Ten reasons why inflation will accelerate

First, a confession. I didn't expect inflation to pick up in February. I anticipated a short-term dip in 2009 as the economy slowed. The inflationary surge would come next year due to the combined effects of a mammoth fiscal deficit, zero interest rates, and the Bank of England printing truckloads of cash.

As part of my recovery from the shock of yesterday's CPI data, I began to reconsider the case for a more accelerated move towards rapid inflation. The more I thought about it, the more yesterday's number made sense, and why it could be the precursor of some very unpleasant inflation numbers in the near future. Eventually, I came up with ten reasons why inflation could be coming to town sooner rather than later.

1. The underlying CPI sub indices are rising more rapidly than expected

February food price inflation was particularly disturbing. The annual rate was over 12 percent, while the monthly increase was a full 1.5 percent. That sharp rise was not due to seasonal factors. In February last year, the monthly increase was just 0.3 percent. Other sub indices, such as furniture, household equipment and maintenance, clothing and footwear, also point to persistent inflationary pressures.

2. Oil prices are rising again

The price of a barrel of crude is now $53. A few short weeks ago, it was hovering below $40. That represents roughly a 30 percent increase. Just as the collapse in oil prices led to a deceleration in inflation towards the end of last year, the recent surge in oil prices will push the rate back up again.

3. The gold price is also rising

Today, gold is trading at $925 an ounce. Only a few short months ago, it was bouncing around at about $700 an ounce. Since gold is the ultimate inflationary hedge, the sharp price increases tells me that inflation expectations across the world are swinging upwards. No doubt some of those gold investors are UK residents.

4. The sterling depreciation will keep inflation bubbling in the short run

According to Mervyn King, sterling has depreciated by 28 percent since the credit crunch started. As if this was somehow detached from the policy choices of the Bank of England, King acknowledged that this would pass through into inflation via elevated import prices. We may not have seen the full force of the devaluation in the CPI. This alone should guarantee a few more difficult months for the Bank of England.

5. Foreigners are selling UK assets, which could put further downward pressure on Sterling

External liabilities of UK banks are perhaps the most alarming numbers produced by the Bank of England. It shows that nonresidents are pulling their cash out of UK banks. This capital flight probably accounts for the recent dramatic fall in the value of sterling. If this capital flight continues, then sterling could come under additional pressure, pushing import prices up further.

If nonresidents panic, the UK could have an exchange-rate crisis. The consequences of such an event are too dreadful to contemplate. It is a scenario which I would prefer to leave in the dark recesses of my imagination.

6. The UK money supply is growing at almost 17 percent a year

This fact is perhaps the most difficult one for deflationists. UK monetary growth is accelerating. The standard deflationist response to this awkward number is that it doesn't matter because most of this new money is being held by banks hoarding liquidity.

In the short run, that may be true, but that doesn't make money held by banks any different from money held by households and corporations. When banks stop hoarding cash and release it into the economy, it will feed directly into higher prices.

7. UK policy rates are highly negative

The Bank of England's policy rate, adjusted for inflation is minus 2.8 percent. OK, I will admit that this is not my strongest argument, not least because the bank rate is now irrelevant in terms of managing overall liquidity conditions. However, it still has powerful symbolic value, expressing the policy confusion that has gripped the MPC.

8. Fiscal policy is out of control

In terms of fiscal policy, New Labour has lost the plot. The UK government is about to run out the largest deficits since the Second World War. These deficits will be larger than anything produced by those ancient lords of inflation - Heath, Wilson, and Callaghan.

9. The Bank of England will monetize the fiscal deficit

All hyperinflations are due to one thing; central banks printing money to cover government deficits. While I'm not suggesting that the UK is in imminent danger of turning into Zimbabwe, the fact remains that monetizing the fiscal deficit is always and everywhere highly inflationary.

10. UK policymakers have lost control

The Bank of England and the Treasury are no longer in control of events. New Labour is paralyzed with fear, knowing that a painful fiscal adjustment before an election will destroy the party. Darling knows that he needs to cut the deficit, but it is politically impossible.

The Bank of England is also powerless. The MPC cut the bank rate too far. It is now disconnected from real economy. The MPC can no longer control liquidity conditions, a fact implicitly recognized in a recent speech by MPC member - Kate Barker. Under normal circumstances, yesterday's CPI data would have required a robust hike in rates. However, the MPC know that it would need to raise the bank rate by several hundred basis points in order to regain some policy traction. In the current political environment, such a move is inconceivable.

So what is the argument against higher inflation? The economy is slowing and therefore firms will be reluctant to push up prices. This may come as a shock to some people, but rapidly rising inflation is invariably associated with weak economic growth. A quick look at the UK growth numbers during the 1970s will confirm this fact.

The UK economy is certainly slowing, and in the short run this might put some modest and temporary downward pressure on prices. However, the prevailing reality is that the UK macroeconomic framework is a total mess. It is incoherent, irresponsible, and driven by short-term political expediency. Sooner or later, this toxic cocktail of confusion will feed into higher prices.