George Osborne needs to have nerve

After a frantic introduction to government in the second half of 2010, which included a Budget, a spending review and crises in Europe, chancellor George Osborne will be hoping for time to draw breath at the start of this year. But it is much more likely that the heat will be turned up as the consequences of policy loosening under Labour and his own attempts to redress the problems they caused start to bite. In the first six months of this year, the ride could get very bumpy and the chancellor will face a test of nerve as much as economic judgment as the headlines become increasingly negative.

Yet, Osborne can take some satisfaction from his early months in office. In the 12 months to September 2010, the economy grew by an impressive 2.7 percent after the near five percent fall in GDP in 2009. There have now been five quarters of positive growth, with the recovery based more on the private sector and, despite protests from special interest groups, his plans for reducing public sector debt have been accepted as realistic and necessary.

So why is the Treasury likely to be facing a testing time, and why is uncertainty still the dominating theme in many parts of the country? The key to sustaining growth is rebalancing the economy, which means a competitive exchange rate to help exporters. It is also important that the private sector fills the gap in terms of output and jobs as the public sector is squeezed. And consumers still need help coping with a massive debt overhang from pre-recession years. For all these objectives it is essential that interest rates stay at about their current, historically low levels.

This is where the nervousness has increased in the past couple of months. The elephant in the room is inflation and, for predictable reasons, prices have been moving north too quickly for the liking of some policy makers. The 20 percent or so fall in the value of the pound in the past few years has boosted exports but raised the prices of imports, many of which feed directly into the Consumer Prices Index (CPI) measure of inflation. Charged with keeping the annual increase in the CPI at one percent to two percent, Mervyn King and his colleagues on the Monetary Policy Committee (MPC) missed the target every month in 2010, yet left the bank rate on hold at 0.5 percent.

With the likelihood that the rate of CPI inflation will rise further towards four percent (helped by Osborne’s 2.5 percent increase in VAT), there are those suggesting rates should rise sooner rather than later, including one of King’s MPC colleagues. Better to ease them up gently now and squeeze inflation, so the argument goes, than let it take hold and be forced to bump up rates much higher. The counter view is that there is still substantial spare capacity in the economy which will prevent companies putting up prices and will lead to the inflation rate falling. There is no need, therefore, to address a problem now that will solve itself before the end of 2011.

The balance of the former argument still favours the latter view. Strip out the imported items, and the inflation numbers look better, within the target range and stable. With unemployment high and likely to increase, moreover, the likelihood of an effect on wage settlements is remote. And at 3.3 percent, the rate is not missing the target by much. Not so long ago inflation was 20 percent-plus. In those days, it was easier to round up to the nearest five percent, whereas today, we agonise about the first digit after the decimal point. It hardly seems worth taking such a big step as raising interest rates to address such a small problem.

Besides, there are still those who believe deflation rather than inflation should be the real worry. They (and anyone with debt) would welcome a little inflation. So, for once, the politically expedient solution makes good economic sense and rates should stay on hold for much of 2011. Osborne may prove to be a lucky chancellor.