BRITISH inflation remains above the Bank of England's target, generating uncomfortable headlines for those within the central bank advocating for greater monetary support for the weakening British economy. Annual inflation rose to 5.2% in September, powered forward by big jumps in housing costs and the price of clothing. Buttonwood comments on the report, writing:
I heard one economist on the radio say this morning that this was not real inflation at all. Many people like to focus on the data excluding food and energy. But if you look through the numbers, you will find that the second biggest contributor to the month-on-month rise was clothing*, which was up 4.4% on the month. Meanwhile rents (which aren't measured directly in this data) are up 4.5% on the year. So this argument becomes a little like the Monty Python sketch about the Romans "Apart from the aqueducts, law and order etc, what have the Romans done for us?" Apart from housing, heating, clothing and food (all the basic necessities of life), prices aren't rising.
What economists mean by real inflation is, of course, a wage-price spiral and that is not happening. However, that is of small comfort to normal people who have to pay a lot more for basic necessities but whose wages aren't rising to compensate. They may not regard this as a policy triumph. The Pensions Corporation notes that the elderly spend a lot more on basics than the rest of us; for them the effective inflation rate may be almost 8%.
I think it's worth thinking about what these price figures actually imply. Prices for some goods, especially housing and clothing but also things like furniture, restaurants, and hotels, are rising. That implies that demand for those goods is outstripping supply. As Buttonwood notes, wages are not following suit. And he is correct to point out that when prices rise and wages do not, that translates into a decline in real purchasing power or the real wages earned by workers. One might worry that this decline could undermine economic growth; perhaps it could, but if it did, we'd expect to see demand fall across the economy leading to a drop in upward price pressures. To the extent that price increases aren't subsiding, there's no reason to worry that falling real wages are undermining demand. Of course, the Bank of England is concerned that other factors, like austerity and a weakening European outlook, may hit demand, thereby leading to rising unemployment and falling prices in the absence of monetary intervention. Hence, the decision to move forward with QE2 despite a rate of inflation above target.
Now, if you're an employer in Britain you observe that you can sell a number of goods at ever rising prices. Further, you may note that the labour needed to produce those goods isn't getting more expensive. As such, the relative price shift we're observing in Britain is making British labour more affordable, which should in turn encourage British firms to hire more of it. That's an awfully convenient state of affairs, given that the government has begun sacking hundreds of thousands of public employees. If the Bank of England were not making it more attractive to hire British workers, one suspects that many more British workers would go unhired, leading to a much larger rise in the unemployment rate than has so far been observed.
Another way of looking at the situation is this: the Bank of England is facilitating a shift in relative prices necessary to maintain something like full employment. Were the Bank to rein in its monetary easing in order to constrain growth in the prices of some goods, that relative price shift could only be achieved through a decline in nominal wages. That would also make a lot of Britons very unhappy, and to the extent that wages are sticky, it would lead to a corresponding rise in unemployment.
By pumping money into the economy, the Bank of England has prevented an appreciation in sterling relative to its major trading partners; given euro-area panic, the pound would likely have shot up absent aggressive easing. That, in turn, facilitates an adjustment in the economy toward external demand, which also provides a cushion against public-sector contraction. The Bank of England is doing exactly what it ought to be doing, namely, sparing the economy the need to adjust through a painful drop in nominal wages, achieved through economic contraction and a gut-wrenching rise in unemployment, and which would in all likelihood undermine the government's fiscal-consolidation efforts.
Now, the distributional impacts of this policy aren't always pretty, but when are they? The distributional impacts of adjustment around the European periphery are far uglier by comparison. And if the British electorate isn't happy with the effect of an appropriate monetary policy on certain subgroups of the population, then it ought to complain to the government, which has the power to redistribute resources through taxation and the provision of public services. But it's unrealistic to think that tight Bank of England policy would make choices easier. One has only to look across the Channel to see that. At some point, the British economy may hit its capacity to produce more goods. We would then observe that more easing would have no real effect on output, and the wages of employed workers would rise with prices in an accelerating spiral. When that occurs, however high the unemployment rate, the central bank is unable to help. It falls to the government to enact the reforms necessary to bring unemployment down further.
Britain isn't at that point, and the Bank of England is responding appropriately. One may regret the impact on pensioners, but their quarrel is with the elected government, not Mervyn King.