Entries Tagged 'inflation' ↓

• Yesterday, the ONS reported a jump in CPI inflation to 3.5% for January (from 2.9% in December.
• RPIX – all items RPI excluding mortgage interest  payments – was 4.6 per cent
• RPI was 3.7%

graph source: ONS

The record monthly increase in annual inflation is mainly due to the rise in VAT from 15% to 17.5%.

However, rising oil prices and transport prices have also contributed to inflationary pressures rising.

Usually, after a long recession, rising unemployment and increase in spare capacity, you would be expecting a fall in inflation.

- Last year, there was great concern about the threat of deflation. Indeed we could look upon these statistics as a vindication of economic policy – better to have a bit of inflation than have deflation. I would not be overly concerned by these statistics. I would certainly be more concerned if inflation was undershooting the target at this stage.

Indeed, there is a growing movement to change the government’s official inflation rate. For a long time, the somewhat arbitary figure of 2% was held up as the holy grail of inflation targetting.

However, 2% is not always the optimal inflation target. This is because

Inflation can spike due to temporary cost push factors. Inflation is influenced by volatile commodities like oil. Just before the recession, we had inflation of 5% – which discouraged Central Banks from cutting rates. But, this inflation was more of a temporary phenomena than evidence of excess demand in the economy. In other words Monetary policy needs to distinguish between temporary rises in inflation and a permanent rise in excess demand.

Higher Inflation Rate would give more Room for Manoeuvre. Some economists argue that a target of 2% gives Monetary policy too little room for maneouvre. E.g. during the current crisis, when inflation fell below the target, cuts in interest rates were ineffective in boosting demand. If we had a higher  inflation target of 3%, we could have had higher nominal interest rates – leaving central banks more room for maneouvre and therefore less need to rely on large budget deficits.

fSee: Interview with Oliver Blanchard from the IMF

For example, in the US, unemployment is at 10% and looks set to remain high for the considerable future. Yet, some economists are already more concerned about the threat of inflation rising above 2%.

Low inflation is desirable for promoting economic stability and long term growth, but, what that low inflation rate is, needs careful examination and a degree of flexibility.

Related

• Bank of England Inflation Target
• Essay – Discuss whether Government’s primary objective should be low inflation?
• Is Inflation really so Bad?

The assumption that the optimal inflation rate is 2% could well be wrong and we would be better off with an inflation target of 3%

Paul Krugman explains why inflation need not be a problem for US. – The Big Inflation Scare

If inflation does remain muted in an economic recovery. The forecast for the dollar may be better than many anticipate – Forecasts for Dollar

I wrote a piece - Is inflation really so bad anyway?

What Could cause US Dollar to collapse?

Readers Question. I have read that in the US (and to some extent in the UK) the money supply has been increasing for a number of years , which was a contributing factor in the ‘credit/asset price bubble’ story. Why did inflation stay so low in this period of expanding money supply?

The link between the money supply and Inflation  is often weak. In theory, an increase in the money supply faster than an increase in Real Output growth will cause inflation, but there are many other variables to take into account such as the Velocity of circulation V (number of times money changes) hand. Therefore, a rapid increase in money supply might not cause inflation.

These help give more answers:

• Link Between Money supply and inflation
• Money Supply and Inflation in US

Latest UK Inflation Figures

Source: BBC

• RPI inflation is now – 1.2%
• CPI Inflation is now 2.3%

The large rise in unemployment and effects of recession are likely to cause CPI inflation to fall further.

If the Pound recovered against the dollar and Euro, this would also reduce inflation further.

Latest Inflation report at Bank of England

source ons

Readers Question: How can we have both inflation and deflation in the economy at the same time? (the RPI falling to 0% and CPI rising to 3.2%)

Deflation requires a fall in prices. We would need a negative inflation rate (e.g -0.3%)  to have deflation

Note if the inflation rate fell from 4% to 3%, this is not deflation, but, it means prices increase at a slower rate

However, next month we could see a negative value for RPI (e.g. -0.2%) and a positive figure for CPI (e.g. 2%). Would that mean we have deflation?

