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The Coalition's Inflation Headache

    Fraser Nelson is right. Last week’s inflation figures should have been the biggest concern to the government. Stuck at 4.5% (2.5% above the MPC’s target), rising prices are starting to hack into people’s standard of living. Food, fuel and energy are all getting more expensive – and it’s ordinary families who are suffering. The excellent IFS analysis has shown that the goods for which prices are rising fastest are those which poorer families spend a much larger proportion of their income on.

    In our recent report on the MPC’s inflation forecasting record, we showed that the MPC had consistently underestimated inflation through each of the past three years. They are currently justifying ultra-low rates because they expect future inflation to fall back to target due to excess capacity in the economy and deflationary pressures. Time will tell whether this forecast is more accurate than their recent offerings. Whilst the levels of inflation currently experienced do help to inflate away some of the nominal national and bank debt, there are plenty of reasons why the government should be worried about stubborn inflationary pressures.

    The most obvious is that people are becoming worse off. Annual wage growth in the UK is currently running at 1.8% - meaning that real wages are plummeting. It would be very difficult for the Conservatives and Liberal Democrats to get anywhere near winning an election after a term in which real wages completely stagnated (or even fell).

    Public sector workers, who are currently bound by a two year nominal pay freeze, are likely to be particularly upset that their real wages are collapsing (even if this is just a rebalancing against the private sector wage cuts during the recession). With 59% of public sector workers as members of well-organised trade unions, high inflation is likely to increase the threat of sustained strike action. And when the pay freeze comes to an end, there are going to be huge demands for public sector pay hikes (especially if inflation expectations kick in).

    But more than that, high inflation will make achieving deficit reduction more difficult. Or rather, if the current departmental budgets are set in stone, cuts in services will have to be deeper in order to meet budgets. This is a particular risk in industries such as health, which have become used to inflation-plus year-on-year budget rises, and will result in many unpalatable news headlines about deteriorating public services.

    So, if inflation is a problem, then what is the solution?

    The only lever the MPC has to curb pressure on prices is the base rate of interest. It must be remembered, however, that the effect of interest rates on inflation works with very long lags (up to 2 years) and operates through depressing aggregate demand. Whilst their recent forecasting record has been poor, there are reasons to suspect that deflationary pressures are around the corner, making this a pretty fruitless policy. In essence, the MPC probably should have raised rates a year or so ago, but now it is probably too late and would further dent consumer and business confidence.

    The government’s role is potentially more important here. Part of the high inflation at the moment is due to both the VAT hike and energy prices. Ed Balls suggested last week that a temporary VAT cut could be a means of both stimulating growth and reducing inflationary pressure. The problem for the government is that, despite the rhetoric, their deficit reduction plans are largely reliant on hugely increased tax revenues. VAT is a crucial component of this – the Treasury estimates that a temporary cut would increase the deficit by a further £12 billion. A cut might therefore undermine the credibility of the Chancellor’s fiscal consolidation plan – a very dangerous game given the situation in the Eurozone.

    A more reasonable idea to combating the cost of living problem would be to re-examine the coalition’s energy policy. Even as far back as December, it was estimated that this would add £500 to household energy bills by 2020. Now, reforms to the electricity market, coupled with the carbon price floor from 2013, will have a further dramatic upward effect on bills. This isn’t just dangerous from an inflationary sense, but also from the point of view of economic growth. The recent upswing in manufacturing will be obliterated by rising energy costs, threatening employment levels in the very industries that the government is hoping to rebalance towards. But more than that, reasonably priced energy is essential to heat the homes of hard-working families across the country.

    The coalition appears to recognise that families are facing tough increases in the cost of living. Whilst the scope it has for targeting inflation is limited, it is important that the government takes the pressure off where it can.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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