Tag Archives | inflation

UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI  inflation rate: 1.7% (headline rate)
  • CPIH grew by 1.6% in the year to Feb 2014
  •  (page updated April 3rd, 2014)

monthly-inflation

CPI and CPIH

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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Should low inflation be the primary objective of economic policy?

The UK government has given the Bank of England an inflation target of CPI 2 % +/-1. The Bank of England are responsible for using monetary policy (e.g. interest rates)  to achieve this goal of low inflation. But, as well as targeting inflation, the Bank of England also have a wider remit of considering objectives such as economic growth.

Summary – Should we aim for low inflation as the primary objective?

Since the spikes in inflation during the 1970s and 1980s, many economies have prioritised low inflation as the primary objective of monetary and economic policy. Low inflation has many benefits for an economy; it is seen as a building block for stability and encouraging investment. The hope is that by keeping inflation low, the economy will avoid boom and bust economic cycles and provide a framework for economic stability and prosperity. If inflation gets out of hand, the economy will experience various costs of uncertainty, menu costs and loss of international competitiveness.

However, since the crisis of 2008, some economists have become increasingly critical of monetary / economic policy which targets low inflation and  ignores other economic objectives such as full employment and economic growth. Critics argue that inflation targets can become too rigid, and recently (especially in Europe) the goal of low inflation has caused unnecessarily high unemployment and a prolonged recession.

Reasons why low inflation is a primary macroeconomic objective

There are many benefits of low inflation. Firstly, if inflation is low and stable, firms will be more confident and optimistic to invest; this will lead to an increase in productive capacity and enable higher rates of economic growth in the future.

Inflationary boom caused recession of 1991

If inflation is allowed to increase because monetary policy is too lax, there could be an economic boom. But if this rate of economic growth is above the long run trend rate of growth, it is likely to be unsustainable and the boom will be followed by a bust (recession). This occurred in the UK in the late 1980s and 1990s. Economic growth was too fast, causing demand pull inflation. By the time inflation increased to 10%, it was too late, and the UK needed a rapid increase in interest rates, which caused the recession of 1991/92. Maintaining low inflation will help avoid these cyclical fluctuations in the economy which can cause booms and recessions

If inflation in the UK is higher than other countries, UK goods will become uncompetitive causing a fall in exports and possibly a deterioration in the current account of the balance of payments. This is particularly important if a country is in a single currency or fixed exchange rate because they can’t devalue to restore competitiveness. Keeping inflation low, will help the UK to be competitive. Low inflation will also help to increase the value of the Pound and maintain living standards. Continue Reading →

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Velocity of circulation and inflation

Readers Question: When does velocity of money pick up and why will it? Clearly the reason US inflation worriers have been wrong so far(NB). Is it confidence or policy?

The velocity of circulation / velocity of money refers to how frequently the money stock in an economy is used in a given time period.

In the basic money supply equation we have MV=PY

  • M= Money supply
  • V = Velocity of circulation
  • P = Price Level
  • Y = Income (in other versions, T also used for transactions)

If there is £1,000bn of money in the economy, and the total value of transactions in a year is £1,000bn, then the velocity of circulation is just 1.

If the total value of transactions rises to £3,000bn, this means the £1,000bn of money stock is being used three times in an economy. This gives a velocity of circulation of 3.

Quantitative easing and a fall in the velocity of circulation

monetary-base-cpi

Blue line is monetary base (one form of money supply). This surge in the monetary base has had no effect on inflation.

During the period of quantitative easing, we saw a big rise in the monetary base, but, inflation didn’t increase. The reason for this is that people didn’t want to spend this extra money. To be more precise, banks didn’t want to lend this extra increase in the money supply, they just kept bigger bank reserves. Therefore, the money supply didn’t filter through to the wider economy.

Velocity of circulation

m1-velocity

The Green line shows a fall in M1 velocity of circulation at the start of 2009 (wiki)

This is to be expected in a recession. Banks reduce lending, consumers reduce spending, and there is a rise in saving. Therefore, the velocity of circulation falls. This explains why a rise in the money supply doesn’t cause inflation (which it might if the economy was at full capacity)
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Impact of global economy on UK inflation

Readers Question: I am currently researching the impact of the global economy on inflation in the UK. I have come across economic policy uncertainty but am unsure what effect policy uncertainty in the EU and USA will have on the UK.

cpi-inflation

UK inflation is primarily due to domestic factors. For example, if you look at the inflation of the early 1990s, it was due to an economic boom and rapid growth in aggregate demand. This level of inflation wasn’t experienced by our main international competitors.

