Alasdair Macleod – 14 June 2009
While trying to negotiate between the Scylla and Charybdis of deflation and inflation, central bankers are pursuing one of Keynes’s primary objectives, price stability. Falling prices will trigger a debt-deflation collapse, while inflation, once going, is extremely painful to stop. The seaway between these two dangers is extremely narrow.
Price stability is assumed to be an inflation rate of 2 or 3 per cent. Keynesians have been prepared to print both money and government debt in whatever quantities it takes to achieve this balance, believing until now that deflation and Irvin Fisher’s debt-deflation collapse was the greater risk. The recent recovery in sentiment suggests that this risk has abated somewhat, and inflation is now an increasing risk.
Everyone should be watching the inflation indices like hawks.
Unfortunately, we are watching the wrong indicators. It is usually forgotten that consumer price indices measure the cost of living, which is not the same as inflation. It is worth defining the difference for the sake of clarity. A cost of living indicator is designed to replicate the spending of a typical family and will include items such as food, utilities, fuel, insurance, holidays, and a full range of “services”. These individual items are weighted, so the necessities of life such as food and clothes typically represent less than 20% of a consumer price index. Most of the items in a cost of living index, such as services and items subject to price controls, have no direct correlation with inflation. This is not to say services are immune from inflation, but they are a second-order event, and they are also discretionary purchases. The CPI and the RPI do not measure inflation, there is no indicator that does.
To illustrate this point, I have extracted the core basics from the UK Consumer Price index. All services are excluded, as are utilities, because they are price-regulated. I have also excluded commodities, such as fuel, whose prices mostly reflect market sentiment and taxation rather than inflation. Goods that are not current expenditure, such as electronic equipment and motor cars are also excluded. In short, our new inflation index represents the basic necessities, and is comprised of food, non-alcoholic beverages, clothing and footwear, and goods bought for home maintenance and repairs. These are the necessities whatever the inflation rate, and are prices not unduly distorted by price controls or taxation.
The results are astonishing. Our new inflation index rose 5.3% in the year to April 2009, compared with a rise of 2.3% for the CPI. So the cost of living indicator (CPI) is under-recording inflation by 3%. In the year to April 2008, it under-recorded inflation by 2.5%, showing the difference is increasing. Of course, our new inflation index is heavily influenced by food prices, which in aggregate only started rising two years ago, having been stable since 2001. However, the rise is now an established trend, which is certain to be fuelled further by recent quantitative easing.
It is particularly worrying that on this basis, base rate is minus 4.8% in real terms. By following the CPI and RPI the Bank of England is monitoring the wrong statistics.
The Bank and the government also appear to be assuming that the choice is between the Scylla of deflation and the Charybdis of inflation. A far more likely outcome will include both, and at the same time. The credit crunch has merely generated the first phase of the downturn. The current rally in sentiment is based on little more than restocking of inventory, an effect that will soon pass. The downturn following will be more prolonged and severe, partly because of the switch from consumption to savings as consumers’ rebuild their balance sheets, and partly due to government interference in the total economy. The likelihood of a debt-deflation sell-off is better than odds-on, with asset prices nowhere near the bargain-basement yet. These are precisely the conditions that foster inflation, stagflation and hyper-inflation. It is a serious policy mistake to assume that inflation is the consequence of economic growth – it rarely is.
So the scene is set. The recession is not over by a long chalk, and already inflation is accelerating. To raise interest rates will bring on the debt-deflation collapse, not to will probably not prevent it, but inflation will rapidly get out of control, if it has not already.
So what is it to be – up or unchanged? Your call Mervyn King!