RPI used to be the official statistic, but recently it was changed to CPI.

The main reason that RPI is currently much lower than CPI is the fact RPI includes the impact of mortgage interest payments. Therefore since interest rates have fallen many people  have seen a decline in the cost of mortgage payments. This explains why RPI could become negative when other prices are still rising.

(It is rather ironic that cutting interest rates to boost growth and inflation causes a fall in the RPI inflation rate. Increasing interest rates to reduce inflation, increases the RPI inflation rate)

If you have a mortgage you will probably  see a fall in the cost of living at the moment. But, if you don’t have a mortgage, then you will find many prices (e.g. food) still increasing in price.

CPI is a more reliable guide to a typical basket of goods. (unaffected by interest rates). I feel that CPI is a better guide to underlying inflation. If CPI becomes negative then this will be the best evidence that we are experiencing widespread deflation.

A Note on Deflation and Deflationary Pressures

As reader Ralph Musgrave pointed out, there is a difference between deflation and deflationary pressures. Deflation is a fall in prices.

Deflationary pressures refers to reduced growth / reduced demand in the economy. e.g. Deflationary fiscal policy involves higher tax and lower spending to reduce growth rates. But usually, deflationary policies don’t cause a fall in prices. (except in a depression where the impact on prices is very significant)

• RPI CPI inflation

Readers Question: I have a question which confused me for a long time. Recently, Zimbabwe’s central bank decided to delete 12 zeros of their currency to deal with the Hyperinflation problem. I just have an intuition that this action doesn’t work as the purchasing power of the currency remains unchanged. Can you tell me the reason why it doesn’t work?
Thanks!

The inflation rate is the percentage change so if prices double from 16billion to 32 billion, it is the  same inflation rate as if prices doubled from 16 million to 32 million.

Knocking zeros off the end doesn’t change the percentage change in prices. Nor does it solve the fundamental imbalances in the economy which caused the inflation in the first place.

It seems Zimbabwe have resorted to using foreign currency as a means of getting past the worst inflation rate in modern times. In other words the Zimbabwe Central Bank has given up on its currency and people are resorting to a mix of foreign currencies.

At its peak the Zimbabwe inflation rate reached 89.7 sextillion per cent (a number expressed with 21 zeroes), 890,700,000,000,000,000,000,000%  (If I can count zeros correctly)

Apparently Zimbabwe hawkers are selling the 100 trillion dollar bank notes for $2 as souvenirs to tourists. – I’d probably buy one and use it as a teaching lesson!

• Hyper inflation in Zimbabwe
• understanding Hyper inflation in Zimbabwe
• How Zimbabwe slew dragon of hyperinflation

The main inflation rate in the UK is now the CPI Consumer Price Index.

The CPI is based on the HCIP (Harmonised Consumer index prices) which measures inflation on internationally agreed standards throughout Europe.

• The RPI (Retail price index) includes mortgage interest payments. Thus changes in the interest rates effect the RPI. If interest rates are cut, it will reduce mortgage interest payments. Thus the RPI will fall but not the CPI.
• The RPI also includes council tax and some other housing costs not included in CPI
• The CPI includes some financial services not included in the RPI
• The CPI is based on a wider sample of the population for working out weights.

RPIX and RPI

• RPIX is the same as RPI minus mortgage interest payments.
• RPIX is closer to CPI but not exactly same.

RPIY (Core Inflation)

The RPIY measures core inflation this is RPIX minus taxes such as VAT and excise duty. Thus a cut in VAT would reduce RPI but not reduce core RPIY

Which is Most Accurate Definition of Inflation?

It’s hard to say. However, I think it is more useful to looking at underlying core inflation. For example, a large cut in interest rates causes a temporary fall in RPI, yet could lead to inflationary pressures in the long term.

