Spending cuts could be bad news for inflation

by Ed Bowsher on 17 August 2010  |  2 comments
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Inflation has edged downwards to 3.1 per cent but I'm worried it's not falling fast enough. The outlook for savers remains rotten.

Regular readers will know that I’ve been relatively relaxed about inflation compared to many commentators, but I’m beginning to worry a little more.

That might surprise you given that inflation has fallen today - the Consumer Price Index (CPI) edged down from 3.2% to 3.1% in July. However, that’s still significantly higher than the target rate of 2% and Mervyn King, the Governor of the Bank of England, has had to write another letter to the Chancellor explaining why the target has been missed.

King blames the falling pound, higher VAT and rising energy prices for the missed target. He believes that these factors are temporary and that the most likely outcome is inflation falling back to 2% in early 2012. That’s because there is still a lot of spare capacity in the economy – businesses can increase their output without having to raise their prices.

There’s a lot of truth in King’s analysis and I agree that there is probably still a lot of spare capacity in the economy. I don’t think that inflation is set to take off.

But I do worry that inflation has been above target for so long. That means that people may expect inflation to stay high and that expectation could become self-fulfilling with rising wage claims. So if I was one of the Bank of England’s monetary boffins, I’d be thinking about a modest rise in the base rate during the next few months.

However, there would be one factor holding me back. The government’s dangerous cocktail of spending cuts and higher taxes. It seems that King and George Osborne have done a deal – Osborne will be brutally tough on spending and, in return, King will keep interest rates low in an attempt to stop us going back into recession.

The danger is that King and his colleagues will keep rates too low for too long and that will lead to inflation going up rather than down. So George Osborne’s austerity budget may well lead to higher prices.

Don’t get me wrong, I’m not expecting inflation to soar into double digits. And I still believe that it was absolutely right to cut the base rate to rock bottom and create billions of extra cash for the economy. But there’s a danger that the super-loose interest rate policy will last for too long.

What about savers?

Sadly, a mix of rock-bottom interest rates and rising prices is very bad news for savers. If inflation is 5% and the base rate is 5%, savers should be able to find an account that will pay sufficient interest to keep up with inflation.

But when inflation is at 3.1% and the base rate is at 0.5%, it’s much harder. Things look even worse when you remember that the other main measure of inflation – the retail price index (RPI) – is at 4.8%.

All savers can do is find the best savings account they can and hope that interest rates and inflation become more closely aligned in 2011.

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