The rate hikes begin

With each passing month, the inflation numbers are getting worse. As the numbers deteriorate, the options available to central banks are becoming narrower; either raise rates and take the inevitable hit on growth and financial stability, or let the problem slide and watch inflation slip further. With double-digit inflation hovering on the horizon, some central banks are beginning to act.

Does the idea of double-digit inflation sound too alarmist? Last month, the RPI inflation rate was only at 4.3 percent; at least 5 percentage points south of a double-digit rate.

Looking at today’s inflation rate is like trying to drive by looking in the rear view mirror. Inflation is a forward-looking phenomenon, and therefore central banks should assess future expectations when formulating policy. In the absence of a credible policy response to rising prices, private sector expectations are adjusting rapidly upwards.

People are not daft; they see what is going on, and they do not like it. So far, central banks have acted too slowly to counter the inflationary threat. People have noticed this growing cowardice in the face of the inflationary enemy.

Whatever economists might think, inflation is not a concept that tests the intellect. When prices start to rise, everyone quickly grasps that money in your pocket today buys less in six months time. Therefore, it is better to spend it before it loses value. Saving is futile when inflation rises above the bank deposit rates; each pound held in the bank will be worth less in the future.

Although inflation destroys the incentive to save, it does not generate a huge consumption boom. Rising prices erodes the value of fixed incomes, unless wage growth keeps up with inflation people become poorer. In fact, inflation is the mother of income inequality. It punishes those on pensions, and those who cannot push through inflation indexed wage increases. It favours the rich, who generally hold real assets and can diversify their wealth, and punishes the poor who cannot.

Inflation is a terrible thing; and ordinary people instinctively understand this. Therefore, once inflation expectations take off; they quickly run out of control. Imaginations run wild; people begin to expect the worse; and once the idea of double-digit inflation enters the popular imagination, it becomes almost self-fulfilling. If people think double digit inflation is possible; it will happen.

Already, 50 countries, including six of the 10 most populous ones, are now dealing with inflation rates in excess of 10 percent. Close to three billion consumers are currently suffering double-digit rates of price increases. If it can happen there, it can happen here.

Some central banks are waking up and starting to act. Yesterday, the ECB finally understood the dangers ahead and hiked rates by a 0.25 percent to 4.25 percent; Earlier, Sweden's central bank raised its benchmark interest rate a quarter point to a 12-year high. The Norwegian central bank raised rates earlier in the week.

Other central banks do not quite have the message yet. Notably, the Fed has been slow to notice the growing inflationary dangers. Its sudden post-credit crunch monetary easing is beginning to look positively foolish. It has not put a floor under equity prices, it has not prevented growth from slowing, and it has not stopped house prices crashing. The monetary easing has not even stabilized financial markets. It has, however, done wonders to excite inflationary expectations.

Here in the UK, the Bank of England did not go quite as mad as the Fed. Nominal rates have come down a little, while rates adjusted for inflation hover fractionally in positive territory. Nevertheless, over the last few months, the MPC repeatedly missed the opportunity to tie down decisively inflationary expectations. Instead, it relied on luck, hoping that a modest slowdown in activity might be sufficient to bring inflation back down close to target. So far, luck has not shined on the hapless MPC.

The MPC would find it easier in the end to try to contain inflation when it hovers at between 4-5 percent, rather than to attack it when it is approaching 10 percent. The mood is shifting, rate rises are coming; and the sooner they arrive, the less painful they will be.