The UK inflation rate jumped to 3.7 percent last month, way above the Bank of England’s 2 percent target. This comes as a surprise to both the monetary policymakers of the BoE and to the newly formed coalition government.
The Bank’s Governor Mervyn King explains this sudden rise in consumer prices in a letter to the new British finance minister George Osborne, largely blaming rising oil prices, the restoration of the standard VAT and the depreciating British pound (which increases the costs of imported goods), thinking that these factors “are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy.”
According to standard Keynesian thought, prices should not rise during a downturn, because of “spare capacity” (as the Bank of England formulates it) or “low resource utilization” (as the Federal Reserve calls it). Thus the BoE “expects that inflation will fall back.” However, low interest rates and massive monetary injections will sooner or later create inflationary pressures. And as experienced in the 1970s, this could very well happen at the same time as output is depressed and unemployment high–economic conditions usually referred to as stagflation.
There are several reasons to expect such a dreaded scenario. First, the assumed economic recovery, both globally and domestically, is at best weak, at worst only temporary. Several factors point in the direction of a double dip recession: the sovereign debt crisis and the crowding out of private investment, China’s overheated economy and expected cooling down (or even a full-blown crash), the need to rebalance economies and wind down debt (increased savings, reduced consumption), and the need to shift resources (capital and labor) from overbloated “bubble” sectors to other parts of the economy, something which could take some time.
Second, prolonged monetary stimulus will put upward pressure on prices, especially when bank lending picks up again, thus gradually restoring the money multiplier.
Third, the weakening fiscal position of Britain will put pressure on the Bank of England to accommodate the Treasury’s borrowing requirements by keeping interest rates low and expanding the money supply. This will most certainly lead to more inflation.
If the Bank of England takes its mandate seriously, it will eventually raise interest rates in a move to squelch the incipient inflation. This would most likely trigger a new recession–the much-dreaded double dip. However, such a recession could be the only way to restore some balance to the economy, and break the vicious cycle of stop-go that macroeconomic stimulus tends to lead into. After all, the Reagan recession of the early 1980s was what broke the cycle in the U.S.