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Britain Is Puzzled By Its Inflation Problem In A Downturn

09/08/2010

Source from: The Economics

LONDON ― Bank of England policy makers are puzzled by persistently rising prices in Britain ― even during the deepest recession since World War II.

Now that a tentative recovery has begun, some economists are worried that the policy makers at the central bank might feel the need to raise interest rates earlier rather than later to combat sticky inflation ― a move that could tip the British economy back into recession.

The Bank of England, which has a mandate to keep inflation low, is expected to keep interest rates unchanged at 0.5 percent on Thursday. But persistently high inflation rates, some economists say, could limit the room the central bank has to keep rates low to encourage a more stable economic recovery.

Unlike the United States and countries that share the euro, inflation in Britain never came close to zero during 2009. And while core inflation, which excludes food and energy, has declined in such countries as the United States, Germany, France and Italy since the beginning of 2008, it rose in Britain. At 3.4 percent in May, the annual inflation rate in Britain is now more than twice the rate in the euro zone.

The Bank of England governor, Mervyn A. King, has had to write six letters to the British Treasury since 2008 explaining why inflation was more than one percentage point above the bank's 2 percent target. The letters ― until recently just a rare reminder of the working arrangements between the government and the central bank ― became so frequent that a joke made the rounds among economists that Mr. King was happy to have found a new pen pal after the recent election in George Osborne, who became chancellor of the Exchequer.

In each letter, Mr. King identified a different set of one-time events, ranging from a drop in the pound to higher commodity prices, as the reason for inflation. He also predicted that the effects of a weak economy would ultimately push inflation lower.

But after two years, some economists are asking whether there might be more to the stickiness of the inflation rate.

“It's noticeable that the U.K. is growing in the opposite direction of the U.S. and the euro zone,” said Danny Gabay, a director at Fathom Financial Consulting in London and a former author of the Bank of England's inflation report. “Economic growth surprised on the downside and inflation on the upside. That's a very uncomfortable position to be in.”

Of course, inflation can be beneficial for highly indebted countries like Britain ― and its highly indebted consumers. But it also eats away at savings and hurts the working class and the poor hardest if wages and pensions do not keep up.

No one is yet talking about stagflation ― a term often attributed to the British politician Iain Macleod, who used it in a speech to Parliament in 1965. It refers to a combination of stagnant growth and inflation ― two economic phenomena usually considered to be contradictory.

But the Bank of England has acknowledged that it is “very concerned about what's been happening to inflation” and that it is “surprised” at “how resilient inflation has been” especially against the background of a recession. In May, it blamed three major factors for the higher inflation rate. It cited oil prices that were on average nearly 80 percent higher than at the beginning of 2009; a temporary cut in the sales tax ended in January; and the continuing effects of pound's sharp drop against the dollar in 2008.

But some economists disagree.

Higher commodity prices were not unique to Britain, and the euro has also slumped against major currencies, albeit more recently. Some economists also pointed out that price increases were especially strong in the service sector, pushing up expenses like insurance premiums, which are not directly related to currency exchange rates.

“The inflation issue recently has been higher levels of service sector inflation,” said Stuart Green, chief British economist at HSBC in London. “That's very unique to the U.K.”

Within the Bank of England, there is no consensus.

Deputy Governor Charles R. Bean, who sits on the rate-setting Monetary Policy Committee, said a lack of lending by banks might have meant that companies are now more concerned about their cash flow and less willing to cut prices than in previous economic downturns.

Another member of the policy committee, Adam Posen, blamed inflation expectations for rising consumer prices. During a speech last month, he argued that the central bank's previous decisions to keep interest rates at a record low despite creeping inflation had led consumers to expect that inflation would remain high for a while. Higher inflation expectations usually prompt companies to increase prices and consumers to push for higher wages. “The most logical and empirically reasonable explanation for inflation creep is some unanchoring of inflation expectations caused by a series of above-target outcomes for U.K. inflation in recent years,” he said.

Andrew Sentance on June 10 became the first committee member to vote for a rate increase in almost two years. Mr. Sentance later told Reuters that he was concerned about inflation expectations and said he would prefer more “gradual” rate increases. He also raised doubts about the strength of existing deflationary pressures, hinting that prices might continue to rise because more companies than initially thought went bankrupt and the supply of products suffered.

Hetal Mehta, an economist at the Ernst & Young ITEM Club, an economic forecasting group, said that while there was evidence that some companies increased or maintained prices, there was less evidence that consumers were asking for higher pay. With 610,000 public-sector jobs to be cut by 2016 as part of the new government's austerity program, that is less likely to change.

Despite disagreements about the root cause of higher consumer prices, most economists expect the Bank of England to keep interest rates unchanged until at least next year. The government's austerity program, which includes another sales tax increase next January, means inflation could remain volatile.

“They should sound worried about inflation but also be mindful that there is a bigger danger, and that's to increase rates when the economy is still low,” Mr. Gabay of Fathom Financial said. “If both consumers and the government save, things can turn ugly very quickly.”

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