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We let our guard down on inflation and now we must parry the blows

Newspaper article

I am just about old enough to remember when Denis Healey was the chancellor (mostly because children’s television got switched to BBC2 to make way for budget coverage back in the 1970s). Budgets were, I think, a bigger deal back then.

I was also lucky enough to spend a little time in the course of my undergraduate economics studies looking at economic policy in the 1970s. I have thought about that period rather little in the intervening years. That partly reflects the passing of time, but also a feeling that the world changed in 1979. Even for those of my vintage, anything before that feels like ancient history.

I do not mention that because we are in any sense returning to that period. Inflation is not likely to average more than 10 per cent a year over this decade, or anything like it. I can’t see millions of days lost to strike action as unions demand pay rises of 20 or 30 per cent. But I was reminded this week of a paper I read as an undergraduate. It looked at the impact that inflation had in undermining the living standards of benefit recipients, and increasing poverty, over the period of a year. If inflation is running at 15 per cent and you are living week-to-week, hand-to-mouth, and your benefits are increased only annually, then what might have been enough to live on at the start of the year may well not be 11 months later.

We haven’t had to worry much about such things for a long while. For this year at least, we need to. Once again, people dependent on welfare benefits are going to be feeling the squeeze. Come March, they are likely to be at least 6 per cent worse off than they were last April. That’s ignoring the loss of the £20 uplift to universal credit. The trouble is that even in April, after their benefits have been increased in line with inflation, they will still be more than 3 per cent worse off than they were a year previously. That’s because benefits are due to rise in line with inflation as it was in September not as it actually will be in March or April. That’s how things have worked for a long time now and it was fine while inflation was low and stable. It’s not really fine when inflation moves from 3 per cent in September to 6 per cent or 7 per cent in April. It will mean a full year of noticeably lower living standards for the poorest.

It’s not a permanent reduction in living standards. These things even up over time. That, though, will be little comfort for anyone struggling to pay for food and fuel during 2022.

This ought to be easy to fix. You may recall that an increase in the generosity of universal credit for low earners was announced in the October budget. It was implemented in November. Presumably, a much simpler increase in benefit levels could be implemented in time for April. And this need not be a permanent increase. Next year’s rise could be adjusted to keep real levels constant over time.

Whether such an adjustment is made or not, we will have to wait and see. Either way, this is illustrative of a wider problem. So benign has inflation been, and so used have politicians and policymakers become to inflation that is low and stable, that rather a lot of public policy is no longer robust to rising prices.

Some of that is recent and deliberate. The decision a year ago to announce a four-year freeze in the level of income tax allowances was intended at the time to add up to a £7 billion tax increase. It is likely to end up raising taxes by £11 billion or more as higher inflation eats away at the real value of the allowances. We should be grateful, at least, that the benefit freeze, in place between 2016 and 2019, is no longer in operation. Freezing benefits and tax allowances over long periods is not good policy. The actual effects are unknowable in advance.

Older tax policies that freeze limits will bite ever harder. The £100,000 point at which a 60 per cent tax rate becomes payable has been unchanged since 2010 (yes, there is a 60 per cent rate of income tax on incomes between £100,000 and £125,000). Its real value will fall quickly as inflation picks up. The same is true of the £150,000 point at which 45 per cent tax becomes payable.

The chancellor may be perfectly happy about these particular stealthy ways of raising additional tax. He will be less keen on inflation’s impact elsewhere. Around a quarter of our national debt is index-linked. The return that holders receive is linked to inflation — ridiculously to the retail prices index, a measure of inflation that we have known for a decade to be overstated. It has already burst through the 7 per cent mark. Back in October, the Office for Budget Responsibility reckoned that the increase in RPI would add £14 billion to debt interest spending this year alone.

Student debt is also, even more absurdly, supposed to be linked to this measure of inflation plus 3 per cent. Had that actually happened, many graduates and those still studying would have seen the interest rate on their outstanding debt rise above 10 per cent this year. Seeing, for once, an upcoming car crash before it actually happens, the government has fixed it so that the interest rate in fact will hit only 4.5 per cent in March: a response to a policy put in place when nobody expected inflation to reach such heights. The link between rail fares and the RPI has also been suspended.

Having lived with rather little inflation for a long while, we have let our guard down. One advantage of at least a little historical perspective should be to remember the perils of doing that.

This article was first published in The Times and is reproduced here with kind permission.


More on this topic

External publication
IFS Senior Research Ben Zaranko responds to the Spring Statement for Public Finance.
Press release
'Today's figures show that annual RPI inflation now stands at 7.8%, well above what was forecast in the October Budget.'