The United Kingdom's inflation performance: an analysis by the CBI's economic staff. (Confederation of Banking Industry)

Introduction

Despite the improvement in the United Kingdom's relative inflation performance in the early 1980s, we have not closed the gap with our major competitors, particularly those in Europe. Indeed, the gap is widening.

Because has more than most to lose from inflation, not least because it undermines out international competitiveness. This will be even more apparent when the United Kingdom joins the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS).

In January this year, therefore, the CBI's Council asked its Economics staff to prepare a study of the underlying causes of the United Kingdom's current inflation problem.

This study is the response to that request. While we take full responsibility for any errors of commission or omission, we have been greatly helped by many CBI members. We have drawn on the advice of a panel of business and academic economists set up for the purposes of this study; Dr Charles Bean, London School of Economics; Professor Alan Budd, Chief Economist, Barclays Bank; Professor David Currie, London Business School; Richard Freeman, Chief Economist ICI plc; Giles Keating Research Director, CSFB Securities; Christopher Johnson, Group Economic Adviser, Lloyds Bank; Bill Robinson, Director Institute for Fiscal Studies; and Keith Skeoch, Chief Economist, James Capel and Co Ltd.

Although they are not ultimately responsible for the conclusions of this report, we are extremely grateful for their advice.

The fact that inflation has been a persistent problem for the United Kingdom economy under many governments suggests that there are no easy solutions available. It is not surprising, therefore, that some of the measures which we conclude are needed to bring down inflation could cause considerable difficulties for CBI members in the short run--indeed they are already doing so in many sectors.

This report does not represent a statement of CBI policy. However, we hope that its conclusions will command serious attention--not only from the CBI Council and its policy committees- -but from all whose actions affect the prospects for inflation in the United Kingdom.

Summary

Throughout the post-war period, the United Kingdom has experienced relatively high inflation. In the 1960s UK inflation averaged just under 4 per cent per annum compared with an average for OECD countries of under 3 per cent. This gap widened in the 1970s and from 1973 to 1979 UK consumer prices increased on average by 15.6 per cent per annum--almost 6 percentage points higher than the OECD average and 11 percentage points higher than West Germany.

By the mid-1980s, we appeared to have put the worst of these problems behind us. Though there had been a tremendous cost--in lost output, capacity and jobs--in the early 1980s, the battle against inflation appeared to have been won. In the five years to 1988, UK inflation(1) averaged 4.6 per cent, a performance which had last been achieved in the 1960s.

The re-emergence, since 1988, of much higher levels of UK inflation has therefore come as a bitter disappointment. The inflation gains of the early 1980s appear to have slipped all too easily through our fingers.

What has gone wrong? What is needed to rectify the situation? This report aims to answer these questions.

Though it is not always apparent in the short-term, inflation is very damaging to our economic prospects. It distorts values and increases uncertainty, resulting in inefficiency and missed investment opportunities. Externally, it threatens competitiveness. Moreover, experience has shown that if moderate inflationary pressures are not checked, they continue to build up. Stable prices are therefore an essential prerequisite for sustained investment and economic growth.

It is business--and particularly business exposed to international competition--that bears the brunt of the national failure to squeeze inflation out of the economy. This exposure will be increased when membership of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) eliminates the possibility of devaluation to maintain our international competitiveness.

Many blame present inflation on policy errors in 1987/8. Yet as chapter 2 makes clear, the roots of the problem lie further back. After years of relatively high inflation, the United Kingdom had fallen into line with the OECD average by 1983/4. However, this achievement was not consolidated: the underlying rate of inflation in the United Kingdom settled at around 5 per cent when other countries were achieving much lower rates. Inflation has picked up again world wide, but the United Kingdom started from a higher base.

The basic problem was that throughout the mid-1980s, domestic demand was allowed to grow much more strongly in the United Kingdom than in our competitors' countries. While this may have been compatible with low inflation as the economy recovered from recession, it could not be sustained without fuelling inflationary pressures. The direct cause of this fast demand growth was the coincidence of financial deregulation and an increased desire to borrow, which fuelled consumer demand, and a recovery in business investment.

