Five reasons the MPC must keep its eye on inflation

Given the tendency of inflation to surprise us on the upside in recent history, we need to be mindful of the risks for the future. There are five good reasons the MPC should keep its eye on the inflation ball at present. First, even though inflation has come down below the target since the end of last year, it has been surprisingly resilient. In the eurozone, inflation is now 0.4pc, 1.5 percentage points below the UK level. There have also been a number of helpful influences holding down price increases in recent months – including very low wage inflation, an appreciating pound, and a period of relatively stable oil and other energy prices. Yet despite all this good news, our main measure of inflation – the Consumer Prices Index – has remained very close to the 2pc target. That should create a concern for the MPC that in less favourable circumstances, above-target inflation could again become an issue for the committee.

A fourth issue the MPC needs to consider is the challenge of raising interest rates gradually so there is not a big shock to the economy as it starts to exit from the stimuli in place since 2009. It will be easier to make the transition to higher interest rates on a gradual basis if inflation is well-contained. If inflation is threatening to pick up more sharply, the MPC would need to pull the interest rate lever more forcefully. For me, this has always been a strong argument for starting the process of raising interest rates early and while inflation is under relatively good control. Waiting until it has become a “real and present danger” would mean the MPC has left it too late to start its exit strategy.

Finally, we are still unclear about the longer-term consequences of the policy of Quantitative Easing which the MPC pursued from 2009 until 2012 and which was accompanied by similar policies in other countries, notably the US. Over this period, the Bank injected £375bn into the financial system, which is at present held by banks and other financial institutions. This money has the potential to create a large injection of demand into the economy, and significant upward pressure on costs and prices, if it starts to feed through into new lending to households and firms. To date that hasn’t happened because of the banks’ caution and new regulatory requirements. But as memories of the financial crisis fade, risks increase that the legacy of QE becomes an inflationary threat.

For all these reasons, we need to be mindful of the possibility that as the recovery develops both at home and abroad, the inflation environment could become much less favourable for the MPC. The present inflation rate of 1.9pc is only half a percentage point lower than the low point of inflation in the Eighties – 2.4pc – 28 years ago in August 1986. That was at the start of the “Lawson boom” which unfolded over the next three years and led to the early Nineties recession with inflation of 10pc and interest rates at 15pc.

In the late Eighties, the government and the Bank took their eye off the inflation ball – which Nigel, Lord Lawson himself has subsequently acknowledged. A long period of high unemployment and the belief that there was plenty of spare capacity in the economy distracted the focus from the need to make timely rises in interest rates. The oil price fell sharply in the mid-Eighties and this lulled policymakers into a false sense of security because headline inflation remained low. There was a concern that the pound was getting too strong and interest rates were held down to counter its appreciation. The financial system had been deregulated and there was an insufficient appreciation of the way these changes would feed through into the economy.

History never repeats itself exactly, but there are parallels between these contributors to the policy errors of the late Eighties and some of the factors affecting today’s policy environment – belief in a large margin of spare capacity, low headline inflation, worries about a strong pound, a benign oil price environment and structural changes affecting the financial system.

Inflation is down but not out. Let us hope that the Bank’s August Inflation Report shows that the MPC is mindful of the risks I have highlighted. The committee should not be lulled into a false sense of security by a combination of strong economic growth and low inflation which might not last.

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