The first thing to consider is Sentance's analysis of the causes of the present above-target inflation. He notes correctly that world commodity prices, especially foodstuffs, have risen and are likely to continue to rise in 2013. Part of the rise in commodity prices can be attributed to the QE programmes undertaken by the US, UK and Japanese central banks since 2009: part also can be attributed to investors seeking safe havens for their money: and part to other factors, such as increasing demand from emerging markets, the Iran stand-off affecting oil prices, and drought in the US and Central Europe affecting food prices. None of these except QE can be attributed to the domestic economic environment in the UK. They are all, without exception, external pressures.
For some reason Sentance completely ignores the main cause of the recent spike in CPI inflation, which is the introduction of higher student tuition fees. Their effect will be felt in higher CPI figures for a year, just as the Government's VAT rise increased reported CPI for a year. But why tuition fees are included in CPI at all is a mystery to me, since they are by any reasonable definition investment rather than consumption, and they only affect a relatively small, largely homogenous group of people. To get a fair view of real inflationary pressures in the economy, surely the effects of government tax rises (tuition fees are effectively a tax) should be eliminated - not ignored.
What Sentence DOES include is the devaluation of sterling in 2008, which he believes will continue to cause inflationary pressure in the economy for years to come. And he says that "creeping tolerance of higher inflation" in the 1960s led to the double-digit inflation of the 1970s. This is simply wrong. He ignores the 1967 devaluation of the pound, which set off an inflationary spiral which was then exacerbated by the oil price shock of 1973 and the secondary banking crisis of 1973-5.
Now, the 1967 experience shows that devaluation can indeed cause inflationary pressures. But the 2009 devaluation was larger than the 1967 one and yet has not had anything like the same effect. A quick look at the inflation record from sterling's 1967 devaluation to the intervention of the IMF in 1976 shows a very different picture from the 2008 base rate cut that devalued sterling by about 25%*. Inflation started to rise dramatically immediately after the 1967 devaluation, reaching 9.4% in 1971- from a low of 2.5% in 1967 before devaluation. Compare this with the 2008 base rate cut: inflation actually fell after that cut and was below zero in 2009, then rose to a high of 5.2% before falling again to its present level of 2.7%. And part of the increase to 5.2% was explained by tax rises. Really, in what way are these scenarios remotely similar? Unless there is an oil price shock or another banking crisis, what reason is there to think that inflation is about to take off and reach the dizzy heights of the mid-1970s? Come to that, what reason is there to think that sterling is about to collapse in the way that it did in 1976, when the Chancellor was forced to ask for help from the IMF to choke off a run on sterling? I can only think that Sentance hasn't bothered to do his homework on the causes of the 1970s inflation. More importantly, he seems to ignore the considerable changes in economic management since the 1970s.
In the 1970s, government was responsible for both monetary and fiscal policy. But it didn't really use monetary policy much as a tool - the preferred means of economic management was fiscal policy, with the primary aim being full employment. There was a prevalent belief that inflation could only happen in a growing economy, so economists and politicians were baffled by the combination of high inflation and a stagnant economy - "stagflation", as they termed it. But there was no attempt to manage inflation directly using monetary methods, as central banks do now - and to be fair to central banks, the evidence of the last twenty years is that they have generally been pretty successful in controlling CPI inflation, though maybe at the price of distortions elsewhere (whether inflation alone is a sufficient target for economic policy is a matter of considerable debate at the present.) No, in the 1970s they tried to control inflation by means of fiscal tools, notably the notorious prices & incomes policies that were universally hated and undermined by union power in the large state-controlled industries of the time. Yet Sentance seems to think that central bank inflation targeting is being completely abandoned in favour of failed 1970s-style fiscal policies and inflation will skyrocket. Really this is a terrible indictment of his former colleagues on the MPC. I hope they didn't send him Christmas cards.
