Last week’s inflation figure was an absolute stinker. You could have been deceived into thinking that it was good news because the headline rate fell from 10.1pc to 8.7pc, but this drop was solely caused by last April's bumper increase in energy prices falling out of the annual comparison.
The villain of the piece was the core rate of inflation – which, far from falling back as some had hoped, actually rose from 6.2pc to 6.8pc. Nor can this be blamed on the current popular scapegoat, namely food prices. They are excluded from the core measure.
No, this was inflation pure and simple, experienced pretty much across the board, everywhere. What is going on?
The Bank of England formerly argued that the forces pushing up prices sharply were “transitory”. The same word was used by the US Federal Reserve. Both central banks were correct in this assessment of the impulse, but completely wrong in the conclusions they derived.
Central banks should never have forgotten that transitory increases in costs and prices can have persistent after-effects as wages and prices chase each other upwards. The huge increases in oil prices in 1973/4 and 1979/80, which were followed by rampant inflation, could have been dismissed as transitory.
The Bank has finally accepted that it has made some errors over this period, and in particular, that there has been something wrong with its inflation forecasting model.
One problem that I and others have highlighted is the Bank’s apparent complete inattention to the money supply. Another is the excessive emphasis placed on expectations of inflation. This was compounded by the assumption that because the central bank was devoted to maintaining the inflation rate at 2pc, 2pc would be the rate of inflation that was generally expected.
In practice, in normal conditions, I have never thought that expectations have such an overwhelming influence on people’s behaviour. In general, both individuals and companies are more concerned with what has happened in the recent past and what seems to be happening in the present than with speculation about the future.
We are living through a wage-price spiral where the main influence has been the squeeze on living standards imposed by the huge increase in costs.
This has occurred at a time when the labour market has been extremely tight, owing to the various factors which have depressed the available workforce, in the context of a loose fiscal policy and a highly accommodative monetary policy.
This forecasting failure led on to failures of policy. Not only did the Bank fail to raise interest rates early enough but it also did not raise them fast enough. The boldest move that it ever seems to have contemplated is an increase in rates of 0.5pc, rather than the usual 0.25pc.
Yet, in the past, when the authorities wanted to get on top of inflation, they were much bolder. In June 1979, the Bank Rate was increased from 12pc to 14pc in one go. Moreover, within a few months, interest rates were increased by a further 3pc – from 14pc to 17pc. In September 1981, the authorities increased rates in two bites, from 12pc to 16pc. And many readers will remember the fateful day, September 16, 1992, when interest rates were increased twice from 10pc to 15pc.
There is no doubt that bold moves of monetary policy are risky, even at the best of times. And we are definitely not living in the best of times.
Ideally, the Bank would like to get on top of inflation without damaging economic growth or employment, and without risking a financial crisis – this last worry made more serious by last year’s pension fund meltdown in the wake of the Truss/Kwarteng mini-budget.
But this is the motherhood and apple pie school of economic policy. In practice, once the cat is out of the bag, it is extremely difficult to get it back in. And doing so is likely to involve considerable pain.
It is important for the monetary authorities to strike early and boldly against inflation. The trouble is that if the central bank moves gently, then inflation may continue to run away from it. Indeed, when inflation really gets a head of steam, the real interest rate can be falling even as the central bank is tightening.
What can we look forward to now? There is scope for the headline rate of inflation to come down over coming months as last year’s monthly increases in the price level fall out of the annual comparison. Moreover, the rate of increase of producer prices – that is to say, both inputs into the production process and the price of goods leaving factories – has started to ease back.
Yet the inflationary process has already moved on to stages two and three. It is no longer primarily the price of goods which is the source of the problem but rather the increase in unit labour costs. This is of particular relevance in the service sector where labour costs are the dominant input.
If productivity growth remains minimal, to be consistent with inflation at 2pc, average earnings growth has to be no more than 3pc, compared to about 6pc now.
For some time, I have thought that interest rates would have to rise to about 5pc. This was once a fairly aggressive view. But no longer. The financial markets are now discounting a rise to 5.5pc. I now suspect that rates will have to go up to 6pc, or possibly even 7pc, to get this tiger back in its cage.
If I am right, not only would this deal a severe blow to mortgagees, both current and potential, but it would surely depress economic activity.
The International Monetary Fund may have recently become more optimistic about the UK economy and is no longer forecasting a recession later this year. But if anything like these interest rates come to pass, then it will be difficult to stave off a downturn.
Roger Bootle is senior independent adviser to Capital Economics: email@example.com