Gap appears in Federal Reserve consensus

Consumer prices in the UK grew by only 1.1pc during the year to September. Britain’s CPI inflation is now at a five-year low.

The usual suspects in the City, and their government lackeys, are using this “below target” inflation number to crank-up, once again, the notion that Britain is about to tip into a “catastrophic deflationary spiral”.

As a result, the argument goes, we have “no choice” but to keep the Bank of England’s printing presses in overdrive, pressing on with so-called “quantitative easing”. And, clearly, any action to get the UK’s disgraceful public finances under control would, given this deflationary threat, be “woefully premature”.

The above paragraph, in essence, captures the consensus view now driving macroeconomic policy in both Britain and America – the “QE two”. Yet it’s completely and utterly wrong – not least as it’s been formulated entirely to serve the financial vested interests that have so thoroughly captured these countries’ political and policy-making “elites”.

I accept that UK inflation in September was low. But 1.1pc is nowhere near “deflation” – which means the CPI remaining negative for many months. The credit crunch has been in full swing for over two years and it’s only very recently that the CPI has gone below the Bank’s 2pc target, let alone breached zero.

Last month’s CPI fall is anyway entirely explained by the one-off impact of lower energy bills (tariffs were hiked last September) and last December's VAT reduction from 17.5pc to 15pc. Once these energy base effects wear-off and the VAT cut is reversed, inflation will rise sharply. Core CPI inflation – excluding energy costs – rose to 1.7pc last month and would be 2.5pc had VAT stayed the same.

For all the talk that Britain is “slipping towards deflation”, even with this September number inflation averaged 1.5pc during the third quarter - above the 1.3pc forecast the Bank made just two months ago. The reality is that UK inflation has remained far higher during the credit crunch than the vast majority of economists expected.

At this point, I could rant on about how a few of us did warn that the threat of deflation was a self-serving “myth”, an intellectual deceit designed to justify the monetary and fiscal incontinence we’ve seen since. Some of us were even called “bonkers” for our trouble and subjected to ad hominem attacks by government place-men within the Bank of England.

But we’ve been proven right. September was the low-point for the UK’s CPI – and it’s still a long way from zero. Given the impact of the recently falling pound on import prices, the Bank will be forced to increase its CPI projections in next month’s quarterly Inflation Report.

With oil prices now rising steadily, having plunged during the fourth quarter of last year, the energy base effects will soon work in reverse, pushing the CPI up as fuel bills start to head skyward.

Even now, the Bank is forecasting 2.1pc inflation in the first three months of 2010 – further away from deflation. I’d say that’s still too low. There are serious price pressures in the pipeline – over and above the “inconvenient truth” that QE means the UK will soon have tripled the size of its monetary base. When banks stop hoarding that cash, inflation will let rip.

Even before that happens, there are undeniable signs that supply-chain realities are now pushing prices up. In September, the producer price index rose for the first time in four months.

Which brings me, once again, to the “output gap” – yet another intellectual device that the City’s pet economists have been using to justify our recent wildly expansionary policies (which, by coincidence have bailed-out the banks that employ them, pumped up the stock market and ensured big bonuses are back in vogue).

For months, we’ve been told the credit crunch has created a "huge reservoir" of excess capacity and the economy’s ability to supply dwarfs demand. So the government can print money and borrow like crazy without fear of stoking inflation.

This is total tosh. By starving firms of credit, this financial crisis has destroyed vast swathes of supply. I’ve said it many times before and now some serious people are starting to agree.

Last week James Bullard, the highly-respected President of the St. Louis Federal Reserve, argued that America’s output gap is “much smaller than is commonly believed” – not least because the credit crunch has caused firms to shut and workforces to disperse, so eradicating productive capacity. Bullard dismisses as “overplayed” the notion that output gaps will keep inflation low.

Unlike his Fed colleagues in Washington, Bullard is no White House lickspittle. He is a serious economist, well capable of independent thought. We desperately need more policymakers like him - who cannot be dismissed as “bonkers” but who dare, nonetheless, to highlight the madness of the current policy consensus.

PUTIN DOES GEOPOLITICS, NOT LIGHT ENTERTAINMENT

I was in Moscow last week when Vladimir Putin proposed an alternative to the Eurovision Song Contest. The Russian Prime Minister wants a televised competition for crooners from Russia, China and the countries of Central Asia.

Eurovision voting patterns are often “political” – with countries awarding “nul points” to diplomatic rivals. Putin’s new “Intervision contest”, too, goes way beyond cheesy songs.

The mooted participants are all members of the Shanghai Co-operation Council (SCO) – a grouping whose main purpose is to limit US influence in resource-rich nations like Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan.

Russia isn’t barred from Eurovision. Far from it. A rather camp Russian singer took first prize in 2008. This year’s contest was held in Moscow – and won by another ethnic Russian, representing Norway.

The big picture is that the economic synergies between Russia, China and Central Asia are huge. Putin says his new music contest would “strengthen our cultural ties”. The real prize is a stronger SCO – that would help keep Western hands off Central Asia’s commodities, metals and minerals, while cementing the Moscow-Beijing axis.

Enemies for much of the Cold War, Russia and China are now building serious commercial relations across their 2,500-mile border. China’s energy needs are almost insatiable, while Russia wants to diversify away from traditional Western markets for its abundant oil and gas.

As if to press that point, Putin went to last week’s SCO meeting in Beijing even though US Secretary of State Hillary Clinton was visiting Moscow. As well as proposing “Intervision”, he also clinched a deal that could soon turn China into the single biggest consumer of Russian gas.

There’s a trend here. Deeply concerned about a falling dollar, China is increasingly using its ever-growing cash pile to buy commodities, rather than US Treasury bills. Beijing in rampant in Africa – in the last month alone moving to secure another major oil deal in Nigeria, access Guinea’s unmatched bauxite reserves and trump Exxon Mobil by bidding for a big stake in oil fields just found in Ghana.

Less widely noticed, but of even more significance, are China’s deals with Russia - including a huge $25bn contract with state-controlled Rosneft to supply the Peoples’ Republic with oil for the next 20 years. Any day now, Russia’s new 1,700 mile oil pipeline to China will become fully operational.

So Putin’s “Intervision” suggestion may have been cheeky. But it wasn’t light entertainment.

Liam Halligan is Chief Economist at Prosperity Capital Management