Philip Booth: The UK should be on “inflation watch”

Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs.

The most recent growth figures surprised many people and this led to sterling rising and speculation about whether a decision to raise interest rates would be made at this week’s MPC meeting. So, what are the prospects for inflation and interest rates?

It is possible to have a rise in growth without any implications for inflation. Dramatic improvements to the supply side of the economy could raise our growth rate significantly. Despite the Prime Minister’s recent speech on growth to the CBI, those improvements to the supply side are not likely to happen any time soon. David Cameron did not focus on reducing the regulatory and tax burdens on business but on how government could spend more and on how bureaucrats could help business more. He is barking up the wrong tree.

Indeed, recent announcements do not bode well for supply-side led growth. The full rate of the minimum wage has been extended to younger people; we have the EU maternity leave directive; new EU regulations on investment markets; the imposition of a new Equality Act; and a pledge by the Chancellor to extract the “maximum sustainable tax revenues” from the financial services industry. All this happened in three weeks.

Despite this, there is now a justified belief that we may have reached the high watermark with regard to attacks on the supply side of the economy. The relentless increase in taxes and tax complexity - as well as increases in business regulation - under Gordon Brown are likely to slow dramatically over the coming years. Changes in perceptions can translate rapidly into changes in business investment plans and economic growth and this may be happening.

Though a supply-led increase in growth will not necessarily lead to an in increase inflation, there are reasons for concern. The Bank of England’s process of quantitative easing (QE) translated into a relatively small rise in the money supply. But as soon as confidence within the banking and business sector picks up, there would be a rapid rise in bank lending, money supply and inflation. QE can be like pouring water into a latex pipe with a blockage at the end – as soon as the blockage is removed, the water floods through and the economy becomes awash with money.

Indeed, there is huge uncertainty about how the rate of inflation will progress over the coming two years. But risks on the upside are surely at least as great as risks on the downside. Even if inflation remains at current levels, there could be a big rise in interest rates in store. Real interest rates are -4% at the moment – this cannot go on. If inflation does not fall, surely, over the next two years, interest rates could climb by 6% or so.

In fact, more inflation is precisely what some economists want. In an article in the New Statesman this time last year, David Blanchflower suggested that we should reflate away the national debt. Professor Blanchflower has recently repeated his calls. This is a policy that is as wrong as it is unachievable. The numbers do not stack up.

Blanchflower suggests that a few years of 5% inflation would do the trick (i.e. continued inflation at current levels). It is not that easy. One fifth of government debt is index-linked. Index-linked debt cannot be inflated away. 35% of the government’s debt is made up of Treasury Bills, short-dated debt or ultra short-dated debt. There is little that the government can do to inflate this away. This will have to be refinanced within the next seven years (most of it much sooner) and, as inflation expectations will rise if the central bank pursues an explicitly inflationary policy, the cost of refinancing this debt will increase. Over the next five years, the UK government is also planning to borrow an amount not much less than the existing national debt in nominal terms. None of this can be inflated away: it will all have to be financed in the new environment of higher inflation if the Keynesians have their way. So what is the bottom line?

The only debt that can be inflated away with any significant effect is the existing long-dated or medium-dated conventional government debt that has already been issued. This is the debt which the government has promised to service with fixed (not inflation-linked) interest and capital payments. This is currently 43% of the existing national debt, but it makes up only about 20% of the debt that will exist by the end of the proposed policy of creating inflation. If inflation were 5% for a few years, as suggested by Professor Blanchflower, the real value of this debt might fall by about 2%-5% of the total projected debt in 2016: this is a drop in the ocean. This "gain" could easily be cancelled out by a higher inflation risk premium that would be demanded by investors on newly issued government debt.

The long-dated debt tends to be held by long-term investing institutions in the UK in order to match long-term sterling payments from insurance and pensions arrangements. As such, though the benefits would be small and spread widely across the UK taxpayers, the costs would be concentrated on future pensioners, holders of annuities and the beneficiaries of long-term insurance policies. This is not exactly a socially desirable outcome.

It is also not an economically desirable outcome. Financial markets were seriously disrupted by the inflation in the 1970s and savers had their savings turned into small change. Inflation expectations might well be affected for decades to come by a bout of inflation, thus raising the cost of borrowing for governments and businesses – or forcing governments and businesses to use index-linked instruments or seek short-term funding. Debt service costs could spiral in the medium term if we had a big increase in inflation in the next few years.

Things have changed since the 1970s. You can’t fool all of the people all of the time, as Milton Friedman once said. We fooled people in the 1970s, we cannot fool them that easily again.

Overall, the latest GDP figures tell us little that we did not already know about the immediate prospects for inflation. However, we should be aware that QE is a policy that has highly uncertain outcomes with variable time lags. As such we should be on “inflation watch” and we should explicitly reject policies of inflating away our national debt.