12 October 2016

Inflation, not Brexit, should be worrying our policy makers


Harold Wilson is alive and well and running Britain’s post-Brexit economic policy. He is telling us why Brexit already means we are worse off and will eventually mean recession, and how that will happen.

When Wilson devalued the pound by nearly 15 per cent against the dollar in November 1967, he declared, to later notoriety, that:

This does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued…

But it did. Now that the pound has again fallen by 15 per cent – actually, 19 per cent since June 23rd, but about 15 per cent from the average rate in the weeks before the referendum – it is worth remembering how. For we seem to have forgotten that inflation exists, and that it has been the most common reason why the British economy has slipped into recession.

Already, the fall in the pound’s value means that everything we import has become costlier. Boris Johnson has been touring Italy telling audiences that Britons so love glugging Italian Prosecco that there’ll be an easy deal to be done allowing Europeans to buy the City’s financial services while we keep importing  Italian booze. But that booze has just got at least a tenth dearer. Petrol prices are creeping up again too.

Devaluation makes British exports cheaper, as Wilson pointed out in 1967, but whether or not that advantage lasts and boosts economic growth depends on how domestic inflation responds, on how long it takes for that competitive advantage to be eroded.

It’s been a while since the Bank of England last had to worry about inflation. The rate of growth in the consumer price index fell below the Bank’s 2 per cent target at the start of 2014. Prior to that it had been surprisingly high, given that the UK was deep in recession following the 2008 Lehman shock, with inflation topping 4 per cent for most of 2011. That wasn’t true in most other western countries: our economy has long been more inflation-prone than others.

That spell of inflation was one main way in which people’s incomes were cut in terms of spending power during that period, even if nominally they had merely been frozen. It is why TUC research shows that real wages in the UK fell by more than 10 per cent between 2007 and 2015.

Now, inflation is back. Mark Carney, the Bank’s Governor, will be watching the rate like a hawk from now on. It is already gently on the up, reaching 0.6 per cent in the year to August. Most of that still benign level will not have been affected by the devaluation. But if the pound stays low, or falls even further against the dollar and euro, that inflation rate will start to climb quite sharply.

So the scene is set for 2017 to be Harold Wilson’s year. In post-referendum Britain, the slump in the pound looks harmless, even beneficial. But next year, the pound in your pocket will be devalued, just as it was in 1968, as inflation climbs.

The big question will be what Governor Carney will do about it: will he simply stand back and watch the real value of incomes being eroded? Or will he tighten monetary policy and even – to everyone’s shock – raise interest rates? With Britain running a huge deficit on the current account of its balance of payments, Carney will feel keenly the need to keep encouraging foreigners to lend to Britain and invest in British assets, which will require higher returns to compensate if inflation rises.

If that is what he finds he has to do, then the path to the next recession will have been set. We have no need to wait to find out what the terms of Brexit will be and what their impact will be on business investment, employment and trade. Inflation is going to tell the story.

Bill Emmott is a former editor of The Economist.