In two recent blogs we have analysed the headache facing the Monetary Policy Committee, given the persistence of inflationary pressures in the UK economy, in deciding whether to raise interest rates. In Food for thought, Elizabeth Jones describes how, despite the weakness of aggregate demand, cost pressures have fuelled inflation while John Sloman in Time for a rise in Bank Rate looks at the difficult judgement call for the MPC in risking a marked dampening of aggregate demand by raising rates while, on the other hand, failing to dampen inflationary expectations by not raising rates. In this blog Dean Garratt analyses some of the latest inflation figures as detailed in the latest Consumer Price Indices Statistical Bulletin. In particular, he focuses on the inflation rates within the overall consumer price inflation rate.
You might be wondering what we mean when we refer to inflation rates within the overall inflation rate. In answering this we need to consider how the Office for National Statistics goes about estimating the Consumer Price Index (CPI) and the CPI inflation rate (further details are available in Consumer Price Indices – A Brief Guide produced by the ONS). In order to compile the Consumer Price Index (CPI), each month an organisation collects on behalf of the ONS something in the region of 110,000 prices quotations for around 560 items. But, the key point is that these goods and services fall into one of 12 broad product groups which are referred to as level 1 product groups. These include, for example, food and non-alcoholic beverages and transport.
The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. Once the price information for our representative goods and services has been collected, the prices are compared with their levels in the previous January and the change recorded. These changes are then aggregated in both each product group and across all groups. The price changes are aggregated by weighting them according to the typical share of household spending that each good or service represents. This process is repeated each month in the year so as to always calculate the aggregate change in prices since January. The final step is to link the price changes with those from earlier years to form one long price index, both for each product group and for the overall shopping basket, so that at one arbitrary moment in time the index takes a value of 100.
Once we have our price indices we can calculate annual rates of price inflation. The annual rate of CPI inflation in December 2010 is recorded at 3.7%. This means that the Consumer Price Index was 3.7% higher in December 2010 than it was December 2009. Similarly, the annual rate of CPI inflation in November 2010 of 3.3% means that consumer prices rose by 3.3% between November 2009 and November 2010. Across 2010 as a whole the CPI rose by 3.3%, so in excess of the Bank of England’s inflation rate target range, and significantly up on the 2.2% across 2009. The Bank has a symmetrical inflation rate target of 2% plus or minus 1 percentage point (you may want to read more about the Bank’s Monetary Policy Framework).
Let’s look to delve deeper because price indices are also available for product groups at two lower levels known as level 2 and level 3 product groups. For example, from within the food and non-alcoholic beverages group there is a price index wholly for food and within this one for vegetables. Again annual rates of price inflation can be found for level 2 and level 3 product groups.
If we consider food and non-alcoholic beverages we find an annual rate of price inflation for December of 6.1%. This was its highest annual rate since May 2009. Across 2010 as a whole we find that prices rose by 3.4%, very much in accordance with the overall CPI inflation rate. Inflationary pressures within this category are not new with 2008 seeing prices rises by 9.1% as compared with 3.6% for the overall CPI inflation rate. Over the past 5 years, food and non-alcoholic beverage inflation has typically been running at an annual rate of 5% while overall consumer price inflation has been running at 2.8%.
If we now focus on food alone, we find an annual rate of food price inflation in December of 5.7%. While this is a little lower than with the inclusion of non-alcoholic beverages, it is nonetheless a full 2 percentage points above the overall CPI inflation rate. Across the year as a whole food price inflation comes in bang on 3% highlighting the extent of the inflationary pressures in more recent months. This, however, still falls some way short of the pressures seen in 2008 when food prices rose by 10.1%. If we drop to level 3 to focus on groups within the food category we find inflation rates for oils and fats of 11%, for fish of 9% and for fruit of 8.6%.
Within the 12 broad groups the highest annual rate of price inflation is currently to be found for transport where the annual rate of price inflation in December was 6.5%. Across 2010, transport prices rose by 8.3% which compares a tad unfavourably with the 0.8% increase seen in 2009. If we drop down to the level 3 groups within this category we can trace the source of the price pressures more readily. The cost of air passenger transport in December was up over 12 months by 13.5% and, you may not be surprised to learn, the cost of fuel and lubricants was up by 12.9%.