Nevertheless, this unfortunate conjuncture of events does not constitute a complete explanation: it is the government's responsibility to regulate demand so that it rises in line with the capacity to supply. The appropriate response would have been to tighten monetary and/or fiscal policy as the demand pressures became apparent.

There appeared to be three main reasons why corrective action was not taken. First, there were technical difficulties in controlling the economy. Financial deregulation distorted monetary indicators and meant that economic monetary policy was increasingly governed by judgment rather than reference to reliable indicators. Measurement errors also distorted the other indicators on which the judgment was based, in particular the national accounts statistics.

Second, in the 1980s, the elimination of inflation was given a lower priority than other policies, such as tax cuts, privatization and reform of local government finance. This would not have been so damaging if decisions taken in pursuit of these policies had not added to inflationary pressures at the same time.

Third, it appears that the task of achieving low inflation had been more difficult in the United Kingdom than elsewhere and the cost of bringing inflation down--in terms of lost output and higher unemployment--has been higher. This obviously weakened the government's desire to bring inflation down further when it appeared that it had been reduced to a reasonable level. Two structural features of the economy have contributed to this:

* UK labour market institutions and practices resulted in wages being less responsive to the level of unemployment in the mid-1980s than in many other countries.

* More significantly, there is a pervasive inflationary psychology in the United Kingdom which is not present in countries with a better inflation record and with greater credibility attached to their anti-inflationary policies. The symptoms of this psychology are all around us--in attitudes to pay bargaining and homeownership and in the still widespread indexation of many contractual arrangements.

What then should be done? The inflationary challenges of the 1990s are likely to be no less intense than the previous decade. Rising oil prices and the spending power which could result from a higher rate of intergenerational inheritance are just two of the possible threats. Chapter 3 puts forward policy conclusions based on the lessons drawn from our experience in the 1980s.

To bring inflation down there appears to be no alternative to tight policies which reduce demand growth, though there may be some scope for changing the mix of monetary and fiscal policy used to achieve this. Such policies will inevitably involve some cost, in terms of business failures, lost output and unemployment, as the experience in France illustrates. However, the more than can be done to influence inflationary expectations in a downward direction and break the inflationary psychology, the lower this cost will need to be.

To keep inflation down, we shall need to institutionalize more firmly the commitment to stable prices. Only in this way can the inflationary psychology be fully squeezed out and a damaging resurgence of inflation avoided. The commitment to maintain the value of the pound against the low-inflation countries of the ERM would be one means of achieving this. An Independent Central Bank, committed to stable prices, would be another alternative, or complementary approach.

Other changes which would help include:

* fiscal measures to raise personal savings;

* a 'counter inflation' unit within government to ensure the full impmpact of policy changes on inflation and inflationary expectations is taken into account when major decisions are taken;

* reform of the UK retail price index;

* continued decentralization and increased flexibility in public as well as private sector pay bargaining;

* further measures to improve the supply-side of the economy.

The mistake made in the mid-1980s was to think that inflation was beaten and to shift attention to other policy goals. Once inflation is brought down again, we need to institutionalize low inflation within the United Kingdom economy, as the (West) Germans have done and as the French are now beginning to do. This is the main challenge for the UK economy in the 1990s.

Why inflation matters

Inflation is a general rise in the price of goods and services in the economy. It is often taken for granted in public debate that inflation is damaging to investment, economic growth and competitiveness. Yet the damage caused by inflation is not very visible, whereas the costs of policies to tackle inflation are often all too plain to see. The reasons for seeking to achieve stable prices (and hence for reducing inflation) as a policy goal therefore need some explanation and justification.

There are three particular problems caused by inflation within a market economy. The first is that it distorts the signals given by prices. In a market economy, price signals are crucial to identifying profitable market opportunities for companies and as the basis for consumer decisions. When all prices are changing, however, it is more difficult for consumers and producers to distinguish relative price changes. Perceptions of value for money are distorted and there is an increased risk that resources will be misallocated.

