September 18, 2008 | posted by Michael Baxter in inflation |

For so long inflation seemed to be the most important economic topic. Now it is off the front pages, and yet the last few days have seen two very important developments on the inflation front.

In the UK, CPI inflation has now reached 4.7 per cent. Remember, the Bank of England’s target is 2 per cent.

Electricity prices rose 18 per cent year on year, gas inflation soared to 27.7 per cent, and food prices were up 14.5 per cent – which according to the ONS is a record.

And with that, Mervyn King put pen to paper and did another of his Dear Chancellor letters.

Letters from Merv to Al or Gordon are usually big news; not this time, it barely got a mention.

Meanwhile, in the US inflation fell. Okay, it didn’t fall by much, dropping from 5.6 to 5.4 per cent.

But then consider these words from Capital Economics: “[US] consumer price inflation is set to plummet over the next twelve months and could be down to less than 1.0% by mid-2009.”

In his letter, Mervyn blamed world agricultural products which he said were up 40 per cent, oil, up 60 per cent and wholesale gas prices, up 90 per cent. He warned the inflation peak is likely to be even greater than the level he previously predicted when he last wrote to his boss, back in June. He now expects inflation to peak at 5 per cent.

But, Mr King insists that the action of the MPC will ensure inflation will be back to target soon.

The truth is, however, that inflation is likely to go negative.

Deflation is often preceded by falling asset prices. Inflation occurs when the money supply expands too fast. But isn’t a shortage of money – or at least credit – the problem right now? It seems unlikely inflationary pressures will continue – it seems far more likely inflation will turn negative.

The traditional response to falling inflation is cutting interest rates. But the underlying problem behind this crisis is too much debt. If the Bank of England tries to stop deflation by encouraging us all to borrow, then this could be a very bad move. That is the dilemma the Bank of England will face next.

The solution is not easy to find, but maybe the underlying problem is that in the West the money supply is expanded through debt. The rate of interest falls, the demand for debt rises, this leads to an expansion in the money supply.

Maybe it is time the government took to its helicopter and threw money out of the window – and maybe the best location for this money is our tax bill.