UK: To control inflation or reduce interest rates - that is the question. (1 of 2)

UK: To control inflation or reduce interest rates - that is the question. (1 of 2) - Can Britain kick the inflation habit in 1991 and its economy be set free from the shackles of a high-interest squeeze? David Smith is pessimistic about the possibility o

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Last Updated: 31 Aug 2010

Can Britain kick the inflation habit in 1991 and its economy be set free from the shackles of a high-interest squeeze? David Smith is pessimistic about the possibility of the two happening easily together.

Milton Friedman, the Chicago monetarist economist, once compared inflation to drug taking. The effects of both, initially at least, can be deceptively pleasing. The nasty consequences only come along later, and by then it may be impossible to stop. Will 1991 be the year when Britain kicks the inflation habit? Or will we learn again how to keep it under control?

Every serious economic forecaster expects a substantial reduction in inflation over the next 12 months. If they are right, interest rates should come down, although not necessarily in direct proportion.

The Treasury, in its Autumn Statement forecast published in November, predicted 5.5% inflation by the final quarter of 1991, a figure which is in line with, even slightly more cautious than, the consensus. A more favourable combination of oil prices and interest rate cuts could produce a fourth-quarter inflation rate as low as 3.5%. Even on pessimistic assumptions, the rate is unlikely to be higher than 7.5% at the end of the year.

There is a vigorous debate on the extent to which inflation will genuinely fall over the next 12 months. Much of the fall in the "headline" inflation rate will be due solely to the composition of the retail prices index. Thus if next April's community charge (poll tax) increases are below those of April 1990 this will automatically take a percentage point or so off the inflation rate. Similar favourable effects will come when earlier mortgage rate rises drop out of the 12-month comparisons. These and other factors mean that the fall in the headline inflation rate will greatly exaggerate the true extent to which the inflationary habit has really been brought under control.

This is accepted by the Treasury. Its forecast for producer price inflation is for a modest fall from 6.25% in the fourth quarter of 1990 to 5% a year later. The gross domestic product deflator, the best overall measure of inflation in the economy, is predicted to rise at 8% in the 1990-91 financial year, dropping to 6% in 1991-92. The official prediction is nevertheless for falling inflation, on both headline and underlying measures. Industry appears to agree. The Confederation of British Industry's latest quarterly survey showed very weak expectations of price increases over the next few months.

Had this piece been written a year ago it would also have reported that the consensus favoured a big fall in inflation over the following 12 months. The Treasury's prediction this time last year was for a 5.75% rate by the fourth quarter of 1990. But the outcome, as we now know, was not far short of double the 5.75% forecast.

At that time, after more than a year of high interest rates, people could not believe that inflation would not respond to the monetary squeeze. They were wrong. The switch from domestic rates to the poll tax and higher mortgage rates pushed up the headline inflation rate. Food price inflation was higher than for many years, and then came the Gulf crisis.

This time the forecasts are more soundly based. After all, there is no doubt that the economy experienced a sea change last summer. Crude as it may be, recession and rising unemployment represent the harsh but effective medicine which reduced inflation before.

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