Friday, June 20, 2008

Two opposing pressures and two unusable policies

Mervyn King says that “we face the most difficult economic challenge for two decades”. This is largely because “growth and inflation are heading in opposite directions”.

Inflation is higher than it has been and is still going up, largely due to a rise in commodity prices (as King says, over 90% of the rise in inflation since December is due to “unanticipated increases in the prices of food, fuel, gas and electricity”). Growth, on the other hand, is dropping, largely arising from the housing market falls sparked by the credit crunch.

These two pressures are having their effects around the world, but it’s been said that the UK is particularly ill-prepared as our budget deficit is already fairly large, so there’s little or no room for fiscal manoeuvre.

But that may not matter. Look at monetary policy, and the dilemma that afflicts the Bank of England: it has been refusing to raise interest rates, even though inflation is well above target and predicted to continue rising. There’s a balance of risks, and it judges that higher inflation for a year or so is a price worth paying to avoid the potential recession and deflation that might arise were rates to go too high during this period of slowing growth. Likewise, a slowing economy would usually tend to mean lower rates, but the inflation trouble rules this out too. The two pressures would individually point to policy changes in different directions; in combination, they more or less cancel one another out.

Something similar is true of fiscal policy. When the economy slows, as it is now, cutting taxes and letting borrowing rise is often useful. But doing so when inflation is on the high side could contribute to a far more serious and sustained rise in prices. So it’s not clear that, given the two pressures, tax cuts would be a good idea now. Therefore the fact that there’s little or no scope for them doesn’t matter.

Indeed, the tight budgetary position may even be useful. If the Chancellor can tell public sector unions – quite obviously truthfully – that there’s no more money to spare, then that will help to keep a lid on public sector pay demands, which could feed more enduring and generalised inflation if wages were to jump in response to the current jump in energy and food prices.

I’m not saying that a high-ish budget deficit is all fine and dandy, just that it may not be the particular problem in this situation that some have suggested.

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