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Times Online
The Sunday Times
June 22, 2008

The Bank’s new challenge

So much has changed in the year since Gordon Brown made the short journey from 11 to 10 Downing Street. Problems were certainly beginning to mount up but the economy did not appear to be one of them. The credit crunch had yet to bite and inflation was on its way down. Mr Brown handed over the economy to Alistair Darling so that he could get on with other things.

Instead, the economy has dominated the prime minister’s year in charge. Labour’s strength in managing a stable economy has become its weakness as instability has taken hold. The credit crunch uncovered gaping holes in the system of banking regulation that Mr Brown had put in place with the Treasury, the Bank of England and the Financial Services Authority, the City watchdog, floundering in a crisis that brought down the Northern Rock bank and led to a collapse in mortgage lending and falling house prices.

Now there is an even bigger danger that low inflation, the foundation of economic stability, has been abandoned in the face of higher energy and food prices. Last week the government’s target inflation measure, the consumer prices index, rose to 3.3%, forcing the governor of the Bank to write an open letter. His message was that if you think it is bad now, it is going to get a lot worse. Inflation will rise much higher before it comes down and it will come down only if people tolerate an intense squeeze on living standards.

Mervyn King, the governor, put it starkly in his speech at the Mansion House. The economic challenge that the country faced was the biggest for two decades: “Rising fuel, gas, electricity and food prices mean that average real take-home pay will stagnate this year.” Unemployment, already rising, will go up further as growth slows.

Inflation threatens the heart of the government’s economic framework. It is more than 15 years since the Tories introduced an inflation target, reinforced by Mr Brown’s independence for the Bank in 1997. Low inflation has run alongside steady growth. This was Mr King’s “nice” era – non-inflationary, consistently expansionary. Now the nice times are over.

Inflation is high and the economy is set to slow sharply. Tanker drivers for Shell, after holding motorists to ransom last weekend, extracted a 14% two-year pay rise. The public sector unions are restless, with Unison pushing for a strike of local government workers and the GMB threatening a big cut in Labour party funding. For those with long memories it looks like the early days of “stagflation” in the 1970s, the last time a Labour government lost control of the economy.

That must not be allowed to happen again. The return of inflation on a sustained basis would be a disaster from which Britain would take years to recover. The Bank’s view is that as long as wage bargainers stay calm and business holds back on price rises, the storm will pass and inflation will head back to target. So far the news on pay is good, with earnings rising by less than 4%. Earlier this month Unison’s members in the National Health Service agreed a three-year deal for a total pay rise of 8%.

The risk is that inflation will become embedded and require the Bank to take tough action by raising interest rates. That could be enough to tip the economy into recession, something neither the banking system nor the public finances could easily withstand. The hope has to be that it will not be necessary. It would, however, be preferable to allowing inflation to get a grip.

“The lesson of the past 50 years is that when inflation becomes embedded the cost of getting it back down again is a prolonged period of sluggish output and high unemployment,” Mr King said. Britain has learnt that lesson before. Mr Brown, deep in the doldrums, has hinted publicly that he would like the Bank to cut interest rates. He should know that high inflation is no solution to his problems. This is a tough time. Allowing inflation back on a permanent basis would make it a lot worse.

http://business.timesonline.co.uk/tol/business/economics/article4187489.ece

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