Inflation is the sustained rise in the general price level and is measured using the government’s preferred measure; the Consumer Price Index. It is useful in that it is designed to show the effects of inflation on a typical household, and, as used elsewhere, it allows easy comparisons with other European nations.
One of the first policies of the Labour government when elected in 1997 was to give control of monetary policy (interest rates) to the independent Bank of England. Each month the Bank’s Monetary Policy Committee (MPC) decides on the UK’s base rate, or interest rate, and this is generally passed on to consumers and businesses by the banks in the form of loan repayment levels and interest payments. However, this Transmission Mechanism for monetary policy has a delay in making a real effect, which the Bank itself estimates to be around 2 years. Therefore their rate decisions are often looking on a long-term and changes in response to recent events, like the current slowdown, may take time to take effect.
Using the Transmission Mechanism, interest rates are used to try and affect aggregate demand. Cuts in interest rates are hoped to increase spending, as borrowers have to pay less in charges and saving is less attractive, and rate rises are used when the economy needs to be cooled (as demand pull inflation occurs).
DIAGRAM 6: Demand Pull Inflation
While there is no increase in prices as demand rises from AD1 to AD2, when the demand nears the Full Capacity Output of the economy all resources are already being fully utilised. There is excess demand and the price rises (see P1/P2 to P3)
The government’s strategy was to detach monetary policy from the political nature of government, to ensure that the best economic decisions were made – not decisions made for political gain.
Earlier governments used interest rate cuts, and fiscal policy tax cuts, to win support in elections, however, this had negative economic effects – often excess demand and demand pull inflation. With an economy so volatile and cyclical, very high growth levels caused demand pull inflation, which then needed to be abruptly halted with high interest rates to match. This severe action to limit inflation actually caused large falls in economic growth, and problems such as recessionary periods.
The government hoped the new system would prevent out-of-control inflation and the problems that were experienced in the boom and bust cycle.
As with economic growth, the government wanted low and stable inflation. These two indicators are often linked and success in one can help with success in the other. Having low and sustained levels of inflation should help businesses to plan for the future, to employ staff and to invest in capital stock. These should all boost the economic potential of the economy (long run aggregate supply) and mean that we are less likely to have demand pull inflation.
While high inflation is damaging for the economy, with savings becoming less valuable and falls in economic growth and employment, inflation must be present in the economy. If inflation was at 0% or less, known as deflation, people would expect prices to be lower soon so would not buy goods and services. This lack of spending would likely stop economic growth and increase unemployment.
Source: Originally from http://news.bbc.co.uk/1/hi/business/7457886.stm
GRAPH 15: Rate of CPI inflation in the UK, 1997 – 2008
As shown in Graph 15, above, the government and Bank of England have done well to keep inflation both low and stable. For their early years in power, the purple RPIX (Retail Price Index) measure was used by the government, at its target of 2.5%. As of December 2003, the preferred measure was changed to the red CPI and the target lowered to 2%.
For the 10 years shown by the graph, the government has continued to keep well to those targets. The government allows a 1% either side of target allowance (shown by the yellow bands) to the Bank of England, and rates have almost entirely fallen within this band.
The UK’s inflation has therefore been kept under control over the last 10 years. The specific targeting of inflation, by the independent Bank of England and its economically based decisions, in addition to interest rates’ use an economic control to spending have been widely and successfully used. The stable inflation levels may well have helped considerable to the continued economic growth, and the system has been a credit to the Bank of England and the Government.
But many would put the stability down to a real deflation in the prices of many consumer goods. Outsourcing of production to factories abroad has meant that many firms have been able to achieve lower costs, and this has been passed onto consumers in increasingly competitive markets, both nationally and globally – which is also driving down prices. Greater imports, along with controlled aggregate demand, has meant we have not experienced demand-pull inflation (see Diagram 6).
Wage growth has also been slow, with the removal of the skills shortages experienced in the boom and bust phase and lower expectations of inflation preventing a wage price spiral forming. This, along with few external shocks in commodity prices, has helped to limit the effects of cost-push inflation (Diagram 7).
DIAGRAM 7: Cost Push Inflation
When businesses experience higher costs (AS1 to AS2), in an demand price inelastic market, they can pass the costs on to consumers in the form of higher prices (O1 to O2)
Many of the above contributors to low inflationary pressures have not come from the government and their policies. Increased foreign production, no sudden commodity price increases and global competition are all features which have been experienced internationally.
GRAPH 16: Global Consumer inflation
Since 1997, Graph 16 clearly shows that global inflation has been low and stable. This has been a period of increased global competition and falls in the costs of production for many firms across the world.
While it has perhaps come from better economic stewardship by governments, it is undoubtable that steady, low inflation in economies around the world has been a major contributor.
As part of the ‘end of boom and bust’ economic stabilisation the government has achieved, a far lower and more steady inflation rate has also arisen.
GRAPH 17: Inflation in the UK since 1989
As said previously, inflation has often seemed to follow a similar path to economic growth though the cyclical volatility. This is clearly shown on a global scale on Graph 16, with large peaks and troughs, similar to those of the economic growth data.
