January 21, 2008 | posted by Michael Baxter in UK economy |

Cast your mind back to the period just after last Easter. Back then, the word subprime had crept into economic talk, but only in a small way. As for credit crunch and Northern Rock, well, the first term had no meaning and the second referred to a successful bank. But even then, we had an inkling of problems to follow, and maybe the biggest clue came in a letter sent on the 17 April. For that was the day the Bank of England’s governor, Mervyn King, put pen to paper, or at least secretary’s fingers to word processor, and produced his apology for inflation.

Inflation had jumped to 3.1 per cent, more than a full percentage point over target, thus triggering the requirement for the letter.

In that climate of over-shooting inflation, interest rates went up, maybe too high. Now of course we are in interest rate cutting mode. Last year, faces at the Bank of England went red, maybe they overreacted as a result. But here’s something for you to ponder. Will the next few months see déjà vu?

Back in April last year, this is what Merv said in his letter, “The actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.” He added, “As the substantial increases in household gas and electricity prices that occurred a year ago drop out of the annual comparison, and the falls in those prices which have already been announced take effect, CPI inflation is likely to fall back within a matter of months.”

He was right, five months later the CPI rate had fallen to just 1.8 per cent, and it was tempting to ask what the fuss was all about.

You need to bear in mind, there is a time lag between changes in the rate of interest and the correlated change in inflation. It can take up to two years for the full effect of a rate change to be felt. When the Bank of England upped rates soon after the infamous letter was sent, in terms of its impact on the inflation rate at that time, it was something of an irrelevance.

In hindsight, the rate rises of that time were a mistake. Some were calling for even higher jumps in interest rates – but it appears they were wrong.

Now look at today. Inflation stands at 2.1 per cent, so it is just a mere 0.1 per cent above target. But it is set to rise.

Capital Economics has calculated that if oil stays at around its current high price, then by February, the rise in petrol prices will probably lift the inflation rate to about 2.5 per cent. Add to the mix, the steady rises in food prices, coupled with the falling pound (sterling has fallen by around 7 per cent against the dollar over the last two months,) then it is clear inflation will rise, significantly.

Come the summer there will be a downward and upward effect. This time last year oil was steadily rising. It fell to $51 last January, but by July it was up to $70. Remember, inflation is an equation that compares data over the last 12 months with data from the previous 12 months. Remember, also, there is a time lag between changes in the price of oil, and what we pay for petrol on the forecourt. So it seems that actually, once the big jumps seen in oil slowly ease their way out of the annual figures, inflation will start to fall – probably this summer, so the oil impact on inflation will peak during the summer (this assumes no more rises in the black stuff.) But, at that time, our utility bills are expected to rise. The time lag between a change in the price of oil and a change in our energy bills is even bigger than the time lag between oil and the retail price of petrol. So it seems that inflation will remain high, and well above target throughout most of this year.

Given this, there has to be a very real risk of inflation once again going over target – creating the need for the Bank of England’s governor to write yet another embarrassing letter to the chancellor – maybe, even, exactly a year after it happened last time, although the following month seems to be a more-likely candidate.

Given all this, it does seem a tad strange that just about everyone is expecting to see sharp falls in interest rates this year.

How can this be? Does it mean the Bank of England is bowing to the pressure from the media and the Government, and is putting its statutory requirement to take measures to keep inflation under control, on hold. Well, to an extent, this might be the case. The pressure to lower rates is huge – but then don’t forget, the time lag between changes in interest rates and inflation is nearer two years. What the Bank of E does now, will have little impact on the inflation data for most of this year.

Really, the Bank needs to focus on what inflation will do at the very end of 2008 and in 2009, and by then, the effects of the rises in the price of oil should be easing out of the system – inflation should be falling.

But, there is a danger with this. First of all there’s the falling value of the pound. If the pound continues to sink – and there‘s good reason to think it will, that will create massive inflationary pressure.

By the way, there’s even a theory the UK deficit on its current account as a percentage of GDP has been substantially understated, because official figures incorrectly allocate revenue generated by multinational companies based in the UK, from their overseas subsidiaries. If this is right, then the downward pressure on the pound will grow.

Surely, though, the real mistake was made earlier this decade when interest rates were slashed to a level which was just too low. It was this action that created an unsustainable asset bubble that fed too much debt, which lies behind the problems we are suffering from today.

And in creating this problem, it seems one major policy mistake was made. Gordon Brown, you will probably recall, changed the inflation index the Bank of England was to target. Out went the RPIX index, which included things like council tax and housing rental costs, and in came the less-exhaustive CPI index. And during that period when the Bank of England cut rates to target the CPI index, the RPIX remained a lot higher.