As Andy Haldane, the Bank of England’s departing chief economist, has recently loudly proclaimed, it is time to talk a wee bit seriously about the risk now posed by inflation. In brief this risk is that inflation is deemed, at some time in the months ahead, to be rising unsustainably, and as a consequence there is a perceived need to tighten monetary and/or fiscal policy in order to put the inflation genie back in its box.

That policy tightening could come just as the recovery from the Covid pandemic is getting into its stride, causing a deceleration in consumption and investment and the prospect of a renewed period of very low – or even negative –growth.

This is by no means the central expectation for those forecasting the UK and Scottish economies. But, as stressed in a recent report from the Bank for International Settlements, it is sufficient of a genuine risk scenario – and one posing significant downside risks – to justify the attention of business and households as the recovery unfolds.

In the UK the implementation of policy related to inflation is primarily the responsibility of the Bank of England’s Monetary Policy Committee (MPC). At its meeting in late June the MPC noted that consumer price index (CPI) inflation had trebled from 0.7% in February to 2.1% in May. The May figure is just a smidgeon above the MPC’s 2% target.

The committee expects CPI inflation to “exceed 3% for a temporary period”, while gross domestic product (GDP) growth accelerates, after which it anticipates that “growth and inflation will fall back”. As a consequence of this belief that above-target inflation will be a transitory and short-term phenomenon, the MPC emphasised that it “will …. focus on the medium-term prospects for inflation …. rather than factors that are likely to be transient …. and does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% target sustainably”.

In other words the (encouraging) expectation is that growth will slow naturally, as capacity is used up via enhanced investment and consumption.

At the same time the MPC expects short-term inflation pressures, related to higher oil and other commodity prices, to dissipate. Given this benign expectation and refreshingly moderate policy stance, we can expect a continuation of ultra-low interest rates for several more months, well into 2022 at the least. Indeed interest rates should only rise from their historically low levels, in the medium term, if growth continues at an above-trend level when excess capacity has been used up, and domestic and global trends result in inflation above target for an extended period, i.e. a risk of a dangerous inflation spiral.

In the longer term the MPC is anticipating a period of rapid economic catch-up post pandemic, then a return to growth around trend, with inflation remaining close to target. At this stage the committee could breathe a deep sigh of relief, slowly but steadily return interest rates to more “normal” levels and gently unwind other aspects of monetary loosening which have been so crucial over the past 18 months.

The other half of macroeconomic policy is on the fiscal front, taxes and public expenditure, led by the UK Treasury and the Chancellor. They will be constantly aware that UK public sector debt is at a record high of some £2.2 trillion! If the forecasts from the Office for Budget Responsibility continue to match those of the MPC, as described above, then the Chancellor should be in no rush to make any sharp increases in taxation and should oversee only a gentle easing back of government expenditure. This will imply government borrowing remaining at high levels for two, three or more years ahead, essential to continue to encourage consumption and investment, while providing clearly necessary support for, inter alia, health, education, reduction of greenhouse gas emissions and the levelling-up agenda.

The last thing our economy needs in the period ahead is another era of austerity. But the inflation risk could have implications for fiscal policy. If the MPC sees it as necessary to raise interest rates earlier than now expected, then the markets will react sharply and the cost of UK government borrowing could rise significantly.

One key reason why we can at present cope with historically high levels of government debt is because interest rates along the curve are all ultra-low – so the cost of servicing that debt is minimal. A significant hike in rates or rate expectations would cause a major change, with the cost of debt-servicing shooting up, resulting in major pressure on government to raise taxes and/or cut expenditure. The last thing the UK or Scotland needs in 2021 or 2022 is tightening of both monetary and fiscal policies.

Thus far the benign scenario continues to be the central expectation. GDP in Scotland remains 5.4% below the pre-pandemic peak, but with GDP growth expected (by the Fraser of Allander Institute) to reach 5.9% this year and 3.5% next. Scotland still needs time to re-adjust to post-Covid conditions in the labour market and across key sectors; and to provide particular support to regions, demographic groups and business sectors which have suffered most. Success in the necessary re-adjustment requires a benign monetary and fiscal policy context.

One final caveat is that the UK is always subject to global forces. Inflation is rising elsewhere – in the USA it has reached 5%. If the financial markets anticipate early upward movement in US short-term rates, then medium and longer-term rates could rise for all nations. At the least that would cause the UK Treasury to worry about debt-servicing costs and hence be reluctant to leave UK debt at the present exceptional level for any length of time.