Show Hide image

Trust me, inflation is not a problem

There is little evidence that greater fiscal stimulus would prove inflationary.

It is fast approaching the time when I have to leave sunny Florida for New Hampshire. I will be teaching a new course in the spring term at Dartmouth called "The Financial Crisis of the Noughties", which should be fun. The first assignment is to write a column on the latest twists of the global crisis. Dartmouth students rank in the top ten in the US on test scores, so the standards are high. We plan to publish the best pieces here in the New Statesman. But there is still the long trek north to come before that, with my middle daughter and the dog. Will keep you posted.

The other big event coming soon is Alistair Darling's last Budget before the election, which will be delivered on Wednesday 24 March. I think Darling has been a highly competent chancellor, doing a very good job in tough circumstances. I suspect he will find some room for further stimulus, given that spending on unemployment benefits has been lower than previously predicted and revenues from the tax on bankers' bonuses (introduced in the pre-Budget report) have been higher.

Contrary to the claims of George "Slasher" Osborne and Jeffrey Sachs, writing in the Financial Times, there is no economic basis whatsoever for arguing that delaying the start of deficit reduction would put long-term recovery at risk. It would not. There is also zero empirical evidence to justify their claims that further stimulus would "darken consumer and business confidence". In any case, Professor Sachs, although a distinguished development economist and expert on poverty and climate change, has no expertise in the intricacies of UK macro policy.

As the distinguished professors Marcus Miller and Robert Skidelsky pointed out in an article in the FT on 3 March, "The government is spending so much because the private sector is investing so little."

More lip gloss

It doesn't seem, to me, a very sensible strategy to frighten voters by talking down the economy. The credit rating agency Moody's made it clear that the UK's AAA rating (indicating the smallest degree of risk) was not under any threat. Moreover, the country has not "run out of money", as Slasher astonishingly claimed in an interview on BBC Radio.

Would maintaining or even increasing the stimulus be inflationary? The answer is no. We are still grappling with the possibility of a deflationary spiral - the retail prices index (RPI) was in negative territory throughout much of 2009. Runaway inflation is not going to happen.

That there are three main published measures of inflation is obviously confusing for many, especially because they have been telling rather different stories recently. The chart above shows changes in the consumer prices index (CPI), the RPI and the RPIX from 1999 to the start of 2010. The CPI excludes a number of items that are included in the RPIX, mainly related to housing, such as council tax, buildings insurance and purchase costs such as estate agent and conveyancing fees. Both the CPI and the RPIX exclude mortgage interest payments, which are included in the RPI.

The chart shows that, from 1999 through the middle of 2008, the RPI was the highest, followed by the RPIX and then the CPI. From about 2005, the RPI rose rapidly during the house-price boom. From the third quarter of 2008, the RPI has mostly been below the other two indices and even negative in 2009. All three indices jumped in early 2010 because of the increase in VAT from 15 per cent back to 17.5 per cent.

The Office for National Statistics has just removed disposable cameras and hairdryers and added lip gloss and Blu-ray disc players to the basket of goods used to calculate inflation. It also announced that it will use, for the RPI, a broader measure of mortgage interest payments, including fixed, tracker and others, rather than the average variable rate offered by lenders that was employed before. The period of retail-price deflation in 2009 would have been much shorter and shallower, had the RPI been measured the new way.

blanchflower table

The Bank of England's latest inflation attitudes survey, for February 2010, showed the difficulties the public is facing in understanding what is happening to inflation. Of particular interest is the question of how prices have changed over the preceding 12 months. From the responses, it is possible to calculate the median of what people believe the inflation rate is, which can then be compared with the actual rate (see the purple "Perceptions" line on the chart). From 1999 through 2008, perceptions were roughly halfway between the RPI and the CPI. Since 2008, perceptions have generally been higher than all three indices.

Too great expectations

Respondents to the survey also comment on how much they expect "prices in the shops" to change over the following 12 months. It is apparent that expectations of inflation were pretty accurate between 1999 and 2008, but people have overestimated inflation recently.

The median expectation for inflation 12 months ahead, in early 2011, is calculated at 2.5 per cent. Assuming interest rates remain constant at 0.5 per cent and quantitative easing remains at £200bn, and we believe the Monetary Policy Committee's overly bullish forecast for output, then the MPC's median forecast for CPI inflation for the first quarter of 2011 is 1 per cent. If growth were lower than the MPC projects, as suggested by the National Institute of Economic and Social Research in its most recent forecast, then inflation would be even less.

Trust me. Inflation is not a problem currently and will not be for the foreseeable future.

If Slasher was to make further cuts in spending within 50 days of being elected, there is every chance that the inflation outcome would be much lower than that and possibly in negative territory. That would force the MPC into more quantitative easing as unemployment spiralled upwards and growing numbers of firms entered bankruptcy. Inflation would be the least of our worries.

David Blanchflower is Bruce V Rauner Professor of Economics at Dartmouth College, New Hampshire, and the University of Stirling

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