we simply don’t know what the reaction of Conservative members to the In-Out referendum will be.

Firstly, there’s a non-trivial possibility that Leave could still win, despite its difficulties at centre-forward. The incentive to “reward” an Outer will be smaller. But if Britain votes to Remain – and if that vote is seen by Conservative members as the result of “dirty tricks” by the Conservative leadership – it could be that many members, far from sticking around for another three to four years to vote in the election, simply decide to leave. The last time that Cameron went against the dearest instincts of many of his party grassroots, the result was victory for the Prime Minister – and an activist base that, as the result of defections to Ukip and cancelled membership fees, is more socially liberal and more sympathetic to Cameron than it was before. Don’t forget that, for all the worry about “entryism” in the Labour leadership, it was “exitism” – of Labour members who supported David Miliband and liked the New Labour years  - that shifted that party towards Jeremy Corbyn.

It could be that if – as Brady predicts in this week’s New Statesman – the final two is an Inner and an Outer, the Eurosceptic candidate finds that the members who might have backed them are simply no longer around.

It comes back to the biggest known unknown in the race to succeed Cameron: Conservative members. For the first time in British political history, a Prime Minister will be chosen, not by MPs with an electoral mandate of their own or by voters at a general election but by an entirelyself-selecting group: party members. And we simply don't know enough about what they feel - yet. 

Stephen Bush is editor of the Staggers, the New Statesman’s political blog. He usually writes about politics.