There’s something oddly perverse about economic
policy. When prices are cheap, thanks to cheap imports from China, consumers are
happy. The Bank of England lowers the rate of interest, in turn making us feel even
better off.

When times are getting tougher, and the price of oil makes us feel the cost of
running our cars, the Bank of England ups the rate of interest, making us worse off still.

But maybe the changes in the rate of interest, designed to stop inflation, are in
fact making it worse – in the long run that is. Economics can be like that. Policy
designed to avoid something happening, can make it happen.

It all depends on what you think causes inflation. If you believe the Monetarists
got it right, and it’s down to the money supply, then we have a problem, and the
policy of the last few years is making it a lot worse.

Economists used to talk about a phenomenon known as the Philips Curve. This
was the idea that there was a trade off between unemployment and inflation; a little
bit of inflation was a good thing, because it enabled full employment. The trouble is
this: when markets, and the labour market in particular, start to expect inflation, the
Philips Curve stops working. And for it to work, inflation has to be greater than
expected. It appears that, in the long run, the trade off is not between unemployment
and inflation, rather it’s between accelerating inflation and unemployment.

But of late, and particularly in the UK, we have had the best of both worlds. The
beast known as inflation has stayed curled up in its cave, while workers went off to
work like they had never done before.

Maybe the underlying reason for this lies with demographics. The high
unemployment of the ’70s and ’80s coincided with the period when the baby boomers
were leaving school. With those days behind us, simple demographics are keeping
unemployment down.

The usual characteristics of an economy with a static or falling working population are
often full employment, low inflation, but low growth. This time, however, we are having fast growth.

The Bank of England, seeing low inflation has kept the rate of
interest low, making us feel good and an creating an unprecedented, consumer boom.

But this has led to worrying growth in the Money Supply, and the
spiralling asset prices of recent years.

So what happens when the era of cheap imports comes to an end. Maybe, just
as the high price of oil was a one off, so too has been the falling high street prices?
And maybe inflation has not been laid up in its cage at all, rather it’s been building its
strength.

The shortage of labour has brought with it immigration, longer working hours, and
people working past normal retirement ages.

And, as Peter Spencer from the Ernst and Young ITEM Club says, the UK is
experiencing an output gap, which means that the UK is producing at below its
capacity, and is capable of growing at faster pace than it is. The rate of interest,
Professor Spencer has previously said, has been a 1/2 percent lower than it would
have been thanks to this extra labour pool the UK has been able to call upon.

But, in the medium term, problems set in. And this output gap could lead to the
UK growing too fast. In order to stop inflation, the rate of interest would need to rise,
and rates of 5.75 percent may be required. Professor Spencer told Investment and
Business News: “My natural interest rate figure of 5.75% assumes that the benefit
from immigration broadly continues as a trend and is not just a blip. If so, the medium
term implication is that rates must rise, even though the short run (blip) effect may be
to lower them.”

But the ITEMS Club’s top economist says his interest rate projection takes no
account of consumer debt.

So it seems to us that in the medium term the UK walks a tightrope. The rising
level of the work force will promote much better growth, and give government
finances a big boost. But, the Bank of England must up the rate of interest to stop the
UK from overheating. Given the high level of consumer debt and house prices, there
are dangers in that and the rate of interest required to temper inflation could spark a
consumer spending crisis.

The rise in immigration could lead to a rise in the natural level of unemployment,
meaning the Philips Curve would become an issue again, with the government
having to make a direct choice between unemployment and inflation.

Then again, you pay your money and take your choice. Do you want low growth,
low inflation and low unemployment, or do you want faster growth? In economics,
good news and bad news can be bed fellows. In the long run, the UK faces a
pension time bomb. The scenario described above could be a mixed blessing in the
medium term, but in the long term, it could be the solution to the needs of our future
pensioners, and that, dear reader, is you and me

Article written by Michael Baxter

© Investment & Business News 2013