The second problem caused by inflation is the uncertainty it creates. Inflation would be easier to cope with if it was predictable--but it is not. In general, high rates of inflation have been associated with more volatility, and hence less predictability, in the inflation rate. The evidence of this can be seen by comparing the United Kingdom's experience with that of (West) Germany. In the United Kingdom, consumer price inflation has averaged 8.1 per cent per annum since 1960, compared with 3.6 per cent for West Germany. However, as Figure 1.1 shows, over this period German inflation has fluctuated between a peak of 7.0 per cent per annum in 1974 and -0.2 per cent in 1986, a range of just 7.2 per cent. United Kingdom inflation has fluctuated within a range three times as great, averaging 24.2 per cent in 1975 but just 2.4 per cent in 1967.

The uncertainty created by inflation has two major economic effects. The first of these is that it diverts economic activity from the creation of wealth to the need to protect against inflation. This effect was recently described by the Governor of the Bank of England:(2)

The higher the inflation rate, the less stable it is likely to be; and the less stable the inflation rate, the greater the uncertainty that is generated. The upshot is that contracts are written, and behaviour is modified, to minimise the effects of the uncertainty. In other words, we find ourselves worrying about how to protect wealth, rather than how to create it.

Zero inflation is likely to be more stable and credible than any other level--and more consistent with a society where contracts mean what they say and the financial system supports enterprise.

One result of the distortion created by high inflation in the United Kingdom has been to focus particular attention on the housing market as a means of protecting the value of personal wealth. As Figure 1.2 shows, during the 1970s this was the only effective hedge in the face of a 261 per cent increase in prices over the decade. This experience has shaped attitudes in the 1980s, even though inflation was much lower over this period. In general, the constant preoccupation with the need to safeguard against the decline in the value of money is a persistent drain on the productive power of the nation.

The second major economic effect of the uncertainty created by inflation is to reinforce the short-termism which is so frequently observed as a feature of the British economy. The more uncertain the future, the shorter will be the time horizon that individuals and companies consider. In a recent study of the cost of capital in a number of different countries,(3) Robert McCauley and Steven Zimmer found that the real cost of capital in the United Kingdom was higher than in Japan and (West) Germany. The conclusions are illustrated in Figure 1.3. For example, the payback required on machinery and equipment with a physical life of twenty years averaged 7.5 per cent per annum in West Germany, between 1977 and 1988, compared with 9.8 per cent in the United Kingdom. For a research and development project with a 10-year pay-off lag, the return required was 24.8 per cent per annum in the United Kingdom compared with just 14.2 per cent per annum in (West) Germany.

Commenting on this result, the authors concluded:

West Germany has enjoyed lower price volatility than the other countries studied. Low price volatility leaves German savers willing to accept low real rates of return on debt. Low and stable inflation (also) limits the risk of paying high real interest rates when an acceleration of inflation induces the monetary authorities to tighten. US corporation and, to a lesser extent, UK corporations regularly issue long-term, fixed interest debt in order to lock in fixed payments to shield their earnings from a sudden rise in higher real interest rates on short-term debt. This insurance carries a cost, however, since long-term, fixed-rate debt exacts over long periods, a premium relative to the cost of short-term, floating-rate debt.

By relying heavily on floating-rate debt from banks, Japanese and German companies avoid paying this premium. Corporations in Japan and Germany expose themselves to less risk in funding themselves at the short end of the yield curve owing to the more stable real rates associated with stable prices.

These problems are reinforced by the fact that the economic system is not neutral with respect to inflation and this is the third main cost associated with inflation. When the general level of price rises within the economy, not all prices change and many values remain fixed in money terms. There are three particular problems that this causes for business.

First, higher inflation means higher nominal interest rates, as Figure 1.4 illustrates. While theoretically this should not affect investment decisions, if the real (i.e. inflation adjusted) cost of capital does not change, the reality is somewhat different. One …