The nightmare scenario: an inflation fuelled recession

One of the curious features of this recession has been the way in which it has come in waves. The financial sector was the first to be hit; followed by commercial property, the residential property market and then the high street, the service sector and more traditional industry.

Geographically too, the downturn which griped London first has rippled out to other parts. About 18 months ago, some commentators were predicting that London would be disproportionally affected because of its over-reliance on financial services. There is no doubt that London has been severely impacted but it increasingly seems likely that areas that have traditionally suffered in economic slumps will suffer more once again.

As London and financial services were first into recession, so they will be the first out. But Labour supporters hoping for a political dividend on the back of economic recovery shouldn’t get too optimistic. Even if the green shoots start to appear in London later this year (and there were some positive signs until yesterday’s dismal data on the supply of credit), there will be a time lag before other areas start to see any pick up. Indeed, the sight of London’s investment bankers enjoying bonuses again while unemployment continues to creep up in other parts of the country could fuel even more resentment against Labour in their heartlands as well as those key marginal seats.

One of the most difficult issues to predict is what will happen to prices? The deflation vs inflation argument is splitting economists down the middle. Yesterday, David Blanchflower, a member of the Monetary Policy Committee until earlier this year, writing in the Telegraph, made a convincing case for deflation.

Yet, I remain firmly in the inflation camp. One of the factors that Blanchflower seems to have underestimated is the impact of globalisation. There was a time when recession in the West would have depressed prices across the globe. Not anymore. The economies of the East are becoming far more significant. China’s GDP is expected to overtake America’s in the next fifteen years or so and is already a major consumer of the world’s natural resources. India’s economy too, is likely to become larger than the States’ by the middle of the century. This is going to have profound implications on global politics, economics and military might, and marks a significant power shift from West to East.

Despite the global downturn, China’s economy is still expected to grow by 6.5% this year. Although well down on the double digit rates of recent years, this is still formidable growth and will fuel further demand for oil and other commodities. As a consequence, the cost of things like oil is rising, despite weaker demand in the West.

So we now face a period where higher petrol prices (which seem to be rising on a weekly basis by 2p a litre at the forecourt) will start to work their way through the UK economy. With wretched timing, Alistair Darling has two fiscal measures in the pipeline that will make matters worse. In September, his fuel levy duty kicks in, adding another 2p a litre to the price of petrol, and in December, the temporary cut in VAT comes to an end. Both will add to inflationary pressures.

If inflation does pick up, the Monetary Policy Committee will have the unenviable dilemma of deciding whether or not to continue with the monetary stimulus package (risking even higher inflation) or dampening inflation through higher interest rates (and thereby prolonging and deepening the recession). This would almost certainly generate even more conflict between the Bank of England, the Treasury and No10 and would bring more misery to the rest of us.