I really do despair of the British media sometimes. In response to the past week's inflation numbers, the Guardian ran a story talking about inflation 'jumping' in November. Kipper Williams even had a cartoon comparing Rudolph and his pals to the sound of galloping inflation.
In reality, the latest data are just not that exciting at all. CPI inflation actually edged up to 3.3%Y/Y in November, just 0.1 percentage points (ppts) higher than in October. That rise reflected higher food and clothing prices, which were stronger than expected. But a rise of just 0.1ppts is nothing to get in a lather about.
Inflation hawks will no doubt point out that this now means inflation has been above target throughout 2010 – and some would probably also point to RPI inflation, which was even higher at 4.7%Y/Y in November. RPI, unlike CPI, includes a measure of house prices, and adds up the individual items in the 'basket of goods' a bit differently. The fact that the lowest RPI inflation has been was 3.7%, back in January and February, is also likely to grate.
Even worse, it is not just cartoonists who are getting excited. A friend of mine attended Charlie Bean's speech on Monday, where the Bank of England's Deputy Governor took stock of the current economic situation, and set out some of the challenges that the UK will face next year. The audience was stacked with City economists. And, when the event got to the Q&A session, all they wanted to talk about was inflation. According to my friend, the level of ignorance was staggering, even among these so-called professionals.
So here's my take on inflation: it's Alastair Darling's fault. I know the Bank of England has operational independence, but the reason CPI inflation is so high right now is that he cut VAT to 15% during the recession, and then put it back up again. That rise to 17.5% (together with other tax effects) is doing more than half of the work in terms of headline inflation – strip out these indirect taxes, and CPI inflation was just 1.6%Y/Y in November, unchanged from October. In fact, this measure has been 2% (in April) or below in every month of this year. The same thing will happen in 2011 when VAT goes up to 20% – headline inflation will remain high, but underlying pricing pressures will remain subdued. (At that point, high inflation will become George Osborne's fault.) Without the rise in VAT to 20%, inflation would fall quite quickly at the start of next year.
Should monetary policy respond to these one-off movements in taxation? Only if they look like triggering second-round effects. If we all basically shrug our shoulders, and get on with things much as we did before, the BoE will not need to raise interest rates. But if we all start marching into our bosses' office and demanding pay increases, to compensate us for the VAT hike, the BoE would probably have to move. Even then, it is worth bearing in mind that changing interest rates today will not stop CPI inflation being above 2% throughout 2011 – the MPC can do (almost) nothing about near-term inflation, because it takes time for changes in interest rates (or QE) to affect the economy.
The big monetary policy question is therefore: how likely is it that we will all march into our bosses' office and get big pay rises? Answer: not very likely at all. For those who had't noticed, the unemployment rate is still 7.9%, and over a million of those in work only have part-time jobs because they can't find full-time ones. I don't know about you, but I'd much rather knuckle down and hold onto my job than try and prise a pay rise out of the powers that be. There are a fair few unemployed economists (and probably a few employed ones) who'd love a go at my job.
The bottom line is that, provided earnings growth remains subdued, the MPC still has breathing space to keep policy in ultra-accommodative mode. Monetary policy can do nothing about high inflation today, tomorrow or even in January. It has to look into the future. And provided workers continue to show wage restraint, that future does not look particularly inflationary at all.