Should we be worried about inflation?

Is rising inflation really something we should be concerned about or are such concerns overblown and a distraction from more important economic considerations? Ben Chu investigates

Inflation might be ‘Rishi’s nightmare’ but should it be ours? (Reuters)

UK inflation is currently rather low, with consumer prices up just 0.7 per cent year on year in January.

Indeed, inflation so low that the governor of the Bank of England has been writing formal letters to the chancellor to explain why it’s more than 1 percentage point below the Bank’s official 2 per cent target.

Yet, despite this, some are beginning to fret that a damaging inflationary surge is on the horizon.

Andy Haldane, the Bank’s chief economist, warned in a recent speech that as the economy reopens later this year “we might see a sharper and more sustained rise in UK inflation than expected”.

There are some signs in financial markets that traders are beginning to price a pick-up in inflation into asset prices. And some have been warning about the impact of inflation on the public finances, pointing to new estimates from the Office for Budget Responsibility (OBR) that 1 percentage point on projected inflation could add £6bn a year to the government’s annual debt interest bill.

The Spectator magazine, highly influential in Conservative circles, this week has a front cover calling resurgent inflation “Rishi’s nightmare”.

The accompanying report warns of “an inflation resurgence that could crush Britain’s economic recovery and follow the pandemic with a financial crisis”.

So: is spiking inflation really something we should be worrying about? Or are such concerns overblown and a distraction from more important economic considerations?

It’s true that there have been some dramatic inflation-related moves in US and UK government bond markets this year.

US 10-year bond yields – which set the effective interest rates at which the Federal government can borrow – have risen by 60 per cent since January.

The equivalent UK yields have also risen – tripling since January – partly because what happens to US bond prices tends to spill over into UK markets.

But it’s crucial to put these moves in context. Though the upward shift has been sudden, yields have only returned to pre-pandemic levels and remain close to historic lows.

The upward yield shift in both countries has been explained by traders as signalling expectations of stronger US growth and inflation thanks to the Biden Administration’s $1.9 trillion stimulus bill.

There are some eminent economists in the US, including the former US Treasury secretary and Barack Obama advisor Larry Summers, who fear that inflation could get out of hand because of that large spending package, which is equivalent to around 9 per cent of the US economy.

But many others, equally eminent, think this isn’t a very likely prospect.

Market inflation expectations, which can be gleaned from comparing the price of inflation-linked bonds to conventional ones – are consistent with a normal economic recovery rather than a destabilising inflationary surge.

And the general public’s inflation expectations shown by surveys – both in the UK and the US – seem to be pretty stable and well anchored.

And what of the government’s finances? Should the Chancellor be worrying about a “financial crisis” brought on by rising inflation?

Take those OBR estimates (or “ready reckoner”) of the impact of various changes in financial conditions.

An additional 1 percentage point on inflation adds £6bn to the debt interest bill in 2024-25 because around a quarter of the government’s bonds are linked to retail price inflation.

But it also calculates that one additional percentage point on the Bank of England’s main interest rate would add around £12bn to the interest bill in that year.

And one percentage point in bond yields would add £7bn to the bill.

Add all that together and you have £25bn in government higher debt payments in 2024-25, almost doubling the current projected bill of £31bn in that year.

This £25bn was the figure that the chancellor was citing in media interviews before the Budget as a concerning number and a reason to rein in public borrowing.

But it’s not obvious that it makes sense to simply add all these various figures together in this crude manner.

“Higher interest rate expectations could reflect greater optimism about future GDP growth, and therefore tax revenues, which could offset some of these additional debt servicing costs,” observed the OBR’s director Richard Hughes this week.

The danger to the public finances is less inflation than stagflation – economic malaise combined with surging prices.

Complacency over prices is inadvisable of course.

It’s not clear cut what the prospects of inflation are. What’s happening now is no indication of what will happen in six months’ time. Financial markets could turn out to be wrong about the outlook.

It’s possible that a surge in consumer spending – as wealthier households splurge their savings accumulated in lockdown on goods and services – will exceed the ability of firms to supply them and that this will force up prices very sharply, compelling the Bank of England to raise rates and creating problems for the chancellor’s debt bill.

No one really knows what impact the pandemic has had on the economy’s overall supply capacity – nor, indeed, what its real supply capacity was before the crisis.

Despite historically low unemployment, for much of the past decade the problem has been excessively weak, rather than excessively strong, inflation, suggesting there was still slack in the economy.

The Bank of England acknowledges this uncertainty. Its most recent projections suggest a one-in-three chance that inflation will be double its 2 per cent target in two years, and a similar chance that it will be below zero.

Yet what we can say is that previous warnings of inflationary spirals over the past decade have proven unfounded. That doesn’t automatically mean they are wrong now of course, but while what are widely recognised as big secular deflationary forces – ageing populations, high savings in Asia and globalisation – have waned, they’ve not disappeared.

Moreover, there’s no reason to believe that, if inflation did risk getting out of hand, independent central banks both in the US and the UK would not raise interest rates to contain it, even if this did create headaches for finance ministries. Some of the wilder suggestions of an imminent return to 1970s-style consumer price inflation spirals, with soaring private sector wage increases and un-anchored public expectations, really do look fanciful.

For many economists the more serious hazard is a disappointing recovery in the wake of the Covid slump, which bakes in permanent “scarring”, harming living standards, productivity growth and investment.

From this point of view, the real danger posed by inflation is that excessive worry about it risks prompting policymakers at the Treasury and the Bank of England to remove stimulus and support for the economy prematurely.

Fear of inflation could do more economic damage than inflation itself.