In the U.K., a dangerous game takes shape

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On a wet, chilly day in North London's unglamorous Kentish Town neighbourhood, Brenda Poynton is doing something she hasn't done in many years. Food price inflation is forcing her to trudge from store to store in a hunt for the lowest prices.

"My word, it's terrible," says the trim 74-year-old retired midwife. "You have to go to every other shop to find a bargain."

She emerges triumphant from the discount supermarket Iceland with several litres of milk at £1.10 a pop - pleasingly short of the typical price of £1.65. Then it's off to Marks & Spencer to test the poultry prices.

Ms. Poynton is terrified that rising prices for food and other essentials will chew into her fixed pension. Like many elderly Britons, her nightmare scenario is a repeat of the early 1970s when inflation in Britain exceeded an astonishing 25 per cent. Even as late as 1990 the figure was 10 per cent. Since then, inflation has come down dramatically and remained subdued.

But inflation has made a rude comeback in the past year or so. In December, the consumer price index hit 3.7 per cent, almost double the Bank of England's 2 per cent target, and it is widely expected to go as high as 5 per cent this year. Inflation is also making a comeback in the euro zone, though at 2.2 per cent in December, the rise is less sharp than Britain's.

Inflation has emerged as a risk to global economic recovery, but different brands of inflation are sprouting up in different areas. In fast-growing emerging markets such as China, surging demand for food staples and other goods is driving prices higher, and pressuring central banks to raise interest rates.

The big risk

Britain, however, suffers from weak to non-existent growth - gross domestic product unexpectedly fell by 0.5 per cent in the fourth quarter - meaning that any inflation-busting rate hikes risk plunging the country back into recession. While both the Bank of England and the European Central Bank are making the right noises about the dangers of inflation and their intention to fight it, they are in essence trapped. They're holding interest rates at rock-bottom levels to stimulate the economy, taking the risk that inflation could suddenly shoot higher.

Even though the Bank of England has consistently underestimated the inflation problem - its February, 2009, prediction was for a mere 0.5 per cent inflation today - bank governor Mervyn King's message is: Relax, this too will pass.

In a speech in Newcastle, England, on Tuesday, the day Britain's worrisome growth reversal was revealed, Mr. King argued that while inflation was "uncomfortably high," domestic factors are not to blame.

He identified three culprits. The first was the 20 per cent fall in the value of the pound since 2007, a decline that drove prices higher by making imports more expensive. The second was soaring energy prices. Measured in exchange rate terms, the cost of oil is up 110 per cent since early 2007. The third was the two recent increases in Britain's value-added tax (VAT, the equivalent to Canada's GST), now at 20 per cent.

Taken together, he said, those three factors contributed three percentage points a year on average to the inflation rate over four years. "Since the consumer price index as a whole rose by not much more, the contribution of domestically generated inflation over that period was close to zero," he said.

Mr. King expects inflation to fall "sharply" next year. The pound has edged up on the expectation of a rate hike (as has the euro); the VAT increases were one-off events that skewed the recent inflation figures; the British economy is running below capacity; and unemployment is high, meaning sharp wage increases are unlikely.

The big danger is that the Bank of England is dead wrong. Since the start of 2008, inflation has consistently hovered above the bank's 2 per cent target. Oil prices could continue marching higher, and U.K. consumers could respond to rising prices by demanding high wage increases.

Some economists acknowledge the risk of runaway inflation, but most attach a low probability to it. "There is a risk that inflation could accelerate, but wage inflation is not there so far," said Jens Larsen, a former Bank of England economist who is now chief economist for Royal Bank Of Canada's investment arm in London.

Some inflation is to be desired - hence the Bank of England's and the ECB's 2 per cent targets. Very high inflation is not, even though it can have one advantage: As inflation rises, growing government revenues make it easier to service debt. While cynics would suggest that the finance ministers of Europe's most indebted countries (Greece and Italy, among them) are secretly thrilled that inflation is above target, all the better to make their debt burdens more manageable, high inflation can wreck household finances and business confidence.

It does so by eroding consumer buying power, the equivalent of a national pay cut that keeps on cutting. High inflation punishes the people who did the right thing by saving their money while rewarding those that did the wrong thing by becoming debtors. It strains the relationship between employees and employers as demands for wage hikes gain momentum. In extreme cases, it triggers social unrest as food and energy prices become unaffordable to the poor.

The big doubts

The Bank of England's own nine-member monetary policy committee (MPC), which meets monthly to set interest rates, is divided on the wisdom of leaving rates unchanged as inflation picks up momentum. MPC member Andrew Sentance has been calling for a rate increase since mid-2010 to deal with price pressures. He gained an MPC ally this month in Martin Weale, who is also calling for a rate hike of 0.25 percentage points.

Mr. Larsen, the RBC economist, thinks Mr. King is probably right about inflation coming down next year. But he also knows that central bankers have no magic forecasting powers. "There is so much uncertainty now," he said.

Even the economists at the European Commission have their doubts about the Bank of England's conviction that high inflation is not embedded in the economy. In its autumn economic forecast, the EC said: "As the high inflation persists [in Britain] the assumption that it is driven by temporary factors becomes harder to maintain."

It certainly appears that Mr. Sentance thinks the bank is making a mistake. His argument is that imported inflation, as a result of high GDP growth rates in most of the developing world, is here to stay and could propel British inflation to painful levels. He argues that modest interest rate increases now would forestall the need for the shock treatment of aggressive rate hikes later. "It would be a mistake to label all the global factors affecting inflation as one-off short-term disturbances," he said in a Jan. 24 speech in London.

The euro zone's predicament is similar, if less urgent. Inflation is coming back, but is relatively benign compared to the British figure. Both the Bank of England and the ECB think there is enough slack in their respective economies to prevent an inflation crisis such as stagflation - rising prices in a sagging economy.

Britain and the euro zone have launched austerity measures that range from the mild (France and Germany) to the aggressive (Britain, Ireland and Greece). In essence, the central bankers and political leaders know they can't have it both ways. "The success of fiscal tightening is conditional on loose monetary policy." Mr. Larsen said.

It appears that the Bank of England and the ECB will wait until they see strong evidence of a sustained economic upturn before they hit the interest rate button. It's a gamble, one that hasn't always worked in the past.

Meanwhile, Britons are bracing for the high inflation rates that the central bankers insist are not coming. In London's Kentish town, Ms. Poynton is getting nervous. "You really have to think about how much you can spend on food now," she said.