Inflation vs Interest Rate Cuts
Britain is squeezed uncomfortably between slowing growth and rising prices. Which poses the greater danger?
Six months ago, the world realised the credit party was over. Ever since, a spotlight has been shining on the central banks as they tackle the worst credit crunch in decades and the very real threat of recession. None has found it easy, but it is the Bank of England that has come most under fire for its apparent lack of flexibility.
Having shaved a quarter-point off interest rates, is it too little, too late? Or is the Monetary Policy Committee, led by the self-confessed inflation nutter Mervyn King, right to hold back on the grounds that rising prices now pose the more serious immediate threat?
The Quarterly Inflation Report certainly made worrying reading. Galloping prices have pushed the Bank's inflation forecasts sharply upwards; indeed King deemed it more likely than not that consumer price inflation will overshoot 3%, causing him to write a letter of explanation to the Chancellor. Moreover, that figure belies much steeper hikes in food, fuel and factory input costs, where inflation is now running in double digits.
And yet this preoccupation with the detail of prices may mask a worrying complacency. The Bank is behaving as if it believes Britain will weather the US slowdown comparatively unscathed. Even a half-point cut wouldn't have been remotely sufficient to head off the emergency we now face.
Growth in this country has come to depend almost entirely on finance, housing and the public sector. All three are at a standstill, and if the US does suffer a full-scale recession, the British economy could face an outright disaster.
The worst of all public worlds is when inflation rears its ugly head even as growth slows. Stagflation – a uniquely debilitating condition – holds a special place in the dark corners of economists' minds because it renders a central banker's monetary armour powerless. He can't stimulate growth with lower interest rates because prices will take off, and he can't bash inflation with higher rates because it will tip the economy into recession.
In America, the rate-slashing Federal Reserve chairman Ben Bernanke is gambling that he can avert recession during 2008 and then turn his attention to rising prices. But history suggests that, as with toothpaste, it is easier to let inflation out of the tube than to squeeze it back in again.
We're not in stagflation territory yet, but rising prices are the mortal enemy of financial assets; and growth in Britain, while declining, is far from grinding to a halt. Mervyn King has got his priorities right: he should be applauded for taking the fight against inflation so seriously.
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