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  1. Wealth
May 1, 2018

Britain’s inflation paradox

By Alec Marsh

Falling government debt is to be welcomed but the bugbear of inflation lurks paradoxically in the attainment of this long-held ambition, writes Alec Marsh

‘Reducing inflation, like most things in life, has its price.’ So wrote Nigel Lawson, chancellor of the exchequer from 1983-89, in his memoirs, before offering an explanation into how to go about it — what he called ‘the black art of monetary control’. This, for a monetarist, involves calculating the rise or fall of the money in an economy, which in turn underpins the rate of inflation in the economy, or at least a significant part of it.

Lawson’s chosen measure then was what economists call ‘broad money’ or £M3, the total value of bank notes and coins in circulation plus all money held in UK bank accounts in sterling. Next, the biggest influencers in causing this to grow were government borrowing — the public sector borrowing requirement or PSBR, ‘plus bank lending, minus net sales of gilt-edge securities other than to banks themselves’.

Once you’ve got your calculator around all that, and then compared it to your previous figure, you should have a good idea of the rate of growth in the money supply or £M3. Keep that growth in check and inflation will also be kept in check — subject to things like exchange rate fluctuations or energy crises — let it spiral, and the supply of money soon works through the economy leading to rising prices and wages, inflation in other words.

Now, I dare say that the intervening decades have supplied many challenges to the monetarist thinking espoused in the memoirs, but it seem relevant in the context of the news out last week about the government’s much-heralded current budget surplus.

For the first time in 16 years the government moved into the black in 2017/18, to the tune of £112 million — astonishing when you consider that the deficit reached a whopping £100 billion in 2009/10 alone.

Not wishing to detract from the celebrations, however, once you take all government spending into account, the public sector net borrowing for the year, was still £42.6 billion, which is equivalent to around 2 per cent of GDP.

Inflation, meanwhile, peaked last November at around 3.1 per cent and has now fallen to 2.5 per cent, so not a million miles off the borrowing figure, especially once you add the falling rate of bank lending to consumers over the year.

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What is interesting then is that when Britain was borrowing much more (for instance back in 2009/10) we did not have runaway inflation, albeit it did rise to over 5 per cent during several months of 2011, which is well above the trend of the last 30 years. (Gas and electricity price rises for this). At the same time, the government and then chancellor George Osborne continued to talk tough on austerity, which sated market forces.

What is interesting, the country having reached this fiscal landmark after almost a decade of effort, is that it now opens the possibility of a loosening of austerity.

As the chancellor Philip Hammond indicated at the Spring statement, should public finances permit (and they now look like they do), then more money might be found at the Budget proper in November to answer the clamour over the continued suppression of public sector pay. In particular the NHS, with winter coming in due course, will be at the front of the queue for salaries (and there are 1.5 million employed in the NHS) and greater resources in general.

And that’s before you throw in the millions of other public sector workers who have had their wages suppressed over the last decade. All of it adds up, in all likelihood, to a rise of inflation later next year, once these rises have begun to be felt in the wider economy.

This is especially the case when you reflect that unemployment has reached historic lows, at around 4.2 per cent, below the threshold at which the Bank of England has previously worried that it would cause wage inflation.

Which all explains why, despite the anaemic growth in the first quarter of 2018 of just 0.1 per cent, the Bank of England is still, apparently, worried about inflation and why economists believe that a rates rise is still upon us.

Over at Capital Economics, the house view is that a rates rise of 0.25 per cent is coming in August, with a second one in November, taking us to 1 per cent — a rate last seen in February 2009. The Bank will not want to fall behind on inflation, notes Andrew Wishart, UK economist at Capital Economics, who points out that forward surveys indicate higher wage growth later in the year. This is already at 2.8 per cent in the year to February — above the rate of inflation, at 2.7 per cent, and has since fallen to 2.5 per cent. ‘We are confident that growth will bounce back after a soft Q1,’ adds Wishart, who says that the UK is still on course for around 1.7 per cent GDP growth this year.

So while the government may have balanced its books – or at least have got much nearer to it — the bugbear of inflation still lurks, though this time from a different source, one paradoxically linked to the fix it has spent years engineering.

But it’s not that surprising. What would be a surprise would be if government spending as a proportion of GDP were to fall much further. Currently at 39 per cent — down from above 47 per cent in the aftermath of the financial crisis — it’s surely impossible for the government to squeeze it any further. Towards the lower end of where it’s been over the last 30 years (it was down to about 36 per cent in 1999/2000), Britain’s population is now significantly greyer, which is relevant to pensions, even before you consider the increasing cost of drugs and procedures in the NHS.

Alec Marsh is editor of Spear’s

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