It is the Bank of England’s responsibility to ensure that inflation remains on target. They use interest rates and the money supply to keep inflation within a 1% band of the inflation target set by the government = 2%. However, for the past 12 months, we have had an inflation rate above the 3% maximum and this looks set to continue. Official figures show that the CPI inflation rate has risen to 3.3% in November, up from 3.2% in October 2010 – above the inflation target. There was also movement on the RPI from 4.5% to 4.7% during the same months. The ONS suggests that this increase is largely down to record increases in food, clothing and furniture prices: not the best news as Christmas approaches. It is not just consumers that are facing rising prices, as factories are also experiencing increasing costs of production, especially with the rising cost of crude oil (see A crude story). Interest rates have not changed, as policymakers believe prices will be ‘reined in’ before too long.
However, the government expects inflation to remain above target over the next year, especially with the approaching increase in VAT from 17.5% to 20%. As this tax is increased, retail prices will also rise and hence inflation is likely to remain high. There is also concern that retailers will use the increase in VAT to push through further price rises. A report by KPMG suggests that 60% of retailers intend not only to increase prices to cover the rise in VAT, but to increase prices over and above the VAT rise.
Despite the planned VAT rise spelling bad news for inflation, it could be the spending cuts that offset this. As next year brings a year of austerity through a decrease in public spending, this could deflate the economy and hence bring inflation back within target. However, there are suggestions that more quantitative easing may be on the cards in order to stimulate growth, if it appears to be slowing next year. The Bank of England’s Deputy Governor, Charles Bean said:
“It is certainly possible that we may well want to undertake a second round of quantitative easing if there is a clear sign that UK output growth and with it inflation prospects are slowing,” Bean told a business audience in London.”
The following articles consider the rising costs experienced by firms, the factors behind the inflation and some of the likely effects we may see over the coming months.
Articles
UK inflation rises to a surprise six-month high The Telegraph, Emma Rowley (14/12/10)
UK inflation rate rises to 3.3% in November BBC News (14/12/10)
Inflation unexpectedly hits 6-month high in November Reuters, David Milliken and Christina Fincher (14/12/10)
Food and clothing push up inflation Associated Press (14/12/10)
Retailers ‘to increase prices by more than VAT rise’ BBC News (14/12/10)
VAT increase ‘will hide price rises’ Guardian, Phillip Inman (14/12/10)
Slower growth may warrant more QE Reuters, Peter Griffiths and David Milliken (13/12/10)
Factories feel squeeze of inflation The Telegraph, Emma Rowley (13/12/10)
Figures show rise in input prices The Press Association (13/12/10)
November producer input prices up more than expected Reuters (13/12/10)
Data
Inflation ONS
Inflation Report Bank of England
Questions
- What is the difference between the RPI and CPI? How are each calculated?
- Why are interest rates the main tool for keeping inflation on target at 2%? How do they work?
- Is the inflation we are experiencing due to demand-pull or cost-push factors? Illustrate this on diagram. How are expectations relevant here?
- Explain why the rise in VAT next year may make inflation worse – use a diagram to help your explanation.
- Explain the process by which rising prices of crude oil affect manufacturers, retailers and hence the retail prices we see in shops.
- How are the inflation rate, the interest rate and the exchange rate linked? What could explain the pound jumping by ‘as much as 0.2pc against the dollar after the report’ was released?
- Explain why the public spending cuts next year may reduce inflation. Why might more quantitative easing be needed and how could this affect inflation in the coming months?
The USA has complained for a long time now that the Chinese currency is undervalued. This makes it hard for American domestic firms to compete with cheap Chinese imports and for US exporters to sell to China. This was a major talking point at the G20 conference in Korea in November 2010: see Seoul traders and the following clip from Reuters: Obama pressures China at G20.
So is the yuan undervalued and, if so, has there been any appreciation to reduce the degree of undervaluation? In 2005, the yuan was pegged at $0.12 (or $1 = ¥8.28). In July 2005 the peg was relaxed and the yuan has appreciated. By mid-December 2010, the yuan was trading at $0.15 (or $1 = ¥6.66) – a 25% appreciation since 2005. In real terms the appreciation has been greater. Chinese inflation is above US inflation. Latest figures for Chinese inflation show consumer prices rising by an annual rate of 5.1%. This compares with 1.2% in the USA. This makes the real appreciation greater.
But despite this appreciation, the USA maintains that the Chinese currency is still considerably undervalued. Estimates for this undervaluation are around 40%. In its latest ‘Big Mac Index’, The Economist calculates this undervaluation at 41.2%. Links to the relevant data are given below. Read the articles and then use the data to answer the questions.
