John Major shows the way

Inflation versus deflation? The answer is obvious. While some assets are likely to fall in nominal terms; particularly house prices, the general price level is likely to keep in rising rapidly. There is a simple reason why: monetary growth in the UK is still very fast.

The last time the UK faced such a serious rise in inflation was back in the late 1980s. The experience offers some basic lessons on how to tackle the problem; lessons that the MPC would do well to study.

Back in the late 1980s, the UK went through a housing market inspired boom. Like our bubble, it was caused by excessive credit growth, irresponsible banks, and a UK public obsessed by making easy money on housing speculation. The consequences of the bubble were disastrous. By late 1989, inflation was touching 10 percent. The Major government, who controlled interest rate policy back then, pushed rates up. Inflation fell, but at the expense of a deep recession.

The chart above compares the last significant period of monetary tightening with today. On the horizontal axis we have months, while on the vertical axis we have the 12 month growth rate of M4. The blue line represents the Major government's tightening. They brought monetary growth down from about 18 percent a year to about 5 percent within about 18 months. Interest rates stayed high until inflation was brought firmly under control.

The Major government began tightening well before the bubble reached its peak. The banks didn't realize they were serious for about a year. They kept on lending throughout the early part of 1989, and the housing bubble continued to appreciate. Likewise, inflation kept on rising. Once the bubble had burst, interest rate stayed high until the government had firmly re-established control over the money supply and inflation was firmly on a downward track.

So what are the lessons from the Major government's fight against inflation? First, monetary policy takes time to work. Typically, it takes about 18 months to 2 years before a rate rise puts downward pressure on prices. Second, if you let inflation run out of control, the output costs are huge. By the time the 1989-92 show was over, unemployment peaked at over three million. Third, it takes resolve to beat inflation. Don't cut rates until inflation is definitively on a downward path. Finally, and Brown and Darling should pay particular attention here; the UK electorate appreciates governments who take on and beat inflation; Major was re-elected in 1992.

Today, monetary policy is in a mess. In contrast to the Major government, the MPC reduced interest rate as inflation was picking up speed. In fact, over the last two months, inflation has begun to grow at an alarming rate. As for monetary growth; it has barely slowed. The MPC seem paralysed with fear.

As an anti-inflation strategy, cutting rates as prices accelerate is incoherent. As a crude attempt to protect banks, it may have some temporary success. In the long term, inflation will continue to rise, and it will probably delay a clean-up of banking balance sheets.

Admittedly, John Major seems an unlikely hero. So if the comparision between today and the Major government leaves you unconvinced, then perhaps the most compelling argument against deflation is the data; inflation continues to rise. This should be no surprise to anyone; the monetary growth numbers tell us to expect it.