So is inflation likely to rise in 2013, as Sentance thinks? Yes, it will rise a bit, due to government policy (including permitting above-inflation price rises by privatised utilities) and external pressures. But there is no evidence that there is significant domestically-generated inflationary pressure over the medium-term - which is all that interest rates can realistically influence. So in my view there is no justification for interest rate rises in the foreseeable future. Raising interest rates to calm down a one-percent increase in inflation which is almost entirely due to government policy would be idiotic. And raising interest rates to choke off an increase in inflation due to price rises in essentials such as energy and food would be utterly ineffective. All it would do is hurt people and businesses who are currently just clinging on to solvency, resulting in mortgage defaults, business bankruptcies, job losses and personal bankruptcies. Yes, higher interest rates would help better-off pensioners whose income is partly made up of interest on savings, and it would give savers a better return on their investments. But why should hard-pressed working people on low incomes lose their jobs and their homes to ease the pressure on better-off pensioners and pad out the savings of the well-off? I am utterly unimpressed by Sentance's attempt to cast himself as St. George, rescuing the UK economy from the clutches of the inflation monster. It's a fairy tale.
But Sentance is far from being the only person who thinks that inflation is about to take off. Here's Bill Gross of PIMCO (h/t Izabella Kaminska):
While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the “out” years towards which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies.Well, I suppose we should be thankful. Unlike Sentance he doesn't seem to think the inflation monster will surface in 2013, so isn't suggesting we should deploy anti-inflation guns now (i.e. raise interest rates). But he's definitely a believer. As are most investment advisers. Here's the American edition of Money Morning predicting inflation in 2013 due to the fiscal cliff and monetary expansion:
The bottom line is that there's a substantial chance of a sudden upsurge in inflation in 2013, though the government statistics may reflect it only very grudgingly.And here's a whole clutch of believers reported in the Economist in September 2011. No, that is not a mistake - 2011. They expected inflation to be well above what it is now:
Meanwhile in Britain, inflation expectations have risen to a three-year high, with those polled expecting 4.2% over the next year and 3.5% over the next five. Those figures are well above the Bank of England's target.Though this monster is only small. Some people believe in a much larger one - a hyperinflation mega-monster. But whatever the size of your monster, the question is whether it really exists, or whether like St George's dragon it is is a creature of fantasy.
Well, both ordinary inflation and hyperinflation are surprisingly common. The Cato Institute documents 56 known cases of hyperinflation, all except one (the aftermath of the French Revolution) in the last 100 years. Ordinary inflation has been moderated in Western countries in the last decade or so, but emerging markets have much higher levels of inflation and history shows that Western economies have at times also experienced much higher levels. So it is reasonable to expect inflationary pressures at some point, though I think it will be quite some time before they are significant enough to warrant monetary tightening . But hyperinflation? Cullen Roche identifies five characteristics of hyperinflations, and he admits that the US might show signs of some of them. But it's not the best candidate by a country mile, and neither is the UK.
It is no surprise that investors and their representatives are those most afraid of the inflation monster in its various forms. For when inflation takes hold, savings lose value - in fact in hyperinflation, savings are worthless unless held in the form of physical assets such as gold. And the defining feature of our age is risk aversion. Investors are desperate to protect their wealth, fearing losses by direct confiscation (taxation, debtor default) or by stealth (inflation, negative interest rates). And people make money from investors' fears. Those who predict hyperinflation and encourage people to move their savings into gold - guess what they are long in? Those who predict ordinary inflation and want interest rates raised so bond yields can get off the floor - guess what they are holding? And some play on fears for overt marketing purposes. The supposedly reputable magazine Money Week recently produced an article predicting total financial collapse in the UK - but not to inform their subscribers. No, it was to sell new subscriptions to their magazine. And it contained some of the worst abuse of statistics and misuse of financial economics that I have ever seen. What a disgrace.
Slaying the inflation monster is important. But so is slaying the unemployment and under-employment monsters, which are wrecking the lives of millions of people, especially the young. And so is slaying the debt deflation monster, which is crippling millions of households and businesses. It is these that roam the Western world at the moment, while the inflation monster is nowhere to be seen. No doubt it will return, but its time is not yet. We should fight the real monsters, not the imaginary ones.
* The two devaluations were very different. In 1967 the pound was still linked to gold on the Bretton Woods standard, so the government directly changed its value in relation to gold. We now have floating exchange rates, so the central bank influences sterling's value by means of interest rate policy and intervention in currency markets.