In the UK, we have an inflation target of 2% and it’s the Bank of England’s job to use monetary policy, in particular interest rates, to keep inflation within 1 percentage point of its target. However, with rising commodity prices and the onset of recession back in 2008, interest rates had another objective: to prevent or at least lessen the recession. Bank Rate fell to 0.5% and there it has remained in a bid to encourage investment, discourage saving and increase consumption, as a means of stimulating the economy.
However, at such a low rate, interest rates are not acting as a brake on inflation, which is now well above target. This rise in inflation, has been largely brought about by cost-push factors, such as the restoration of the 17.5% VAT (up from the temporary 15%), higher oil and commodity prices, and a fall in the exchange rate. But part of the reason might be found in the increase in money supply that resulted from quantitative easing.
There are concerns that the UK may lose its credibility on inflation if action isn’t taken. The OECD has advised the Bank of England to raise Bank Rate to 3.5% by the end of 2011. The following articles consider this issue.
Articles
Time to worry about inflation? BBC News blogs, Stephanomics, Stephanie Flanders (28/5/10)
UK must not fall for the false promise of higher inflation Telegraph, Charles Bean, Deputy Governor of the Bank of England (4/6/10)
Reports and documents
General Assessment of the Macroeconomic Situation OECD Economic Outlook, No. 87 Chapter 1 (see especially pages 53–4) (May 2010)
United Kingdom – Country Summary OECD Economic Outlook, No. 87 (May 2010)
Statistical Annex OECD Economic Outlook, No. 87 (available 10/6/10)
Inflation Report portal Bank of England (see May 2010)
Questions
- Explain the relationship between interest rates and inflation. Why have such low interest rates caused inflation to increase?
- In 2008, the UK moved into recession, but was also suffering from inflation. This was unusual, as AD/AS analysis suggests that when aggregate demand falls, growth will fall, but so will prices. What can explain the low growth and inflation we saw in 2008?
- What is the difference between real and nominal GDP?
- What are the causes of the current high inflation and what solutions are available and viable?
- Why are expectations of inflation so important and how might they influence the Bank of England’s plans for interest rates?
- Do you think the OECD should have advised the Bank of England? Will there be any adverse effects internationally if the UK doesn’t heed the OECD’s advice?
- Is the OECD’s assessment of the UK in the above Country Summary consistent with its view on UK interest rates contained in pages 53 and 54 in the first OECD link?