We ignore the threat of inflation at our peril

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The high rate of inflation in the UK is a problem that won’t go away.

On two occasions over the past five years, inflation has risen above 5pc a level last seen in the early 1990s. Inflation has been above the Bank of England’s 2pc target for 54 out of the past 60 months (90pc of the time). And for 39 out of 60 months nearly two-thirds of the time inflation has been above 3pc.

Prices in the UK have risen by 3.3pc a year since the autumn of 2007. That may not sound a big difference from 2pc. But it means that prices are now around 7pc higher than they would have been if inflation had been kept in line with the target.

This has added to the squeeze on consumers. For people relying on savings income including many pensioners this is a “triple whammy”. Rising prices have eroded their living standards and the value of their savings at the same time as their interest income has collapsed.

Inflation was 2.7pc in November (Xetra: A0Z24E - news) unchanged from October. That may not look too worrying at first sight. But we have yet to see the impact on the inflation figures of rising energy prices, which were announced in the second half of this year.

These will come through in the next few months and will almost certainly push inflation over 3pc. Food price rises driven by poor UK weather and the US drought will add to this inflation surge in early 2013.

In addition to these current food and energy price pressures, there is the risk that an improving world economy in 2013 and 2014 will push the oil price and other energy and commodity prices even higher. Just as we saw in 2010-11 and earlier in the late 1980s, what starts out as a small inflation “blip” can turn into something bigger and more prolonged.

UK inflation seems to be running at around 3pc to 4pc on average, which means that any fall below 2pc is likely to be short lived and there is always the risk of a spike above 5pc.

This appears to be a surprise to the Monetary Policy Committee, but it is not for me. Two years ago, in the final year of my time on the MPC (KOSDAQ: 050540.KQ - news) , I argued that inflation would remain stubbornly high in the absence of monetary policy action to keep it in check. So I am tempted to say “I told you so”.

There were four main reasons why I thought UK inflation would remain relatively high. First (Other OTC: FSTC - news) , spare capacity in the UK economy was not pushing down inflation in the way the MPC had expected.

Second, strong growth in China, India and other emerging market economies would continue to push up energy and commodity prices.

Third, the big devaluation in the pound in 2008-9, which was the biggest fall in the currency since Britain abandoned the gold standard in 1931, would continue to push up inflation for many years.

And fourth, businesses were starting to expect sustained higher price rises in some sectors of the economy that were shielded from competitive pressures.

These same four factors underpin the outlook for 3pc-plus inflation next year. Energy and food prices are rising globally. The pound remains relatively weak against the euro our main trading partner currency despite the euro crisis.

And inflation in the services component of the Consumer Prices index which accounts for about half of the household spending basket has continued at around 4pc since 1997. CPI (Other OTC: CPIC - news) services inflation in November was 4.2pc and this high rate increase looks set to continue. For example, rail fares are set to rise by more than 4pc in the new year and London Underground is planning to increase car parking charges by nearly 20pc.

So far, the response of the Bank of England has been to disregard this problem of above-target inflation, arguing that it is a temporary phase.

But this argument now looks thin. The current phase of above-target inflation started in late 2006 and Sir Mervyn King wrote his first open letter to the Chancellor in April (Paris: FR0004037125 - news) 2007.

Since then, the Governor has written one or more letters every year (a total of 14 letters) to explain why inflation has been so high. 2013 is likely to be no exception, making a run of seven years of persistent above-target inflation and explanatory letters. This is a long time for a “temporary” inflation over-run.

Instead of trying to explain away this record of relatively high inflation, some economists and commentators have started to argue that we should change the inflation target either raising it to accommodate higher price rises or choosing some other objective for monetary policy.

This line of thinking was stimulated by a recent suggestion from our Governor-elect, Mark Carney, that it can make sense for a central bank to target nominal GDP a composite measure of economic growth and inflation rather than inflation itself.

There are all sorts of technical problems with this approach not least the unreliability of early GDP estimates, which are frequently revised. But perhaps the most significant objection to a shift away from the 2pc inflation target is that it would be seen as a signal that the Government and the Bank of England want to accommodate more inflation, not less, in the future.

We have been here before in the UK. A creeping tolerance of higher inflation in the 1960s paved the way for double-digit inflation in the 1970s and early 1980s. Policymakers might think they can prevent such a drift towards highly damaging price rises. But the easiest way to stop the drift is not to take the first step.

That leaves us with the challenge of making the current inflation target framework in the UK work better.

An inflation target has been used to guide UK monetary policy since 1992, and taking good times with bad times it is not clear whether this approach has stifled economic growth.

In the 20 years from 1992 to 2012, UK economic growth averaged 2.3pc despite the impact of the global financial crisis and a major recession.

This is above the growth rate for the previous 20 years, and a respectable growth rate for a mature Western economy such as the UK. Unemployment also fell between 1992 and 2012 from over 10pc of the labour force to below 8pc now.

When Mark Carney takes over as Bank of England Governor in the middle of next year, there is a chance to rethink the MPC’s policies.

But, rather than abandoning the inflation target or weakening it, he should be aiming to reassure the British public that under his governorship they can expect stable prices.

If inflation remains stubbornly high, as I expect, action to gradually raise interest rates and withdraw monetary stimulus should be on the MPC agenda next year.

This would help curb some of the underlying sources of our inflation problem supporting the pound and giving a clearer signal to businesses that their ability to pass through price increases will be limited.

There are worries about the short-term impact of higher interest rates on economic growth, but over a number of years the positive impact of increased confidence in price stability and on the returns available to savers should outweigh any negative impacts on borrowers.

We should beware the fallacy that high inflation will help economic growth and unemployment in anything but the very short term. That has not been our experience in the past, or the conclusion of decades of economic analysis. And it should not be the basis of our policy in the future.

Andrew Sentance is senior economic adviser to PwC and a former member of the Bank of England’s Monetary Policy Committee