Today sees the publication of the UK inflation figures for April which are likely to show for the first time in a while a fall in the rate of annual inflation. However whilst this dip is welcome it will remain over target which will make it some 41 months in a row that this has been the case. To show the significance of this in relation to UK economic policy making I would like to take you back to the Bank of England Inflation Report of May 2009 which told us this.

Inflation is likely to fall back sharply over the next few months…..inflation is more likely to be below the target than above it for most of the forecast period.

Okay why was that?

the margin of spare capacity that is likely to persist over the forecast period pushes down on CPI inflation

This margin of spare capacity or what is called the output gap never did push down on UK inflation did it? Never mind some still think that it doing so is just around the corner.

This policy error led the Bank of England to keep expanding a programme designed to increase the rate of inflation.

to increase the programme of asset purchases to £125 billion in total

It is of course treble that size now.

Back then an excellent question was asked by Sam Fleming

Could I ask you – the recovery and growth in 2010 gets us towards about 3% growth, looking at the Fan Chart. Could you explain why it is that, given that sharp recovery – or apparently sharp recovery – you expect inflation to remain so low,

So as we are reminded that it was not only inflation the Bank of England has been useless at forcasting as its growth projections were hopeless too, we are also reminded that the two were contradictory. Just to add to the air of incompetence let me use Mervyn King’s explanation of why UK inflation would fall.

I think we’ve had news on energy prices, retail energy prices, over the next year or so, which actually is on the downside

How did that fall in energy prices work out Governor?

Surely they are not one of the “administered prices” that you complain about now…….

Anyway his fantasy world of 3% economic growth and rising and inflation below target never took place. Neither did the rises in base rate expected by other forecasters to 3.4% by now (this was an average hence the 3.4% reading). Instead the UK has found itself in a stagflationary environment with little growth and over target inflation that back in the autumn of 2011 exceeded 5%.

The cost of this inflationary excess

The Item Club has done some work to estimate the cost to the UK economy of this persistent inflation overshoot where annual inflation averaged 3.3% in 2010,4.5% in 2011,2.8% in 2012 and they expect to average 2.9% this year.

The main factor involved is something very familiar to readers of this blog which is the fall in real wage levels.

The high retail price inflation seen in recent years has outpaced earnings and eaten into household spending power.

They have quantified an impact of this on UK economic growth.

Persistently high inflation has knocked almost 3% off UK growth over the last three years…….had inflation averaged 2% over the last three years – rather than 3.5% – UK GDP would now be over £10bn higher.

It is nice to see this issue get some publicity although the Item Club fail to point out the fundamental issue in a policy supposedly designed to provide economic growth that reduces it. Perhaps they are frightened that HM Treasury would ask for their economic model back if they did! Something must have caused the barrage of ill-logic that they deploy about those like me who suggested alternative courses of action as I was an outlier so to speak and yet they make suggestions such as base rates at 4% way beyond what I suggested.

Why didn’t UK prices fall?

Returning to the title of this post I think that considering the scale of the UK economic contraction which we have still not retraced we would have expected not only falls in the annual rate of inflation but outright price falls. A bit like what is beginning now to spread across the periphery of the Euro area. The reason why we did not have them is that the incredibly expansionary monetary policy acted to stop it. It was not the only influence as rises in indirect taxation for example contributed but we persisted in above target inflation when the Value Added Tax rise dropped out of the annual figures.

The consequence for the UK economy was a fall in real wages which has persisted and in spite of today’s inflation fall remains at an annual rate of 2% using our official inflation measure or 2.5% using the Retail Price Index. If you asked me to name the biggest error in UK economic policy over this period I would say that this is it.

We will have to see what develops in the months ahead but we also know that nominal wages fell in March and so this unfortunate state is likely to persist and may even get worse. Predictably the Item Club seem to have ignored such a reality and wandered off in a some sort of alternative universe.

Meanwhile, average earnings growth will experience a pick-up from 2014, but is likely to take several years to return to more ‘normal’ rates of 4% or more.

Today’s numbers

These were rather welcome as we saw a drop in the annual rate of inflation.

The Consumer Prices Index (CPI) grew by 2.4% in the year to April 2013, down from 2.8% in March.

Okay why?

By far the largest downward contribution came from transport costs (notably motor fuels and air fares).

This made me think that surely we should be expecting a drop in household bills for energy as surely one barrel of oil is the same cost as another? But of course the government which is anxious to pass the blame for this onto the utilities supplying this is also acting to raise household energy costs. Or as the Item Club report put it.

as suppliers’ costs are increased by the need to comply with climate change targets

Please remember that the next time they are on television promising to help with energy costs. It is government policy to raise them.

Back to the numbers

The monthly rise in the CPI was 0.2% and the underlying index is now at 125.9 where 2005=100.

The Retail Price Index rose at an annual rate of 2.9% down from 3.3% and its underlying index is 249.5 where 1987=100.

Consumer Prices Index Housing

Last summer/autumn I was very critical of the methodology used in this measure which is called CPIH. If you look at today’s numbers you can see why.

In April 2013, the 12-month rate (the rate at which prices increased between April 2012 and April 2013) for CPIH grew by 2.2%, down from 2.6% in March.

Okay so we know that this is lower than the headline rate so house prices must be falling? Er well no..

In the 12 months to March 2013 UK house prices increased by 2.7%, up from a 1.9% increase in the 12 months to February 2013.

Not the same month as that is March rather than April but I suspect that the same will hold. Rather than a theoretical dissection of the position I thought it would be clearer to show the numbers and the contradictions they clearly imply.

Comment

I wanted today to illustrate a major policy error made by the UK which in spite of today’s good news on inflation leaves us with a contractionary problem as real wages continue to fall. We can also permit ourselves some familiar light relief.

Economist watch: Not one of the 29 polled by Reuters got UK inflation right. Range was 2.5% to 2.9%. Figure was 2.4%.

That has become familiar but it did not use to be so as there was a time when the numbers were forecast accurately. Either economists have got worse or the situation has become less predictable or some combination thereof.

If we move forwards we are likely to see less favourable annual numbers for May and June because they will be compared with price falls of 0.1% and 0.4% respectively from last year. However Mervyn King is less likely to have to write another letter explaining why inflation has exceeded 3% as he may have in a version of what is called a hospital pass in rugby shifted this to his replacement Mark Carney,who accordingly may have been the only person who regarded today’s inflation numbers with a grim smile.

Looking forwards we face a future with very contrary pressures as whilst the UK remains prone to inflation there are also disinflationary pressures on the march. Yet factors which you might think would help us are not currently doing so. For example the oil price seems to have plenty of reasons to fall ( US production for example..) but invariably seems to bounce back (US $104 as I type this) and the pound’s exchange rate has been drifting lower to below US $1.52 compounding this.