Everyone is talking about rising VAT, the dangers of falling demand and spiralling prices – but that’s only half the story.
High inflation was largely ignored throughout 2010 but it will have a much more marked effect this year.
It’s already beginning to have an impact on expectations. Wage demands – if not yet settled – are beginning to rise.
Although inflation is running significantly over target, the UK’s mortgage and housing industries need a knee-jerk reaction to the situation like a hole in the head.
The Monetary Policy Committee therefore faces a delicate task ensuring the rate of inflation works for us now and in the years to come.
For one, the MPC needs to think hard about inflation’s effect on the finances of property owners.
A rate rise would have a devastating effect on borrowers on variable rate and tracker mortgages who have only been able to keep up with payments thanks to the current affordability of finance.
A rate rise, along with reduced levels of housing benefits, could lead to a sharp drop in prices, meaning the spectre of negative equity could return to haunt home owners.
A rigid adherence to the 2% target could mean the MPC cuts off its nose to spite its face
Aside from the obvious pain this would cause for borrowers who default – and their lenders – a significant fall in property values would restrict labour mobility and hold back consumer spending, which would have dire consequences for the wider economy.
If rates really must rise, one way to avoid defaults and negative equity would be for the Bank of England to buy-up mortgage based securities, but this would be an expensive and controversial option that would establish a potentially uncomfortable precedent.
A simpler solution is to keep rates low. If inflation were to run at around 4%, it would be possible to largely abrogate austerity measures and inflate debt away.
After all, much of the current price growth is transitory. If you strip out the effects of tax rises, currency devaluation and rising energy, food and commodity prices, Retail Price Index inflation in the UK looks closer to zero than the current 4.7%.
This is not to say the rates should remain at 0.5% for the next few years. The current Bank rate represents an historic low that may well prove unsustainable in the face of increasing commodity, utility and tax costs.
If these begin to significantly outstrip wage inflation, then UK households will find that they lose out at the supermarket till, rather than the broker’s office.
A fine line has to be trodden, but a rigid adherence to the 2% target could mean the MPC cuts off its nose to spite its face.
Of course, rates must rise in the long term – if only so the MPC has some room to manoeuvre through the next crisis.
But for the moment, a bold approach to monetary policy is the best way to ensure medium-term growth and to ensure borrowers’ finances are sustainable.