Seven ‘inflation-friendly’ policies being pursued by the UK government

Inflation-friendly policies

Economics Affairs

This week my academic journal article was published in Economic Affairs entitled “The Purpose of Inflation“. You can access it from Wiley here. In it, I highlight the ways in which the government can follow ‘inflation-friendly’ policies to ensure that we will continue to have inflation in the UK.

These are as follows:

1. More quantitative easing. The MPC has not ruled out further quantitative easing. It may well be considered should the economy falter before the 2015 election. Many commentators expected the injection of £375bn during 2009–12 to be highly inflationary. It was not, primarily because at the same time the money supply was contracting due to widespread deleveraging and the banks’ attempts to shore up their balance sheets. However, the money supply is now increasing (Bank of England 2013b) and any further round of quantitative easing could well be inflationary.

2. Increases in regulated prices. A large part of the inflation rate is under the direct control of the government through regulated prices of, for example utilities, train fares, and student loans. Indeed, Mervyn King, the previous Governor of the Bank, often pointed out that this was the largest factor behind current UK inflation (Bank of England 2013c). Despite the Labour Opposition’s threats to temporarily freeze some utility prices if elected, this tool is still going to be an important one for any government to foster inflation.

3. Government housing schemes. Schemes that assist home buyers (such as Help to Buy) have already helped revitalise the UK housing market and increase the amount of mortgage loans and consumer credit (Giles 2013) This has increased house prices, which have a direct impact on inflation measures such as RPI and indirect effects through increased money supply and enhanced consumer spending, which boost prices. While the banks are still recovering their financial positions, continued government support for housing in various ways is likely to remain (especially in the pre-election period) and this will enhance inflation.

4. Devaluation of the pound. It is quite easy for a few words from the Bank of England to the effect that it expects a decline in sterling to lead to dramatic changes in the exchange rate, as was witnessed in early 2013. Such a policy has also been very effective in Japan recently. Such devaluations lead directly to higher import prices, and, as Table 1 shows, these have the power to increase UK inflation.

5. Creating a wage–price spiral. Since 2008, wages have lagged significantly behind inflation (The Economist 2013). There will come a tipping point in the economic recovery when workers start to regain the upper hand. This could even be prompted by a government which allowed widespread public sector wage increases, for example. If that occurred at a time when inflation was already at a higher level, it would enhance the effect of the wage–price spiral.

6. Increasing bank credit. The government and the Bank are already doing a lot to bolster private bank finances to encourage lending. They will probably continue to do so for some time. There will come a point when balance sheets are sufficiently repaired that animal spirits return and banks are able to significantly expand the money supply and promote further inflation in the UK. Indeed, we have already witnessed a marked upswing in unsecured loans and consumer credit in 2013 (Bank of England 2013d).

7. Increased government spending. Despite the current era of austerity, the government can also increase the money supply by investing in large projects which may not appear in the national accounts. For example, the UK government has recently sanctioned the construction of many new nuclear power stations (with funding provided by the private sector). Another large project recently agreed is the proposed high-speed train between London and the north of England. It is unclear yet how it will be funded, but it will probably not be directly from tax revenue or further government debt (Oodit 2012). However, such large-scale projects will further add to inflationary pressure.

In addition to these seven published in the article, I forgot to add what is arguably the most important driver of UK inflation today:

8. The Bank of England’s target for 2% inflation. This provide a justification for governments to follow any of the above seven policies with impunity.