As shown by Graph 17, inflation, both RPIX and CPI, was far higher in the early 1990’s. RPIX was around 9.5% at its peak for this period, before falling to a roughly stable level around 2.5% in 1994/1995.
Since then both RPIX and CPI inflation have remained at this low level. While CPI has fallen further than its level at 1995, there is perhaps a question as to whether it was this government or the previous one that laid the foundations for this sustained low inflation decade.
Nonetheless, during this Labour government’s time in power, the economy has enjoyed a long period of stable inflation at far lower levels than before.
The recent shocks to the economy have had a significant effect on inflation.
There have been large increases in businesses costs, which are being passed onto consumers and are causing cost push inflation. Many of the products which are affected by this are also price inelastic in their demand, meaning households have to continue buying these goods, pushing inflation up.
GRAPH 18: Recent inflation levels in the UK, annual % change
The rate of inflation for August 2008, as shown above, is 4.7%, and since then has again rise to 5.2% in September – the highest level during Labour’s time in government. Our escalating inflation is a serious worry in the economy, especially when little appears available to stop the rises. The Bank of England cannot deploy interest rate changes due to our stagnant economic growth (two contrasting situations which would normally trigger opposite monetary policy actions), the Bank’s Transmission Mechanism is breaking down and with an estimate 2-year delay in changes taking effect changes seem likely to be ineffective.
A major cause for this inflation has been international external shocks – the rising prices of commodities such as oil, feeding through to car fuel and utilities, and food.
Poor harvests in usually high yielding countries has meant there is less supply, and combined with the steadily growing demand for western foods from newly developing nations, prices are rising (Graph 19), up over 10% this year.
GRAPH 19: Food prices over the last year
Oil prices have also had a significant effect (Graph 20). Petrol prices have increased 5.3% between May and June this year, as have most other oil derivatives, making travel and transportation more expensive for consumers and firms. In both nominal and real terms, there have been very large increases in oil prices.
GRAPH 20: Oil prices since 1970
Some firms can pass on their costs, pushing up consumer prices, but those in demand price elastic markets, often those which are most competitive, will have to absorb some cost, lowering their own profits. Not only is oil used for fuel, but is widely used for power generation in this country. Increases in the gas and electricity input costs mean higher prices for households and businesses.
All of these, plus rising charges on large sums of personal debt, continue to squeeze household budgets. As disposable incomes shrink, there are worries that the next effect may be higher wage bargaining. With high expectations of inflation, workers may demand higher wages, in turn fuelling the growth in prices. This is, however, not yet appearing in the labour market. As employees feel unsecure about their jobs, wage demands are remaining low, at only 3.8% in August 2008, and a wage-price spiral has not formed.
The Bank of England, under its terms of reference, wants to keep inflation low, at or around 2%. Normally, if it were to reach nearly 5% they would raise the base rate to slow the economy, however falling demand is already having this effect and any further slowing could cause even greater recessionary problems such as unemployment. However, lowering rates could encourage inflation to increase out of control.
Even if they were to act, the Transmission Mechanism that the Monetary Policy system is based upon is also breaking down. Changes to the Base Rate are not being passed on to businesses and consumers as interbank lending tightens up and rates such as the Libor, a measure regarded as the more realistic cost of money, are pushed far higher than the Base Rate is usually tracks.
The Bank hopes that this inflation problem will be only transitory and will soon begin to subside and diminish during early 2009 (Graph 21b). As a result, they have maintained rates at 5% for a number of months (Graph 21a) until the 0.5% cut in October. This cut itself may cause only limited effect, except to raise confidence.
GRAPH 21a: Bank of England Base Rate decisions from early 2006
GRAPH 21b: August 2008 CPI Fan Chart
Again, the government has been in office during an extended period when inflation has been low and stable and in line with that of other nations.
While the government has taken good fiscal decisions to allow inflation to be at the desired level, the control of monetary policy has been passed over to the Bank of England and the MPC has controlled interest rates.
Secondly, this decade has seen a large move to outsourcing; leading to lower costs of production, cheaper goods and a real deflation in some prices. Increased importing has allowed for our demand to be fed without inflationary pressure arising and commodities have remained at stable levels. However, the saving grace of outsourcing to cheaper production can only be carried out once. Increased globalisation also means the government has had less control over our prices, as they are fuelled by international variations.
Currently however, inflationary pressures are high. Rising input prices mean higher costs for many businesses and increased living costs for households. Many of the problems are external shocks and are combined with a growing likelihood of recession. These, plus the banking crisis and breakdown of the Transmission Mechanism, mean the government and Bank of England can do little to stop inflation.
Inflation is currently not at a level anywhere near it’s historical peaks, but the rapid and continuing rise is worrying. As input costs continue to rise for firms it may be many years before this inflation has subsided back to levels experienced over the past decade.
Over their time, inflationary control with monetary policy has worked well under stable conditions, and in this sense the government has done very well with its strategy. However, now, when the economic climate is increasingly volatile, they are unable to stop inflation heading away from target. They hope is that falls in the prices of the goods that peaked, causing this inflation, will continue to reduce the cost of living for consumers.
Please note that this was written during Summer 2008, before the worst of the economic problems of the following months