Bill Jamieson - Inflation puts savers on borrowed time

IF THE frenzied interest rate cutting by the US Federal Reserve over the past fortnight is not proof enough of the serious times we are in, then the dramatic policy volte face by the International Monetary Fund last week should dispel any doubts.

In an extraordinary U-turn, Dominique Strauss-Kahn, the new head of the IMF, has declared that the intensifying credit crisis is so severe that lower interest rates will not be enough and that other countries should follow the US with fiscal stimulus packages. "A new fiscal policy," he said, "is probably today an accurate way to answer the crisis."

Both the actions of the Fed – and the radical change of advice from the IMF – set a quandary for millions of households and those who advise them on financial matters. Should the rational household use the period ahead to pay down debt and save more, as Mervyn King, governor of the Bank of England, recently insists? Or should we do what governments are about to do – and step up spending and borrowing?

For governments, the advice of the new IMF chief overthrows 25 years of orthodoxy – an iron insistence that they should bear down on fiscal deficits as the key component of any international programme aimed at ensuring economic stability.

This sudden change of tack has astonished policymakers. Foremost among them is former US Treasury Secretary Lawrence Summers who has been in favour of fiscal stimulus by the US government. "This is the first time in 25 years," he said, "that the IMF managing director has called for an increase in fiscal deficits, and I regard this as a recognition of the gravity of the situation that we face."

The IMF's call for countries to loosen their budgets will be seized upon in Britain and elsewhere as a lifeline those struggling to keep their fiscal deficits under control. Although Strauss-Kahn's remarks were directed at governments with strong fiscal positions, the UK Government has long insisted that its finances are rock solid – even though the public finances this financial year look on course for a breach of the Maastricht ceiling of a budget deficit no greater than 3% of GDP.

And if this was not enough, the Institute for Fiscal Studies warned last week that Chancellor Alistair Darling would need to announce fresh tax increases worth about £8bn in this year's Budget to keep public sector debt below the government's self-imposed ceiling and to bring about the improvement in the public finances over the next five years that the Treasury wants to see.

Can it really be right for governments to increase their borrowing yet at the same time individual households should cut borrowing and increase saving?

Common sense would suggest that after a five-year borrowing binge, households – particularly in the UK – need to bring down their outstanding debt and increase savings to provide a cushion for difficult times. After all, it is debt default – and the massive provisioning by global banks in respect of their lending to the US sub-prime mortgage market, direct or indirect – that has triggered the worst financial crisis in more than a decade.

The other week Nigel Lawson, the former Conservative chancellor, deployed a familiar metaphor: that as a nation we had been on a borrowing binge, and "now comes the hangover". Many would go along with this picturesque assessment. But the problem with this analogy, superficially accurate though it sounds, is that it is the prudent people who avoided extremes of debt and built up their savings who are now suffering the hangover as their stock market funds have been battered and interest rates are cut on fixed interest savings. And it is the borrowers who are being rewarded by cuts in their borrowing rates. What the US central bank has done has not stopped the party at all – but poured more neat alcohol into the punch bowl.

While many will approve the prompt and radical action taken by the Fed in taking interest rates down so quickly from 5.25% to 3%, this is taking a huge gamble with inflation. And the bigger that gamble, the more savers have cause to be apprehensive – and borrowers jubilant.

"Inflation," as Stephen Lewis, economist at Insinger De Beaufort, points out, "would tend to make the debt load on US households and financial institutions more easily bearable. Investors are right to be wary a rise in inflation risks stemming from the Fed's credit market priorities."

As those with large mortgages in the inflation-ridden 1970s and 1980s will testify, the burden of these home loans tumbled as repayment costs came to represent a shrinking share of household incomes and house prices rose. If inflation is set to take off again, the rational response of households is thus to step up borrowings and cut savings – the opposite of what Mervyn King insists we do.

The January Citigroup/Yougov inflation expectations survey released last week shows that inflation is expected to reach 3.3% over the next 12 months. This is the highest level since the series started in 2005 and up markedly from 2.7% in December, fuelled in no small part by relentless news of price increases such as those just announced by ScottishPower – electricity prices are to rise by an average of 14% and gas prices by 15% from yesterday. The 3.3% expected rate is also substantially above the Bank of England's target inflation rate of 2%.

And even if the inflation rate is pegged to "just" 3% a year, this means that the purchasing power of money is halved over a lifetime – not at all good news for anyone saving through a pension scheme.

The survey highlights the difficult situation the bank's Monetary Policy Committee is in. While the MPC is under pressure to cut rates to minimise the risk that the faltering economy suffers an extended sharp slowdown or goes into recession, there are still significant inflation risks. Indeed, probably the Bank of England's greatest concern is that a near-term marked spike in inflation resulting from higher utility and food bills could lift inflation expectations and lead to higher wages. This would increase the risk of a damaging wage-price spiral developing.

However, for the greatest borrower of all – HM Treasury – there will at least be some relief. Any embarrassment over breached fiscal targets can now be excused on the grounds that the IMF has effectively given the green light for a larger budget deficit than previously allowed for. Dangerous times? Too right they are.