Yes, inflation will fall
Yesterday’s rise in inflation (pdf) has led several people to claim that our problem is inflation, not deflation. I disagree. Insofar as we can be sure of anything in economic forecasting, inflation will fall. I say so for three reasons.1) A big chunk of inflation is the legacy of last spring’s rise in utility bills. Gas and electricity prices have risen 22.6% in the last 12 months, contributing 1.05 points to the 3.2% CPI inflation rate. But these price rises will fall out of the annual inflation rate in the next few months. This alone would take inflation down close to its 2% target.2) Some of the stubbornness of inflation reflects a rise in import prices as a result of sterling’s fall in the autumn. But unless sterling falls again - and anyone who’s certain it will is just mentally ill - this is a one-off effect that’ll drop out of the annual inflation rate next winter.3) As I’ve been saying for some time in my day job, the first effect of recession can be to raise inflation by reducing firms’ willingness to cut prices. The reason for this was spelt out in a paper (pdf) by Garth Saloner and Julio Rotemberg back in 1986. Quite simply, if there are few potential customers to be won, there’s no point cutting prices. Firms are more likely to engage in price wars in booms than in slumps. Why do you think new car prices have held up as demand has collapsed? It’s only as the recession creates spare capacity - forcing firms to scramble to win orders to keep in business - that it leads to prices coming down. But this take time. As Mervyn King wrote (pdf):The outlook for global activity will constrain UK demand prospects and, as a result, the margin of spare capacity is likely to build in the coming quarters, pulling down on CPI inflation.The key phrase there is “coming quarters.” The thing about macroeconomics - and I’ve learned this the hard way - is that things are slow. Booms go on longer than you expect, inflation is slow to rise and slow to fall, and so on. And, crucially, monetary policy - be it conventional or unconventional - is slow to affect inflation. Life is lived through time lags - a point which semi-economists, obsessed only with comparative statics, tend to forget.So yes, inflation will fall and the Bank is right to act now to take measures to raise inflation. Why does something as bland as this need saying?