Higher prices are squeezing consumers rather than sparking pay rises

THE script for 2011 had been well rehearsed. The Treasury’s fierce fiscal retrenchment would undoubtedly hurt the economic recovery. But the Bank of England would add balm by maintaining an extraordinarily loose monetary stance. Just three weeks into the new year, however, surging inflation has disrupted the story. The worry is that this could endanger the recovery by forcing a premature tightening in monetary policy.

Official figures out this week made uncomfortable reading for the central bank, which has the task of meeting the government’s 2% inflation target. They showed consumer prices rising by 3.7% in the year to December, up from 3.3% in November. The outcome was a lot worse than the 3.4% rate that City economists had predicted. The upward lurch largely reflected higher fuel and food prices. The price of petrol at the pump reached a record high of £1.22 ($1.90) a litre, home gas and heating-oil bills increased and food-price inflation went up from 4.9% to 5.7%.

Throughout 2010 inflation ran at or above 3%. That is a pretty dismal record, but it will get even more wretched this year as inflation heads above 4%. For on January 4th, the main rate for VAT, a consumption tax, was raised from 17.5% to 20%. While some retailers might already have jumped the gun, the main effect of the tax rise will be felt in early 2011. When VAT went up a year ago only about half of the increase was passed on to prices. This time virtually all of it is expected to go through to prices.

But a jump in inflation caused by higher commodity prices and a rise in VAT—in an economy with spare capacity—is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending. Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.

Unsurprisingly, households are now expecting inflation to be higher over the coming year. But other official figures published this week showed no sign of a pay-price spiral. Average earnings are rising by just 2.1%, a very muted rate by historical standards. It is difficult to envisage wages taking off when the public sector is shedding jobs and facing a two-year pay freeze and there are 2.5m people unemployed, close to 8% of the labour force. Indeed the youth-unemployment rate has reached 20.3%, the highest since comparable records began in 1992.

The economy clearly retains quite a bit of spare capacity—the main reason why the Bank of England has insisted that the flare-up in inflation will be temporary. The bank has lost credibility as the inflation overshoot has persisted and its forecasts have proved incorrect. But the best way to regain its credentials is not to make a panicky move now but to hold its ground, tightening policy only when it is clear that the recovery can cope with the fiscal clampdown. That should be apparent by late summer. And that is when the bank is likely to start restoring more normal monetary settings, by raising the base rate from its all-time low of 0.5%.