We finish by noting the only level 1 category to see prices fall across 2010: clothing and footwear. This product group saw prices fall by 1% in 2010. But, even here price pressures have emerged. Between April 1992 and August 2010 clothing and footwear consistently recorded annual rates of price deflation. Since September this has ceased with positive annual rates of inflation. The annual rate of inflation for clothing and footwear in December was estimated at 1.5%. Perhaps those socks in my bottom drawer really will have to last me just a little bit longer!
Articles
Inflation is a blip says Bootle BBC News (21/1/11)
Fuel prices could rise by 4p in April BBC News (22/1/11)
Paul Lewis: Why inflation is starting to buy BBC News (20/1/11)
High levels of inflation remains a worry for Beijing BBC News (20/1/11)
Inflation ‘biggest money worry for families’ BBC News (19/1/11)
UK inflation rate rises to 3.7% BBC News (18/1/11)
Inflation hysterics Financial Times (19/1/11)
Top investors raise alarm on inflation Financial Times, Richard Milne, Dan McCrum and Robert Cookson (21/1/11) )
Inflation hits 3.7% after record monthly increase Guardian UK, Graeme Wearden (18/1/11)
We knew inflation would be bad, but not this bad Guardian, Larry Elliott (18/1/11)
The mystery of clothes inflation and the formula effect The Economist (21/1/11)
Data
Latest on inflation Office for National Statistics (18/1/11)
Consumer Price Indices, Statistical Bulletin, March 2010 Office for National Statistics (18/1/11)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank
Questions
- Describe the process of compiling the Consumer Price Index (CPI). Are we comparing the cost of the same basket of goods and services across years? What about within a given year? (Further details are available in Consumer Price Indices – A Brief Guide).
- Explain the difference between an increase in the level of prices and an increase in the rate of price inflation. Can the rate of price inflation fall even if price levels are rising? Explain your answer.
- Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
- What factors do you think lie behind the pressures on; (i) food prices; (ii) clothes prices; and (iii) transport prices? How would your answers help to inform how you would vote on interest rates if you were on the Monetary Policy Committee?
- The following are the consumer price index values for all items, food and non-alcoholic beverages, clothing and footwear and transport in 1988, 2009 and 2010. Use these values to calculate the percentage change between 1988 and 2010 and those between 2009 and 2010. Comment on your findings.
All items: 1988= 63.5; 2009= 110.8; 2010= 114.5
Food and non-alcoholic beverages: 1988= 68.2; 2009= 123.2; 2010= 127.4
Clothing and footwear: 1988= 163.8; 2009= 79.6; 2010= 78.8
Transport: 1988= 55.4; 2009= 112.7; 2010= 122.1
- How serious an economic issue do you think inflation is? Illustrate your answer drawing on real-world examples of the impact of inflation.
Bank rate in the UK has been at the historically low level of 0.5% since March 2009 and the MPC decision on 13 January was to leave the rate unchanged (see also). But inflation has been well above the Bank of England’s target of 2% since December 2009 and it could well rise further as international commodity prices are soaring. Some economists are thus arguing that Bank rate should rise. This is crucial, they say, to dampen inflationary expectations.
Other economists, however, argue that aggregate demand is likely to remain depressed and that the economy is operating with a large negative output gap. What is more, house prices are falling, as are real wages (see Bosses gain – workers’ pain)
In the following extract from BBC Radio 4’s Today Programme, two economists, Charles Goodhart and Willem Buiter, both former members of the MPC, debate the issue.
Podcast
Should interest rates rise? BBC Today Programme (13/1/11)
Data
Economic and Labour Market Review, Office for National Statistics (For inflation data see Tables Chapter 3, Table 3.01; for interest rates see Tables Chapter 5, Table 5.08)
Monetary Policy Committee Decisions Bank of England
Questions
- What are the arguments for a rise in Bank rate at the current time?