Articles
China’s soaring inflation could hit UK shoppers The Telegraph, Richard Tyler (11/12/10)
China says November inflation rises to 5.1 percent Bloomberg, Cara Anna (11/12/10)
Jump in China inflation keeps focus on tightening Reuters, Aileen Wang and Simon Rabinovitch (11/12/10)
China inflation rise fastest since July 2008, exceeds market forecast The Australian, Aaron Back (11/12/10)
China’s top economic planner says December CPI likely below 5% Xinhuanet (11/12/10)
Yuan rises vs dollar after strong trade data The Economic Times of India (11/12/10)
Who wins if Yuan is significantly revalued? International Business Times (12/12/10)
Currency war reveals growing global fissures AsiaOne (11/12/10)
How China’s Inflation Policy Will Help the Yuan / Dollar Exchange Rate Seeking Alpha, Ed Dolan (29/11/10)
Data
Monthly Data Chinese National Bureau of Statistics
US Inflation Rate in Percent for Jan 2000-Present InflationData.com
BIS effective exchange rate indices Bank for International Settlements
Spot Exchange Rates Bank of England
IMF World Economic Ourlook Data Find The Best
Economic Data freely available online The Economics Network
The Big Mac Index The Economist
Questions
- Using Bank for International Settlements data above (broad indices), plot the nominal and real exchange rate indices for the US dollar and the yuan from 2005 to the present day. How much have (a) the nominal and (b) the real yuan exchange rate indices appreciated against the dollar exchange rate indices? (Note: you can use the Excel data to plot all four series on the same diagram.)
- Why has the Chinese rate of inflation risen?
- How are the anti-inflationary policies being considered by the Chinese authorities likely to impact on (a) the yuan exchange rate (b) the Chinese current account?
- In what ways do the Chinese authorities intervene in the foreign exchange market?
- What are the implications of the People’s Bank of China increasing the amount of yuan that can be traded on currency markets and increasing the amount of yuan-denominated debt?
- What are meant by purchasing power parity (PPP) exchange rates? Is the Big Mac index a good guide to the degree to which a currency is under- or overvalued?
If ever there was something to make you clean out your house and sort out your ‘rubbish’, this has got to be it!! A Chinese vase found gathering dust in an attic has just sold for £43 million at auction. The buyer will pay around £53 million after paying the buyer’s 20% commission to the auction house and VAT. The seller will get around £40.75 million, after deduction of the seller’s commission by the auction house. The auction house itself will make over £10 million – not a bad day to be an auctioneer!
With the price starting at £500,000, onlookers could hardly believe it as the price began to increase by £1 million at a time. The buyer is thought to be a Chinese person or a state-backed company. And, just in case you didn’t realise, the FT article does make special mention that the person is likely to be ‘wealthy’!
The Chinese vase sold for over 40 times its estimate, with speculation that the price was forced up by a Chinese cultural agency owned by the state. As China aims to regain many of its lost artefacts, prices for objects such as this have been pushed up: although perhaps £53 million is a little expensive for the everyday consumer! However, unstable financial markets and rising inflation may also be partly to blame for the surge in prices for objects such as this. We’ve seen how gold and other commodities have increased in value throughout the recession, as investors look for more stable investments – and the same appears to be happening in the world of art. I’ll certainly be keeping a look out for any dusty artefacts!
House clearance vase fetches £53 million Financial Times, Jan Dalley, Peter Aspden and Justine Lau (12/11/10)
Chinese vase: the suburban auction house that made £12m Telegraph, Andy Bloxham and Martin Evans (12/11/10)
Qianlong Chinese porcelain vase sold for £43m BBC News (12/11/10)
Chinese vase fetches record $69 million in UK auction Reuters (12/11/10)
Questions
- Why are auctions a good way of selling and buying a product?
- The auction house has made over £10 million from this sale, despite only employing 8 people. Does this income guarantee the success of this business?
- Using a demand and supply diagram, explain the factors that have fuelled the price increase in artefacts, such as this Qianlong porcelain vase.
- Why are people investing in assets, such as art and commodities, rather than in more traditional financial assets?
- Could an auction be an example of price discrimination?
The News is something that we probably take for granted. For many, it’s the first thing they switch on in the morning, or it’s something you listen to while you drive to work or before you go to bed. But, tomorrow and Saturday (5 and 6 Nov) could be a different story, as the BBC faces a 48-hour strike over pensions, which has been organised by the National Union of Journalists. Star presenters, including Fiona Bruce, are expected to participate in the walkout, which will lead to News Bulletins being hit, Newsnight facing disruption and certain radio programmes being cancelled. The Director General of the BBC made a last minute plea to those participating in the walk-out, as core news services across both TV and radio will suffer, as there simply aren’t sufficient resources to provide the necessary cover.
The strike follows significant changes to the BBC’s final salary pension scheme, in response to a growing pension deficit. The BBC plans to reduce the £1.5bn pension deficit by capping increases in pensionable pay at 1% from next April. Although some negotiations have already taken place, the NUJ claims that the BBC ‘has no appetite for negotiation’. After negotiations, employee contributions were reduced from 7% to 6% and a career average pension scheme would be introduced to replace the final salary pension scheme, which is very lucrative for the worker, but hugely expensive for the firm. Despite these changes, members of the NUJ still believe the proposals are fundamentally ‘unfair’.
