Well there's a shock, the ONS has revised the GDP for Q4 2010 from -0.5% to -0.6%. Everyone was expecting a change but no one was expecting it to be down. It seems Q4 (Oct, Nov, Dec) was even worse than realised.
Inflation ended the year at 3.7% (CPI, RPI was higher.) It has subsequently gone higher, to 4.0%.
So it looks like we have stagflation: price inflation but GDP shrinkage.
The BoE is now being ground between a rock and a hard place. They claim interest rates cannot be raised to combat inflation because economic growth would be choked off if debt became more expensive, but growth is already negative. One member of the MPC, Adam Posen, even wants to inject more QE money into the economy to stimulate growth. But QE is inflationary. When they did the first round of QE there were deflationary pressures in the economy which meant the inflationary effect was delayed, but the delay has expired and we're seeing the inflation now. More QE now would be like spraying petrol onto a naked flame. There are now no deflationary pressures to delay the effect.
So to preserve the buying power of sterling we need higher interest rates. And yet there is no doubt MK and his ilk are right, higher interest rates will reduce growth - or rather increase economic shrinkage, since we don't have any growth.
(MK is fond of pointing out that higher interest rates leave less money in the pockets of borrowers so spending is reduced. He never adds that savers get more money. However he's not wrong that spending would be reduced since savers are, by definition, people who are less inclined to spend.)
So what's the answer? Go for growth or try to hold the line on inflation?
Basically there isn't an answer. You have to pick the lesser evil and let it happen. The Bank has clearly chosen inflation as the lesser evil. They'll take growth at the cost of inflation. This is the wrong decision though.
Inflation is like a vampire, sucking wealth from us all. You can kill it with a stake through the heart, but if the stake ever falls out the vampire gets back up again and comes straight at your throat. Trying to do a deal with the vampire is futile. You can say, "I'll let you suck a little blood for now and deal with you later," but all the time it's sucking blood the vampire grows stronger and it doesn't stop until you've died of hyperinflation.
The alternative is to keep the stake in the inflation vampire and have a recession instead. Recessions are of course painful, asset prices drop, house prices drop, jobs are lost, salaries of those lucky enough to have a job decline, but recessions are not self-fuelling. They don't grow stronger the longer they last. In fact they bring their own solutions with them. As jobs are lost, asset prices decline and wages decrease, the country becomes more competitive. Making something, anything, costs less. It costs less to buy the land, to build the factory, to hire the workers, and so exports pick up. Jobs are created, wages rise and the recession is over.
If the BoE had dealt with the inflation vampire years back, when this blog first started making the sign of the cross in the direction of inflation, it wouldn't be facing the current dilemma. However they didn't. They took the easy option and let the vampire have a little suck. A small stake could have fixed the problem back then. Now it will take a big stake and the resulting recession will be worse as a result.
But even now, the sooner they bite the bullet the better it will be.
If they refuse to bite the bullet the path ahead looks something like this.
Sterling will fall relative to other world currencies because there will be little point holding such a low-yielding currency. So commodity prices, set on the world markets, will rise. This will feed through into shop prices in the UK and choke off demand. There will be some attempt to get wages up, but this will mainly fail: in the public sector because of the government's determination to freeze public sector pay, and in the private sector because the profits won't be there to sustain pay rises.
Sterling will then fall further because of a lack of market confidence. One pound is essentially one share in UK plc. With the economy failing there will be little interest in owning such a share. And as sterling falls so imported inflation (oil prices etc) become relatively higher and the economy fails even more.
Then sooner or later the "wage freeze" breaks; it always does, and money will be borrowed or printed to fund pay hikes. Making money is inflationary and the only solution that governments see is to make even more money. And the more money they make, the less it's worth. The cycle is very difficult to break.
Frankly it's better not to get into that state in the first place.
Disclosure: The author of this blog keeps his savings in Swiss francs. In the 1960s £1 would have bought you more than 10 Swiss francs; as recently as a couple of years ago you could have bought over 2 Swiss francs for £1. Yesterday, for the first time, £1 was worth less than one and a half francs. Most likely in the medium term future we will have parity between the Swiss franc and sterling. Then after that 1 franc will buy you more than 1 pound. Somehow the Swiss have managed to hold the value of their currency while we haven't. The fault for this lies with the Bank of England.