- What are the arguments against a rise in Bank rate at the current time?
- What information would you require to decide which of the arguments was the more powerful?
- Why is it difficult to decide the size of the output gap?
- To what extent do the arguments for and against a rise in Bank rate depend on the factors determining expectations, and what expectations are important here?
- To what extent are exchange rates relevant to the effectiveness of interest rate policy?
Every six months the Bank of England publishes its Financial Stability Report. “It aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities and the wider public in managing and preparing for these risks.”
In the latest report, published on 17 December 2010, the Bank expresses concern about the UK’s exposure to problems overseas. The two most important problems are the continuing weaknesses of a number of banks and the difficulties of certain EU countries in repaying government bonds as they fall due and borrowing more capital at acceptable interest rates. As the report says:
Sovereign and banking system concerns have re-emerged in parts of Europe. The IMF and European authorities proposed a substantial package of support for Ireland. But market concerns spilled over to several other European countries. At the time of writing, contagion to the largest European banking systems has been limited. In this environment, it is important that resilience among UK banks has improved over the past year, including progress on refinancing debt and on raising capital buffers. But the United Kingdom is only partially insulated given the interconnectedness of European financial systems and the importance of their stability to global capital markets.
The Bank identifies a number of specific risks to the UK and global financial systems and examines various policy options for tackling them. The following articles consider the report.
Articles
Bank warns of eurozone risks to UK as EU leaders meet Independent, Sean O’Grady (17/12/10)
Deep potholes on the road to recovery Guardian, Nils Pratley (17/12/10)
It’s reassuring that regulators are still worried about financial stability The Telegraph, Tracy Corrigan (17/12/10)
Europe is still searching for stability and the UK must find it too Independent, Hamish McRae (17/12/10)
Shafts of light between the storm clouds The Economist blogs: ‘Blighty’ (17/12/10)
Report
Financial Stability Report, December 2010: Overview Bank of England
Financial Stability Report, December 2010: Links to rest of report Bank of England
Questions
- What are the most important financial risks facing (a) the UK; (b) eurozone countries?
- What is the significance of the rise in banks’ tier-1 capital ratios since 2007?
- Which is likely to be more serious over the coming months: banking weaknesses or sovereign debt? Explain.
- What is being done to reduce the risks of sovereign default?
- Why might the weaker EU countries struggle to achieve economic growth over the next two or three years?
- How do interest rates on government debt, as expressed by bond yields, compare with historical levels? What conclusions can you draw from this?
- What is likely to happen to bond yields in the USA, the UK and Germany over the coming months?
- What has been the effect of the extra £200 billion that the Bank of England injected into the banking system through its policy of quantitative easing?
The growth in money supply is slowing. This is not surprising, given that the programme of quantitative easing, whereby the Bank of England injected an extra £200bn of (narrow) money into the banking system between March 2009 and February 2010, has come to an end.
Should we be worried about this? Has sufficient money been injected into the economy to sustain the recovery, especially as fiscal policy is about to be radically tightened (see the BBC’s Spending Review section of its website)? One person who thinks that the Bank of England should do more is Adam Posen, an external member of the Bank of England’s Monetary Policy Committee. In a speech on 28 September 2010, he argued that the UK was in danger of slipping into Japanese-style sluggish growth that could last many years. The reason is that capacity would be lost unless aggregate demand is increased sufficiently to bring the UK back up towards the potential level of output. Firms are unlikely to want to retain unused plant and equipment and underutilised skilled labour for very long. If they do start ‘disinvesting’ in this way, potential output will fall.
What, according to Adam Posen is the answer? With fiscal policy being tightened and with Bank rate as low as it can go, the only option is to increase money supply. But with CPI inflation at 3.1%, considerably above the target 2%, is there a danger that increasing the money supply will cause inflation to rise further? Not according to Posen, who sees inflation falling over the medium term.
Not surprisingly other economists and commentators disagree – including some of his colleagues on the MPC. The following articles look at the arguments on both sides. You will also find below a link to the speech and to money supply data. There is also a link to the latest Bank of England inflation and GDP forecasts.