This strike is unlikely to be the only disruption faced by the public, as further action is expected to occur throughout the rest of November and there are also concerns that Christmas broadcasts may face interruption. Those NUJ members taking part in the walk-out are expected to experience a significant loss in earnings, without there being any noticeable benefit in the long term. Although some will support the strike action, many will be unimpressed. As the Director General wrote in an email to all BBC staff:
“The public – many of whom are facing difficult employment and economic pressures – will find it very hard to understand why the BBC’s service to them should be impaired in this way”.
Articles
Report
Questions
- What is the difference between a final salary pension scheme and a career average pension scheme? Which is more beneficial for a) the recipient of the pension and b) the pension provider?
- Is anyone likely to benefit from this 48-hour strike? (Think about who the BBC’s competitors are.)
- The BBC article says that ‘payments will increase automatically each year in line with inflation’. What does this mean? Are increases in payments that are indexed to inflation better than payments being indexed to earnings? Explain your answer.
- Apart from striking against changes to pensions, what are some of the other typical reasons for strike action?
- How effective are strikes likely to be? What are the key determinants of the success or failure of them?
The prices of grains and other foodstuffs are rising rapidly. Wheat prices rose some 40 per cent in July and have continued to rise rapidly since. In June wheat futures were trading at around 450 US cents/bushel. By early September, they were trading at around 700 US cents/bushel. Global food prices generally rose by 5% over the two months July/August. And it’s not just food. Various other commodity prices, such as copper and oil, have also increased substantially.
At the beginning of September there were three days of food riots in Mozambique in protest against the 30% rise in the price of bread. Seven people were killed and 288 were injured. On 2 September Russia announced that it was extending a ban on wheat exports for another 12 months following a disastrous harvest. In Pakistan, the floods have destroyed a fifth of the country’s crops. Drought in Australia and floods in the Canadian prairies have reduced these countries’ grain production.
In response to the higher prices and fears of food riots spreading, the United Nations has called a special meeting on 24 September to bring food exporters and importers together to consider “appropriate reactions to the current market situation”. And yet, although global cereal production is down by some 5% on last year, it is still predicted to be the third largest harvest on record.
So what is causing the price rises? Is it simply a question of the balance of supply and demand and, if so, what has caused the relevant shifts in supply and/or demand? And what role does speculation play? The following articles look at the issues and at the outlook for commodity prices over the coming months.
Clearly changes in commodity prices affect the rate of inflation. The news item (Bank of England navigates choppy waters) amongst other issues looks at the outlook for inflation and the various factors influencing it.
Articles
Commodity prices soar as spectre of food inflation is back Guardian, Simon Bowers (6/8/10)
Food inflation is a rumble that won’t go away Telegraph, Garry White (8/8/10)
Global wheat supply forecast cut BBC News (12/8/10)
Commodity crisis sparks fear of food inflation on high street Independent, James Thompson and Sean O’Grady (10/8/10)
Should we be concerned about high wheat prices? BBC News, Will Smale (6/8/10)
Commodity prices: Wheat The Economist (12/8/10)
Interactive: What’s driving the wheat price spike? Financial Times, Akanksha Awal, Valentina Romei and Steven Bernard (20/8/10)
Wheat pushes world food prices up BBC News (1/9/10)
UN to hold crisis talks on food prices as riots hit Mozambique Guardian, David Smith (3/9/10)
Grain prices spark global supply fears CBC News, Kevin Sauvé (3/9/10)
GRAINS-US wheat firms after Russian ban extension Forex Yard (3/9/10)
Global food prices reach 20 year high BBC News, John Moylan (3/9/10)
Speculators ‘not to blame for higher food costs’ BBC Today Programme, David Hightower (4/9/10)
Q&A: Rising world food prices BBC News (3/9/10)
Don’t starve thy neighbour The Economist (9/9/10)
Data
Commodity prices Index Mundi
Commodity prices BBC market data
Energy prices U.S. Energy Information Administration
Questions
- Use a supply and demand diagram to illustrate (a) what has been happening to wheat prices (b) what is likely to happen to wheat prices over the coming months?
- How relevant is the price elasticity of demand and supply and the income elasticity of demand to your analysis?
- What factors have caused the shifts in demand and/or supply of wheat and copper?
- What has been the role of speculation in the price rises? Is this role likely to change over the coming months?
- What is likely to happen to food prices in the shops over the coming months? Would you expect bread prices to rise by the same percentage as wheat? If so, why; if not, why not?
- If commodity prices generally rose by 5 per cent over the coming year, would you expect inflation to be 5 per cent? Again, if so, why; if not, why not?