Articles:
Inflation, not Brexit, should be worrying our policy makers

12.10.16 Publication:

Harold Wilson is alive and well and running Britain’s
post-Brexit economic policy. He is telling us why Brexit already means we are
worse off and will eventually mean recession, and how that will happen.

When Wilson devalued the pound by nearly 15% against the
dollar in November 1967, he declared, to later notoriety, that:

This does not mean
that the pound here in Britain, in your pocket or purse or in your bank, has
been devalued…

But it did. Now that the pound has again fallen by 15% —
actually, 19% since June 23rd, but about 15% from the average rate
in the weeks before the referendum – it is worth remembering how. For we seem
to have forgotten that inflation exists, and that it has been the most common
reason why the British economy has slipped into recession.

Already, the fall in the pound’s value means that everything
we import has become costlier. Boris Johnson has been touring Italy telling
audiences that Britons so love glugging Italian Prosecco that there’ll be an
easy deal to be done allowing Europeans to buy the City’s financial services
while we keep importing  Italian booze.
But that booze has just got at least a tenth dearer. Petrol prices are creeping
up again too.

Devaluation makes British exports cheaper, as Wilson pointed
out in 1967, but whether or not that advantage lasts and boosts economic growth
depends on how domestic inflation responds, on how long it takes for that
competitive advantage to be eroded.

It’s been a while since the Bank of England last had to
worry about inflation. The rate of growth in the consumer price index fell
below the Bank’s 2% target at the start of 2014. Prior to that it had been
surprisingly high, given that the UK was deep in recession following the 2008
Lehman shock, with inflation topping 4% for most of 2011. That wasn’t true in
most other western countries: our economy has long been more inflation-prone
than others.

That spell of inflation was one main way in which people’s
incomes were cut in terms of spending power during that period, even if
nominally they had merely been frozen. It is why TUC research shows that real
wages in the UK fell by more than 10% between 2007and 2015.

Now, inflation is back. Mark Carney, the Bank’s governor,
will be watching the rate like a hawk from now on. It is already gently on the
up, reaching 0.6% in the year to August. Most of that still benign level will
not have been affected by the devaluation. But if the pound stays low or falls
even further against the dollar and euro, that inflation rate will start to climb
quite sharply.

With unemployment now just 5.4% of the labour force, lower
even than in America, the British labour market will be fairly tight. No one
can yet be sure what the Brexit vote has done to the incentive for EU citizens
to come to Britain looking for work, but if it turns out to have reduced the
inflow even before full Brexit has occurred, that will tighten the market still
further. Wages are already, to much rejoicing, rising at their fastest rate
since the crash.


So the scene is set for 2017 to be Harold Wilson’s year. In
post-referendum Britain, the slump in the pound looks harmless, even
beneficial. But next year, the pound in your pocket will be devalued, just as
it was in 1968, as inflation climbs. 

The big question will be what Governor Carney will do about
it: will he simply stand back and watch the real value of incomes being eroded?
Or will he tighten monetary policy and even – to everyone’s shock – raise
interest rates? With – as in Wilson’s day – Britain running a huge deficit on
the current account of its balance of payments, Carney will feel keenly the
need to keep encouraging foreigners to lend to Britain and invest in British
assets, which will
require higher returns to compensate if inflation rises. 

If that is what he finds he has to do, then the path to the
next recession will have been set. We have no need to wait to find out what the
terms of Brexit will be and what their impact will be on business investment,
employment and trade. Inflation is going to tell the story.