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What inflation problem?

Created:
20 June 2008
Written by:
Chris Dillow

Reading newspapers is usually bad for one's sanity. This is especially true of all the scary headlines about inflation. Let's be clear. The inflation problem is only temporary. It's almost certain that inflation will fall sharply next year. You don't need a fancy macroeconometric model to see this. The back of a beermat will do.

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Oil prices have almost doubled in the last 12 months, causing petrol prices to rise 19.5 per cent and adding 0.7 percentage points to CPI inflation. But oil prices probably won't double in the next 12 months - and if they do, 4 per cent inflation will the the least of our troubles. Oil futures markets reckon they won't change much. If they're right, 0.7 percentage points will fall out of the inflation rate by next summer.

And this isn't the only thing that's raising inflation temporarily. The rate of increase of food commodity prices seems to be moderating. And sterling might have stopped falling. By next year, therefore, big rises in food and some imported goods should also drop out of the inflation rate.

For these reasons, pretty much all economists agree with the Bank of England, that inflation will fall sharply next year. The threat to this is that this temporary inflation will become permanent, if it leads to higher wage inflation which in turn would push up prices.

But this is a possibility, not a probability. Of course, we'd all like a big pay rise. But one fact at least stops us getting one - that there are two billion Indians and Chinese who can do our jobs cheaper. Wage growth was low even when the economy was strong and unemployment falling. Why should it take off now the economy is weakening and joblessness rising?

Which raises the question. If inflation is only temporary, why are breakeven inflation rates so high?

I suspect it's because investors in index-linked gilts are buying insurance against the risk of inflation, not the certainty of it. The small probability of a wage-price spiral is so nasty for conventional gilts that folk are willing to pay a lot to insure against it.

And if we're thinking of the wisdom of crowds, why not heed the message shoppers are sending? If these thought inflation was a serious danger, sales wouldn't have soared last month; inflation usually causes people to save more. More likely, consumers agree with economists - that inflation will fall next year, raising real incomes and, perhaps, allowing base rates to fall. But doom and gloom sells more newspapers.

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