The spectre of 'stagflation'

It was the curse of the 1970s – rampant inflation and stagnant economic growth. Now there are fears that Britain could once again be haunted by the spectre of 'stagflation'

By Sean O'Grady, Economics Editor
Wednesday, 14 May 2008

A combination of stagnant output and high inflation not seen for decades is set to haunt policy makers for months if not years to come.

Even with the credit crunch, the housing market at its lowest ebb in 30 years, high street sales at their most miserable in half a decade, and industry reporting a collapse in orders, prices are still rising – and at an ever-faster rate. The Chancellor, Alistair Darling, did not admit as much in his mini-Budget yesterday, but his injection of £2.7bn of spending power into the economy may be designed to prevent a catastrophic collapse in demand as Bank of England policy makers find their room for manoeuvre to reduce interest rates constrained by record inflation.

In April, we discovered yesterday, consumer price inflation hit 3 per cent, well above the official target rate of 2 per cent, and a whisker away from the level at which the Governor of the Bank of England, Mervyn King, is obliged to write an open letter to the Chancellor of the Exchequer explaining the failure of policy.

The jump, from 2.5 per cent last month, is the most dramatic since 2002, and the rise in the cost of living is unusually broadly based. The retail price index, which includes housing costs, rose to 4 per cent, up from 3.8 per cent the previous month. Increases in the sort of basic items that families have to buy were the highest. Food is 7.2 per cent up on a year ago, with analysts expecting 10 per cent inflation in a few months. And it's the essentials that are up the most – bread by 13 per cent, butter by 32. 2 per cent and eggs by a third. The increase in food prices is the fastest since 1990.

The twin effects of the credit crunch and the commodities crunch have sucked purchasing power out of the economy while increasing the cost of housing, food, energy and almost everything else. Global food prices are up 40 per cent in a year and oil is up by 70 per cent – a barrel costs four times what it did in 2004. With the American property market still in freefall and the sub-prime crisis as acute as ever, little seems to ease the credit crunch. Propelled ever higher by an insatiable demand from China and other fast-growing emerging economies there also seems little end in sight to the rise in commodity prices.

The 15 per cent decline in the value of sterling – as steep as when the pound was forced out of the ERM on "Black Wednesday" in 1992 – has exacerbated inflationary pressures. The fall is hitting living standards, especially for pensioners and the poorest.

Electricity bills are 8.3 per cent higher and gas up 3.7 per cent. Heating oil is a staggering 59.4 per cent more expensive than this time last year. Yesterday British Gas became the latest energy supplier to threaten yet more price rises by the end of the year, having raised its tariffs by 15 per cent in January. Average household gas bills could top £1,000 in 2008. The average price of petrol rose by 1.9p per litre between March and April this year, with diesel up by 4.2p a litre.

During the past few years or so, the Bank of England's Monetary Policy Committee (MPC) would have a simple remedy for such an increase in prices – a rise in interest rates. During the "Great Stability", a decade of generally low inflation, low interest rates and rapidly rising living standards, policy makers could expect to influence the economy relatively easily. Now their task is more difficult, as they are pulled between the need to fight inflation and avoid a slump.

The Bank of England recognised the danger of inflation this time last year, and began a programme of interest-rate rises to rein it in. Then came the credit crunch, the risk of recession, and the plan was abandoned. The fear was of a slump, one that would damage the economy so badly that, if anything, the longer-term danger would be of inflation undershooting the target as demand and confidence collapsed. The need to prevent this happening while tolerating a "temporary spike" in inflation has been the Bank of England's rationale for a series of interest-rate cuts since last autumn. However, after a quarter percentage point cut to 5 per cent in April, the Bank has chosen to keep rates on hold this month. It could mark the end of that plan, and a return to a keener watch on rising prices.

Tellingly, the MPC knew how bad the new inflation figures would be when members met last Thursday. Economists now believe that a rate cut that had been predicted for June will also be cancelled. The Inflation Report, due from the Bank today, will tell us more about how they see the likely "path" of rates over the next year or so.

Matters are made more complicated because the Bank's "policy rate" is almost irrelevant when market interest rates remain stubbornly high, thanks to the credit crunch. Almost as fast as the Bank of England has been reducing rates the commercial lenders have been raising them and putting up their fees for arranging a mortgage, cutting the flow of funds into the housing market by a half.

Attempts to "inject liquidity" into the banks by swapping government securities for unwanted mortgage-backed securities have been only partially successful. At least for now, the Bank seems more concerned about inflation. Even so, there is little chance of the MPC raising rates to address this danger. Mr King said as recently as two weeks ago that "it doesn't make sense to raise interest rates at this stage to induce a recession to keep inflation below 3 per cent".

Yet a recession may be just what Mr King gets – no matter what he and his colleagues do. The British economy is growing at its slowest rate for three years, with expansion in the first quarter of this year just 0.4 per cent, compared with a rise of 0.6 per cent in the previous quarter. Bank officials have admitted that its forecast for growth is consistent with the possibility of a brief, shallow recession, that is negative growth. Few now expect the Government's official estimate of growth in a 1.75 per cent to 2.25 per cent range to be achieved. Most independent observers put the growth rate much lower, some as low as 1 per cent this year. Even the bottom range of the Treasury's own projection would be consistent with a quarter or two of virtually no growth, as close to a recession as makes no difference. Some sectors are already in, or close to, recession.

Most ominously, this week saw a sharp rise in the number of "forced sales", consistent with last week's poor news on repossessions. The accidental leak by the Housing minister, Caroline Flint, of an expectation of a 5 to 10 per cent decline in house prices looks optimistic by some standards.

This time next year, on the conventional four-year cycle, the country should be in the middle of a general election campaign. Gordon Brown may find himself haunted not only by the spectre of stagflation, but by the infinitely more terrifying spectre of humiliation and defeat.