Articles
Posen calls for QE to be resumed Financial Times, Chris Giles (28/9/10)
Weak lending data fuel debate on QE Financial Times, Norma Cohen (29/9/10)
Bank of England’s Adam Posen calls for more quantitative easing Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Posen pleads for new stimulus to save economy and democracy Independent, Sean O’Grady (29/9/10)
Bring back the usury laws Independent, Hamish McRae (29/9/10)
Rocking the boat on the MPC BBC News blogs, Stephanomics, Stephanie Flanders (28/9/10)
A Response to Adam Posen The Source, Alen Mattich (28/9/10)
Adam Posen is posing the Bank of England a tricky question Guardian, Nils Pratley (28/9/10)
UK economy: optimists vs. pessimists FT blogs, Chris Giles (29/9/10)
What should the Bank of England do next? BBC Today Programme, Stephanie Flanders and John Redwood (1/10/10)
Interest rates will rise, predicts former Bank of England deputy governor Guardian, Dan Milmo (4/10/10)
UK interest rates on hold at record low of 0.5% BBC News (7/10/10)
Speech
The Case for Doing More Speech to the Hull and Humber Chamber of Commerce, Industry and Shipping, Adam Posen (28/9/10)
Data
Money supply data
Money and Lending (Statistical Interactive Database) Bank of England
Bank of England Inflation and GDP forecasts
Inflation and GDP forecasts (Inflation Report) Bank of England
Questions
- Summarise Adam Posen’s arguments for a further round of quantitative easing.
- How may changes in aggregate demand affect a country’s potential (as well as actual) output?
- What are the similarities and differences between the UK now and Japan over the past two decades?
- Describe what has been happening to the various components of money supply over the past few months.
- What might suggest that the Bank of England was wrong in believing that the trend rate of growth was about 2.75%?
- What are the moral arguments about personal and state borrowing? Should we begin the ‘long retreat from the never-never society’?
- Analyse the arguments against a further round of quantitative easing.
One of the structural problems facing the UK economy is that people have been borrowing too much and saving too little. As a result, vast numbers of people have been living on credit and accumulating large debts, and many people have little in the way of savings when they retire.
So should the government or Bank of England be encouraging people to save? Not according to Charles Bean, Deputy Governor of the Bank of England – at least not in the short term. While acknowledging that people should be saving more over the long term, he argues that the main purpose of the historically low Bank Rate since the beginning of 2009 has been to encourage people to spend, thereby boosting the economy. In other words, if the purpose of a loose monetary policy is to increase aggregate demand and stimulate the economy, then what is needed is increased consumption and reduced saving, not increased saving.
In the following webcast, Charles Bean gives his views about interest rates and counters the criticism that savers are being pid too little interest. He argues that for many the solution is to start drawing on some of their capital – not a solution that most savers find very appealing!
Webcast
Bank of England: savers should eat into cash Channel 4 News, Faisal Islam (27/9/10)
Articles
Savers told to stop moaning and start spending Telegraph, Robert Winnett and Myra Butterworth (28/9/10)
Bean Says Bank of England Trying to Get Reasonable Economic Activity Level Bloomberg, Scott Hamilton and Gonzalo Vina (27/9/10)
Spend, spend, spend, demands Bank of England deputy governor Investment & Business News , Tom Harris (28/9/10)
Data
International saving data (see Table 23) Economic Outlook, OECD
AMECO on line (see tables in section 15.3) AMECO, Economic and Financial Affairs (European Commission)
Economic and Labour Market Review (see Table 1.07) National Statistics
Questions
- What is meant by the ‘paradox of thrift’?
- Reconcile the argument that it is in the long-term interests of the UK economy for people to save more with the Bank of England’s current intention that people should save less?
- Is there a parallel argument about fiscal policy and government spending (see the news item The ‘paradox of cuts’?)
- What are the determinants of saving?
- Look at the data links above and compare the UK’s saving rate with that of other countries.
- What has happened to the UK saving rate over the past four years? Attempt an explanation of this.