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UK haunted by the spectre of stagflation

by Scott Bicheno on 19 January 2011, 17:07

Tags: General Business

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Catch 22

A couple of not very encouraging pieces of macroeconomic news have hit the UK in the past few days. Yesterday it was revealed that inflation - already way above the target of two percent, had unexpectedly jumped from 3.3 to 3.7 percent. Our inflation is now the highest of any developed country.

Today the Office of National Statistics announced that the employment rate for the quarter ending in November 2010 fell by 0.3 percent, with youth unemployment now at a record high.

With economics very much at the forefront of political debate these days, anyone with a political vested interest has jumped on the figures as affirmation of their positions.

"It's no surprise that the job loss totals are creeping up," said Dave Prentice of public sector union Unison. "The coalition's policies are poisonous for our recovery, and risk a downward spiral for our economy... Meanwhile it's easy street for the bankers who caused this crisis, and are still making off with billions in bonuses."

Of course it doesn't suit Prentice, or the public sector workers he represents, to acknowledge the greater threat to the entire country faced by its debt burden. But his rabble-rousing did yield, presumably by accident, some insight: "It's misery for families, hit with a toxic cocktail of high inflation which is pricing them out of everyday living, and dwindling job opportunities."

The term ‘stagflation' was coined in the States in the 70s to describe the Catch 22 situation of coexisting economic stagnation (as defined by high unemployment) and high inflation. The reason this is such a big problem is that the short-term measures available to boost economic activity are, by definition, inflationary.

In theory stagflation isn't supposed to be possible, because high unemployment should be deflationary as people and companies spend less money. So much for theory, but the question is: what can and will be done about it?

"Sky high consumer price inflation coupled with subdued wage inflation and falling employment means that household real incomes are being squeezed," said Alan Clarke, UK economist at BNP Paribas. "This reaffirms our belief that consumer spending growth will be much weaker than consensus expectations this year."

The Bank of England was under pressure to raise interest rates yesterday on the back of the inflation increase, but that clamour will be subdued by these unemployment figures. This neatly encapsulates the dilemma faced by policy-makers in a time of stagflation: do you address inflation or economic activity?

Right now, despite the fact that its core remit is supposed to be to keep inflation around two percent, the BoE still favours loose monetary policy for fear of damaging the recovery. In the public letter to the Chancellor that he's is obliged to write when inflation tops three percent, Mervyn King will say transient external factors such as global commodity prices are to blame for the high inflation.

But he's been using that argument for a while, and you have to wonder how long it will be before King admits the high inflation is due to interest rates being the lowest they've ever been for the past two years. When he does, especially if GDP is on the rise too, we wouldn't be surprised to see interest rates climbing rapidly.

 



HEXUS Forums :: 12 Comments

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The economy needs a good deflating.
Re: the last para of that article ….
But he's been using that argument for a while, and you have to wonder how long it will be before King admits the high inflation is due to interest rates being the lowest they've ever been for the past two years. When he does, especially if GDP is on the rise too, we wouldn't be surprised to see interest rates climbing rapidly.
I don't agree with the inference or the conclusion. A large part of our current inflation clearly is due to external factors, not least, commodity prices, including oil, food (like wheat, etc) and metals. And in turn, a large part of that is because growing demand from “3rd world” countries like China, India and Brazil are, through a basic supply/demand effect, driving up prices and I see no end to that basic pressure any time soon.

If you extract the impact of those from inflation, you're left wit an underlying trend of about 1.2%, and a chunk of that is caused by steady QE over the last year or two, with some heavy injections but a regular, steady trend, too. And that, inevitably, has an inflationary effect.

So the big question is whether, IF the BoE increases interest rates, will it be able to impact on inflation by doing it, and to what extent, because it WILL hit economic activity in other regards if they do that. For a start, it has an inflationary imperative of it's own - if they increase rates “rapidly”, as you said, it will hit anyone with a mortgage in the wallet, right at the time when other “austerity measures” are coming in to effect, and not only will that dampen down domestic demand but the risk is that a combination of that pain and the austerity measure's pain will strengthen the union's case for wage rises to compensate. And if that starts to happen then we'll face something far worse than the current inflation, which is a slowly ingrained inflation expectation. And that is dangerous, because if we get started on that, it can be very hard indeed to get it out of people's psyche, and you'll get a perpetual cycle of wage demands based on that expectation, which directly feeds back into business costs, so prices up up because of the action people took to combat their expectations of inflation. In other words, a pernicious self-reinforcing inflationary cycle.

Interest rates are, in all probability, not the answer to our current problems, and instead, could well add to our woes. There may well be some pressure to increase them, but there will also be pressure not to.

Finally, the “stagflation” idea is not germane at he moment either. At about 2.7%, the worry is not stagnation, but rather, whether a relatively healthy growth level for a modern, Western economy is maintainable at that level, or whether the “austerity measures” could derail it. If you add rising interest rates to the austerity measures, that chance gets bigger.
The problem is the principles which created the market. When economics was first proposed by Adam Smith the thought of natural resources running out was as far fetched as Alien invaders are today. Thus the infinite growth paradigm emerged which dominates the market.

It is impossible to maintain growth while resources continue to diminish and thus, through simple supply and demand, you get inflation. Essentially there is nothing that can be done to reduce it in our current system. A radical rethink of the way in which economies operate is required to achieve sustainable economics so we may manage our finite resources better instead of waste them in the infinite growth market currently in operation.

The system is it's own downfall.
ExHail
Indeed, well said. The monopoly money in circulation doesn't help, either.
Saracen
Re: the last para of that article …. I don't agree with the inference or the conclusion. A large part of our current inflation clearly is due to external factors, not least, commodity prices, including oil, food (like wheat, etc) and metals. And in turn, a large part of that is because growing demand from “3rd world” countries like China, India and Brazil are, through a basic supply/demand effect, driving up prices and I see no end to that basic pressure any time soon.

Regardless of the relative contributions to inflation that come from internal and external factors, it is way over the target level at a time when interest rates, which are the primary tool at the disposal of the BoE to influence inflation, have been at a record low for years.

So I ask: is it no longer the remit of the BoE to aim for 2% inflation? If not then fine, but if it is then how long is it permissible for it to utterly fail in that regard.

The point I was trying to make in that final para, perhaps not very well, is to question how long we can keep calling an inflationary factor transient. Because as soon as we accept it's not transient, then surely it has to be addressed.