Inflation: Ticking Time Bomb for Next Year
Comment of the Day

October 24 2016

Commentary by David Fuller

Inflation: Ticking Time Bomb for Next Year

The last time sterling fell off a cliff we were in the midst of global financial crisis from 2007 to 2008. The currency shock sent inflation shooting up to 5.2pc, abruptly squeezing on real living standards.

On that occasion the poor were at least protected. Benefits and in-work tax credits were indexed to inflation. Social cohesion was preserved.

This time the most vulnerable families will take the brunt as the cost of imported food, clothes, and fuel suddenly jump. A parting gift of the last Government was to freeze benefits for 11.5 million households until 2020.

This is a political time bomb that will detonate next year when the inflation ‘pass-through’ from imports bites in earnest. It threatens to poison the already fractious national debate unless steps are taken to mitigate the damage.

The Institute for Fiscal Studies estimates that the freeze was going top cut these benefits by 4pc even before the slide in sterling, but this will now be 6pc based on the deteriorating picture for inflation.

The poorest 8.3 million families will lose an average of £470 a year by 2020, and many will suffer further losses from the effects of universal credit.

“The rise in the minimum wage will help some people but beyond that the only way to compensate those on benefits is to increase those benefits in line with inflation,” said Paul Johnson, the head of the IFS.

Marmite wars have already led to a ghoulish scare over food prices, which may have been the intention of Unilever’s highly-political chief executive Paul Polman. His push for a 10pc rise across the board – regardless of whether items were produced in Britain – smacked of theatre.

In reality the exchange rate adjustment has not even begun. The Office for National Statistics says the jump in headline inflation from 0.6pc to 1pc in September had little to do with the pound. It was a legacy effect from prior causes. The Brexit shock on prices will hit next year.

How much inflation will rise – and how soon – is a hotly-debated topic. The trade-weighted devaluation in 2007-08 was 30pc from peak to trough, an earthquake for a world reserve currency.

The headline impact in that episode was aggravated by a surge in the dollar price of oil over two years following the Great Recession, from $32 to $115 a barrel. This will not be repeated.

Global crude stocks remain near record highs, and the flexibility of US shale drilling has broken the back of the OPEC cartel. The structure of the oil market has changed completely. China’s industrial revolution has in any case come off the boil, and it is China that sets the marginal price of oil in the global economy.

This year’s devaluation has been less extreme (so far) though you would never know it from the cacophany. Sterling has fallen 22pc. The drop is more like 15pc if you shave off the speculative jump last year driven by unwelcome inflows of hot capital.

In strict macroeconomic terms a weaker pound is necessary and unavoidable. The Bank of England describes it as a “shock absorber”, the least painful way to correct a severe economic imbalance. It is a boost to tourism and manufacturing exports.

David Fuller's view

The headline above is to catch attention.  However, in his concluding words for this column, AEP says: … “a jump in inflation to 2pc or even 3pc is hardly Götterdämmerung”.

I agree, and prices will vary considerably.  However, provided the UK gets out of the EU quickly, all-important food prices should not rise very much and some would actually fall.  For many years the UK has been paying EU food prices, which include hefty subsidies for France and tariffs on imports from other countries.  Free trade agreements commencing with former Commonwealth countries such as New Zealand would end these tariffs. 

Here is a PDF of AEP’s article.

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