• CPI tends to be a little lower than RPI (except when interest rates are cut like at moment)

• Definition inflation
• RPI CPI at statistics.gov.uk
• Problems measuring inflation

Readers Question: How do we know whether is inflation is increasing or decreasing?

• Inflation measures the annual change in prices.
• An inflation rate of 4.7% means that on average prices increased 4.7% in the last 12 months.
• You can find the latest inflation rate at the Bank of England Home page
• Next month, we expect the inflation rate to fall ( let us say it falls to 4.3%)
• This is a fall in the inflation rate. It means that prices are increasing at a slower rate (note: it doesn’t mean prices are falling. It just means they are increasing at a slower rate)

Graph of UK Inflation

This is a graph of UK inflation. To complicate things there are two ways of measuring inflation (but, they are fairly similar. You can see that CPI inflation rate increased from October 2007 to July 2008. This was partly due to increased oil prices. Now the inflation rate is falling because we are entering recession. It will probably keep falling to about 1-2% by the middle of next year

See also: Fall in Inflation and rise in prices

How Does Inflation affect Firms?

Inflation imposes various costs on firms. These firms will be worse of the inflation is unexpected. For example, if firms expect inflation of 2%, but, it proves to be 5%, this is worse than if they had expected inflation of 5%.

Some of the costs of inflation

• Menu costs. These are the costs of changing price lists. Modern technology makes it easier to do. But, the higher inflation is, the more frequently price lists will have to be updated.
• Uncertainty and confusion. If inflation is higher than expected, then the costs of investing will be changing frequently. This makes firms less willing to invest because they are uncertain over future costs and returns. This is particularly a problem with unexpected cost push inflation raising the price of raw material costs.
• Wage Inflation. Unexpected inflation may lead to the necessity of renegotiating wage deals with workers. However, these wage rises may be expensive for the firm because they cannot afford them.
• UK Inflation may make UK firms less competitive than international competitors; this is important for exporters.

Benefits of Inflation for Firms

• Reduce Value of Debt. If firms have debt then inflation may reduce the value of debt. In this case inflation is more desirable than deflation, where the real value of debt will be increasing. This also depends on interest rates which affect the real interest rate.
• Low inflation of around 2% suggests economic growth is likely to be high. Moderate inflation makes it easier to change relative prices.

Readers Question How does the price of food affect inflation?

inflation CPI basket

Source: Statistics.gov.uk pdf – CPI weights for 2008

The CPI is calculated using a basket of goods.

The sub group food accounts for 10.2% of the total CPI weight. Therefore, if food prices increase these account for 10% of the total inflation rate.

Very roughly if food prices increased by 5%, the CPI would increase by 0.5%.

Therefore food is relatively important. The table also suggests that food prices tend to be more volatile than other components. Food is also more subject to seasonal variations in prices. The seasonally adjusted inflation rate takes this into account.

In 2008, rising food prices contributed to cost push inflation.

The

Readers Question: Why is Inflation Increasing?

In the last economic quarter, the UK economy stagnated 0% growth. At this stage in the economic cycle, you would usually expect a lower rate of inflation. – As demand in the economy falls there is downward pressure on prices causing lower inflation rates.

Inflation is increasing because of cost push factors. In particular the cost of living is rising because of

• Higher oil prices – leading to higher petrol prices, and higher transport costs which affects all goods.
• Higher food prices – caused by a combination of rising global demand and bottlenecks in supply.
• Rising Energy prices – the price of natural gas is linked to the price of oil.
• Rising commoditiy prices such as metals and minerals. Many blame rapid economic growth in India and China for this increased demand and higher prices

• CPI Inflation is 4.7%, RPI is 5%.

Having said all that, I feel the prospects for inflation is that inflationary pressures will reduce in the coming year.

• The slowing economy, rising unemployment and on going credit crunch will reduce demand pull inflation further
• Global recession has already caused the price of oil to fall from its midsummer peak.
• Evidence of food prices stabilising as supply bottlenecks overcome