Posted on by John Sloman

Too much of a push from costs but no pull from demand

Inflation’s rising again! After a year of falling inflation, with CPI inflation being below the Bank of England’s target of 2% since June 2009, inflation began rising again in October 2009 and then shot up in December. In the year to November 2009, CPI inflation was 1.9%. In the year to December it had risen to 2.9% – well above the 2% target. As the National Statistics article states, however:

This record increase is due to a number of exceptional events that took place in December 2008:

  • the reduction in the standard rate of Value Added Tax (VAT) to 15 per cent from 17.5 per cent
  • sharp falls in the price of oil
  • pre-Christmas sales as a result of the economic downturn

    • These exceptional events led to the CPI falling by 0.4 per cent between November and December 2008 (a record fall between these two months). The CPI increase between November and December 2009 of 0.6 per cent is far more typical (the CPI increased by 0.6 per cent between November and December in both 2006 and 2007). These exceptional events also affected the change in the RPI annual rate.

    So what should the Bank of England do? 2.9% is well above the target of 2%. So should the Monetary Policy Committee raise interest rates at its next meeting? The answer is no. Although inflation is above target, the Bank of England is concerned with predicted inflation in 24 months’ time. Almost certainly, the rate of inflation will fall back as the special factors, such as the increase in VAT back to 17.5% and earlier falls in VAT and oil prices, fall out of the annual data.

    What is more, the sudden rise in CPI inflation is almost entirely due to cost-push factors, not demand-pull ones. Rises in costs have a dampening effect on demand. Raising interest rates in these circumstances would further dampen demand – the last thing you want to do as the economy is beginning a fragile recovery from recession.

    The Bank of England’s policy recognises that the prime determinant of inflation over the medium term is aggregate demand relative to potential output. For this reason it doesn’t respond to temporary supply-side (cost) shocks.

    Avoid false alarm over UK inflation Financial Times (20/1/10)
    Oh dear. Inflation is back again Telegraph, Jeremy Warner (19/1/10)
    Mervyn King confident on inflation target Times Online, Grainne Gilmore (19/1/10)
    How should we remember 2009? As the year the Bank of England’s inflation target died Telegraph, Jeremy Warner (20/1/10)
    An embarrassing bungee-jump The Economist (21/1/10)
    Priced in BBC News, Stephanomics, Stephanie Flanders’ blog (19/1/10)
    This MPC is not fit for purpose New Statesman, David Blanchflower (21/1/10)
    Jobs joy takes sting out of inflation misery Sunday Times, David Smith (24/1/10)

    For CPI inflation data, see Consumer Prices Index (CPI) National Statistics

    Questions

    1. For what reasons might inflation be expected to fall back to 2% later in the year?
    2. Does the rise in inflation to 2.9% put pressure on the Bank of England’s Monetary Policy Committee (MPC) to raise interest rates? Explain why or why not.
    3. What factors is the MPC likely to consider at its February meeting when deciding whether or not to embark on a further round of quantitative easing?
    4. What effects has the depreciation of sterling had on inflation? Explain whether this effect is likely to continue and what account of it should be taken by the MPC when setting interest rates.
    5. What is meant by ‘core inflation’? Why did this rise to 2.8% in December 2009?
    6. What is the role of expectations in determining (a) inflation and (b) real GDP in 24 months’ time?
    7. Why, according to David Blanchflower, is the MPC not ‘fit for purpose’?