Inflation OK (just don't pass it on)
The Bank of England's deputy governor, Charlie Bean, was a bit defensive about the Bank's recent inflation record in a speech he gave in London this morning [44KB PDF]. And well he might be.
In August, 2009, the Bank was forecasting that CPI inflation would now be around 1.5%. In fact, it is running at an annual rate of 3.2%.
As the Chief Economist, Spencer Dale, pointed out recently, in the past four years, inflation has been above target for 39 of the past 48 months. It has averaged almost 3%.
There are some plausible explanations for this, which the deputy governor went through in his remarks, the most important of which are unexpectedly high energy prices, and a surprisingly high degree of "pass-through" into final retail prices of the impact of a lower pound.
(Put simply, when a 25% fall in the pound caused a sharp increase in the cost of imported materials, companies have chosen to pass this increase on directly to the consumer.)
The other, more worrying, explanation is that there is less spare capacity in the economy than we would think, given the depth of the recession - because the financial crisis has destroyed more of our long-term capacity than we thought. That would suggest we have less room to grow without triggering inflation.
This has been a running theme here. There is some evidence of this in the business surveys: companies do not report having as much room to grow in the short-term as you would expect, on the basis of what they were producing during the boom.
But if companies were really hitting bottlenecks, you would expect to see an increase in pay, at least for skilled workers in high demand. There is not much sign of that, so far.
Relative to the scale of the downturn, you've also seen surprisingly few corporate bankruptcies: if there has been an exceptional hit to Britain's supply potential it doesn't seem to have come from firms going bust.
That speaks to the larger surprise about the increase in inflation - which is the degree to which the cost has been shouldered by consumers rather than companies.
As I've mentioned many times in the past, corporate profitability has held up surprisingly well in this recession (see, for example, my post Feast and Famine for UK businesses). It is real disposable income that is taking the hit.
At the end of the second quarter of 2010, the economy was 1.7% bigger than it was 12 months earlier, but real household disposable income was 2.6% smaller. You get a similar picture from the TPI - a cost of living index which measures not just the impact of price increases but higher taxes as well. That suggests that the overall cost of living has risen by 5% since the end of 2009, whereas average weekly earnings (including bonuses) have risen by just 1% in that time.
As the deputy governor says, this is how the Bank's "constrained discretion" on inflation is supposed to work. The Bank "looks through" temporary increases in inflation, because it seems more sensible to let the inflation rate wander around a bit than to force big swings in the real economy, just to keep inflation rigidly to target (assuming that kind of fine-tuning were even possible).
It makes a lot of sense. But we shouldn't be under any illusions: this approach says that inflation isn't really worth worrying about, as long as households continue to bear the brunt. Price rises can be "looked through" - wage increases to compensate for those higher prices must be stopped.
The inflation may be temporary - and it may be due to "exceptional" increases in energy and other costs. But that doesn't make the price increases any less real. Households have been squeezed in 2010 and, with higher VAT and more benefit cuts coming down the track, they are going to be squeezed again in 2011.