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

UK: To control inflation or reduce interest rates - that is the question. (2 of 2) - The money supply, regarded by economists such as Friedman as the only solid evidence of a future fall in inflation, slowed markedly in the second half of 1990. Both narr

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Last Updated: 31 Aug 2010

The money supply, regarded by economists such as Friedman as the only solid evidence of a future fall in inflation, slowed markedly in the second half of 1990. Both narrow (M0) and broad (M4) money measures pointed unequivocally to both a slower pace of economic activity and lower inflation. This was not the case a year ago.

And 1991 will be the first full year under the new discipline of sterling's membership of the European exchange rate mechanism (ERM). A falling pound, which last winter contributed to inflation by pushing up import prices, is now subject to the important restriction of sterling's ERM limits.

That said, there is still plenty of scope for things to go wrong. Higher oil prices have already contributed to Britain's inflationary woes, and could do so again. And many businesses face cost pressures in 1991 every bit as bad as those of 1990. The Uniform Business Rate will increase by an average of nearly 11% in April. Within this average, some businesses will face a rise of more than 30%. Wages are displaying a stubborn end-of-cycle refusal to adjust to economic realities. The combination of 10%-plus increases in earnings and a particularly sharp cyclical slowdown in productivity means that the outlook for unit labour costs is worrying.

How can inflation fall so sharply if there are so many cost pressures? On the old dichotomy, cost-push appears to have taken over from demand-pull as the engine of inflation some time during 1990. The answer, according to the conventional wisdom, is that the cost-push may be there but the demand will be too weak to allow it to be translated into final prices. Companies are having to accept a squeeze on margins and to implement cutbacks in output, stocks, investment and employment. And they will continue to have to do so until inflation is squeezed out, or at least down to 5 or 6%.

This is fine in theory. What I find it difficult to reconcile with is the idea that the present recession will be both shallow and relatively short-lived. The Treasury, for example, expects the economy to be growing at an annual rate of 4% in the second half of 1991, only slightly below its rate in the period from mid-1987 to mid-1988.

Faced with this prospect, many decision makers will accept that a squeeze on margins is inevitable as long as demand - both at home and in export markets - is very weak. But if the downturn is going to be a short one, they will not wish to make irreversible decisions to cut back investment and employment: they will be waiting for the hoped-for robust recovery to increase prices. A flurry of pent-up price rises does not sit easily with the expected continued downward progress on inflation.

Nineteen ninety one may well be the year in which inflation in Britain falls very sharply. It may also be the year in which the economy escapes from the shackles of a prolonged high-interest squeeze. I fear, however, that the two will not easily happen together. Either there will be less progress on inflation or the economy remains subdued. The choice is not a happy one, but it could be worse. After all, lasting success in the fight against inflation in 1991 should provide the basis for economic recovery in 1992.

(David Smith is economics editor of The Sunday Times.)

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