Pensions Minister facing barrage of questions on inflation dangers for pensioners

Bank of England should raise interest rates this week

Savers and pensioners need protection from effects of inflation

by Dr. Ros Altmann

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As Parliament returns from its Christmas break, the Pensions Minister, Steve Webb, is facing a barrage of questions from angry MPs about how the Government plans to protect pensioners from the effects of high inflation. So far, savers and pensioners have been the innocent victims of the problems caused by excessively easy monetary policy.

Rates were cut to near zero as an emergency measure, but although the emergency has passed, rates have not moved up: Throughout the past eighteen months, warnings of the dangers of rock bottom rates have been ignored by policymakers. Rates were brought down to these levels as an ’emergency’ measure to stave off potential deflation, but they have not been returned to more appropriate levels, despite the emergency situation having long since passed.

Inflation is stuck way above official target, but rates have not moved: The economy has recovered and there is no deflation. On the contrary, UK inflation has been at levels significantly above the Bank of England’s target rate. Yet the Bank of England has not responded in its normal manner of precautionary action to avoid an inflationary spiral.

Steve Webb facing barrage of questions from MPs as savers and pensioners are suffering: With the latest increase in VAT, petrol and food prices, anyone on fixed incomes or trying to live off the income from their savings is suffering from the effects of inflation. Heating, clothing and insurance costs are also rising sharply. The latest figures show that retail price inflation (rpi) is at 4.5% and consumer price inflation (cpi) is at 3.5%. Government has withdrawn the National Savings inflation-linked certificates, which was the only way for savers to safely protect their money against inflation. This leaves older people unable to properly protect their retirement incomes. Steve Webb is facing a barrage of questions in Parliament today, with MPs concerned about how the Government will protect pensioners from the damaging effects of inflation.

MPC needs to wake up to reality and should raise rates this week: Andrew Sentance has called for rates to rise and he is right. Even if the economy weakens a little this year, the dangers of ‘stagflation’ – where inflation stays high despite sluggish growth – should not be ignored. So far, the majority of the Monetary Policy Committee has ignored this risk, but the evidence is becoming clearer all the time. Even the Bank’s own forecasts now show that inflation is expected to stay at high levels throughout 2011. There is now a significant risk that inflation expectations will start feeding through to wages, which could set up the kind of wage-price spiral that has been so damaging to price stability in the past. In order to pre-empt such problems, the Bank of England needs to wake up to reality and start to raise interest rates.

The risks of not raising rates now outweigh the risks of a rate rise: Despite the Government’s forthcoming measures to reduce the budget deficit, rising interest rates are unlikely to hamper growth. If rates do start to rise from the current exceptionally low levels, this could actually help growth and markets. In fact, the real beneficiaries of ultra-low rates are the banks, who can borrow so cheaply from the central bank. But if inflation dangers are ignored, then rates will be forced up sooner or later by the markets and the eventual rate rises will be much larger if inflation has already become an entrenched problem. By failing to take action, there is a greater risk that the Bank of England loses credibility and will have to increase rates much more in the future.

Current interest rates are inappropriate to the economic situation: There is a risk that markets suddenly realise UK interest rates are too low, causing a sharp correction in bond markets. Gilt yields are currently priced to an inflation level that does not exist in reality. Two-to-five year gilt yields of 1-2% and ten-year yields of just 3.5%, against the background of 3-4% inflation and a huge fiscal deficit, are not rewarding investors sufficiently for holding UK paper. Unless the Bank of England acts soon to restore its inflation-fighting credentials, there is a serious risk of a sell-off in gilts. If gilt prices fall, there is a risk that other assets will also be hit as interest rates rise.

Failure to act soon could leave Bank of England powerless to stop inflation: If inflation continues rising, the Bank of England may become powerless to halt the upward price spiral. Instead of being ahead of the curve, monetary policy may stay consistently behind the curve, tightening too little, too late, to avoid inflation becoming entrenched in the system.

Savers suffer – Government could issue inflation-linked certificates for over 50s: Savers lose out as inflation erodes their income. If interest rates do not keep up with rising inflation, savers’ incomes will keep falling in real terms. Government should bring back inflation-linked certificates that will enable those coming up to retirement to protect their future income from the dangers of inflation.

Pensioners with level annuities become poorer each year: Anyone who has bought a fixed annuity could see the value of their pension erode significantly over time. The longer they live, the poorer these pensioners become, as the real value of their fixed pensions is reduced by inflation.

Effect of inflation
The Table below shows the damaging effect of inflation on real incomes. If inflation stays at 3%, then the real value of £1,000 a month income will fall by over a quarter after ten years and by over a third if inflation is 4%. After 20 years, £1,000 loses around half its value with 3-4% inflation and it loses nearly two-thirds of its value after 20 years if inflation hits 5%.

EFFECT OF INFLATION
Value of £1000 after inflation, in real terms

Inflation rate	3%	4%	5%
5 year	£858	£815	£774
10 year	£737	£664	£598
15 year	£633	£542	£463
20 year	£543	£442	£358
25 year	£466	£360	£277
30 year	£400	£294	£215
35 year	£343	£239	£166
40 year	£295	£195	£129