UK’s Inflation Balloon Starts to Deflate

Inflation is back at the official 2% target. Even though that news came out a few days ago, I was determined to write that sentence, not least because it is so long since I have been able to do so.

The last time inflation was at or below the 2% target was in November 2009, since which time we have been through the long nightmare of above-target inflation, at the very time when it was able to inflict maximum damage on a fragile economy.

That nightmare saw inflation at or above 4% through 2011, only partly because of George Osborne’s Vat hike that year to 20%. It peaked at 5.2% in September 2011, which hurt the public finances because that is the monthly inflation rate used for the annual pension and benefits uprating.

Even before then, in fact for the past 8-9 years, inflation was usually above target. In September 2008, when the banks were collapsing, inflation also hit 5.2%. For 85 of the past 100 months it has exceeded 2%.

Above-target inflation has been a key element in constraining recovery. I have cited before Bill Wells, an economist in Vince Cable’s business department, who points out that real take-home pay would not have fallen at all had inflation remained at the 2% target over the past few years.

Lord (Mervyn) King, the former Bank of England governor, argued that had the monetary policy committee tried to keep inflation at 2% in the face of international pressures, with higher interest rates, the consequences for the economy would have been much more severe.

His successor Mark Carney is proving, if nothing else, timing is everything. He would be the first to admit the combination of low inflation and strong growth is not all his doing. But it is far better than weak growth and high inflation.

I am obliged, before getting on to whether this is just a brief return to target before normal service resumes, to mention the retail prices index (RPI). Retail price inflation is higher than consumer price inflation and edged up between November and December, the latest month, from 2.6% to 2.7%, even as consumer price inflation dipped from 2.1% to 2%.

Many people regard the retail prices index as the only true inflation measure. I think this is a mistake. The independent Office for National Statistics has relegated the RPI to pariah status, saying it does not meet the standard required to be a national statistic. Its successor, using a different method of calculation, called RPIJ, is also at 2% and got there earlier than the CPI.

That’s enough of that. Consumer price inflation is back to target and raises three questions. Will it stay there, does it mean the end of the cost of living squeeze, and when do we start to worry, not that inflation is too high, but that it is too low?

On the first question, I do think I will be able to write my opening sentence many more times in the coming months. Inflation is set for a prolonged period of on-target, or even below-target inflation.

The Ernst & Young Item Club, in a new forecast to be published this week, predicts that inflation will average 1.8% this year and only inch back above 2% in the second half of 2015.

That looks right. Suddenly the air has gone out of the inflation balloon. From an inflation perspective, all that needs to happen for the rate to fall is for prices to stop rising, or at least stop rising so fast.

In the case of global commodity and energy prices, things have gone further. They have fallen significantly over the past year. One factor that was contributing to their rise was aggressive quantitative easing (QE) by the Federal Reserve in Washington. The Fed’s “tapering” of its QE will reduce the impetus from this source.

What about real wages and the cost of living? This is the big question, one I will discuss at a Resolution Foundation event early next month. Even with inflation back at 2%, it is running well ahead of average earnings growth, currently 0.9%.

There is a strong possibility this is understating growth in pay, as discussed here before. Even if that is not the case, however, we should see a combination of stronger growth in earnings alongside lower inflation.

The tide is turning. The chancellor says the government backs an above-inflation increase in the national minimum wage, currently £6.31 an hour. Rising demand for labour, and skill shortages, will support an increase in earnings growth.

You would hope that any increase in real wages is natural rather than artificial. The minimum wage is an artificial construct, and business groups and free-market think tanks warn that increasing it will rebound on the low-paid. It may, to an extent, but the effect is likely to be quite small. We do not want a return to the days when governments (and the unions) established pay norms. But as long as recovery brings stronger growth in productivity, higher pay should be both natural and affordable.

There will not be a sudden lurch from falling to strongly rising real wages. This year, however, should see pay at the very least keep up with inflation, giving way to meaningful real wage rises (conveniently timed for the election) next year.

When do we start to worry inflation is too low? Christine Lagarde, the managing director of the International Monetary Fund, warned last week of “rising risks of deflation” – falling prices – as “the ogre that has to be fought decisively”.

I see it a little differently. We have been through a period in which inflation was higher than warranted by domestic conditions, mainly because of strong rises in commodity prices driven by emerging-market demand.

We are now through that period, which means inflation is more in line with domestic realities. That means low inflation in Britain but it will not mean deflation. Nor will it in America, where inflation is running at 1.5%.

The eurozone, where inflation is running at 0.8%, is slightly different. But inflation in most of its “core” economies is running at between 1% and 2%. Where it is lower, in Spain (0.3%) or Portugal (0.2%) or where there is already deflation, as in Greece (-1.8%), it is in economies that need to boost their competitiveness with smaller increases in costs and prices.

We should celebrate lower inflation, and hope it lasts, which it should, not fret unduly about deflation.

This piece is cross-posted from with permission.