In 2011, the UK experienced higher rates of inflation than the Eurozone and the US. The reason inflation was higher in the UK than the Eurozone was due to factors such as:

  • Impact of devaluation causing imported inflation.
  • Rise in taxes. CPIY (a measure of inflation excluding taxes) was much lower than the headline CPI rate
  • Rise in commodity prices having a greater impact in the UK.

Global factors affecting UK inflation

There are still global factors affecting UK inflation. Firstly, the price of commodities, such as oil, metals, food will affect UK inflation. The rise in oil prices in 2008 and later in 2011/12 was a factor in causing UK inflation.

Global trends in inflation. Since the 1970s, inflation in advanced industrial countries has fallen. This global trend towards lower inflation has helped the UK also experience lower inflation. Lower inflation across the globe is due to several factors, such as:

  • Rising productivity and cheap manufactured goods from China / Asia.
  • Improved technology and working practices which have helped reduce costs.
  • Perhaps inflation targeting. e.g. Monetary policy geared towards keeping inflation low.
  • Decreased inflation expectations making it easier to keep inflation low.

The UK has definitely benefited from these global inflationary trends. But, at the same time, domestic factors have been influential in affecting UK inflation. Currently, Eurozone inflation has fallen to 1.1% but UK inflation is higher at 2.7%

What will be the effect of policy uncertainty in the USA  on the UK?

There is significant policy uncertainty in the US, with the government shut down. A prolonged debate about US government spending could risk precipitating a downturn in the US economy and an end to the US economies reasonable recovery. This would be highly damaging to the global economy. If the US economy falters, it will definitely have a negative impact on economic growth elsewhere in the world. There is also the risk of adversely affecting confidence in countries like UK and Europe. Continue Reading →

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UK Unemployment Target

The new Bank of England governor, Mark Carney, has implemented a type of unemployment target.

As part of forward guidance, the Bank of England state that:

Interest rates won’t rise from 0.5% until unemployment falls below at least 7%.

Essentially, the bank are committing to expansionary (loose) monetary policy until there is a stronger economic recovery and unemployment has fallen. The hope is that the commitment to low interest rates will encourage firms to invest and consumers to spend.

However, this unemployment target of 7% has a few caveats.  The unemployment target and forward guidance on interest rates can be ignored if:

  • Inflation is forecast to breach a 2.5% target over a 24 month horizon.
  • If there is a sharp rise in the public’s expectations of inflation
  • If low interests are likely to imperil the stability of the financial system, e.g. low interest rates could fuel an asset bubble.

UK unemployment-past-5-years-percent

Under the Bank of England’s latest targets, it does not expect unemployment to fall below 7% until 2016. According to the ONS, unemployment is currently 7.8%. It would require the creation of nearly 750,000 new jobs for the rate to fall below 7%

Equilibrium Unemployment

The Bank of England also mentioned the term ‘equilibrium unemployment’. They believe the equilibrium unemployment rate is around 6.5%. The equilibrium rate means that if unemployment falls below 6.5% it might start causing inflation (e.g. competition for employers pushes up wages). If unemployment is above the equilibrium rate of 6.5% then there is slack in the economy (demand deficient unemployment) and this will keep inflation low.

This equilibrium rate of 6.5% is therefore composed of structural factors / supply side factors (the natural rate of unemployment) Continue Reading →

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GDP deflator

GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestic goods and services in an economy. The GDP deflator regularly updates the type of goods and services used to measure the implicit price deflator – depending on which goods are being bought.

e.g.If the price of mobile calls increase relative to landline calls, people will spend less on mobiles so the rise in price becomes less significant.. This is the same principle as a chain weighted measure.

The Consumer price index CPI also tries to measure the average level of prices in an economy. However, it tends to use a more fixed basket of goods. The basket of goods in CPI is often updated less frequently, than the GDP deflator. Even if people stop buying the mobile phones, the price increases will contribute to the CPI.

Use of GDP deflator

The GDP deflator is used to convert nominal GDP statistics into real GDP.

GDP deflator

 

To find real GDP, you can divide nominal GDP / GDP deflator and times by 100

 

Often GDP deflator and CPI inflation can give a similar figure and similar impression of inflationary pressures. But, in some cases, the GDP deflator can give a more accurate reflection of actual inflation / deflation in the economy. The CPI can lag behind.

UK GDP deflator and CPI

UK-gdp-deflator-cpi

UK GDP deflators

GDP deflator has been less volatile than CPI in recent years.

 

GDP deflator in Japan

Japan gdp deflator

This graph shows that in Japan, the GDP deflator showed substantial deflation. Much more deflation than CPI. Thus concentrating on CPI gave a misleading impression of economy and contributed to lost decade and low growth.

GDP deflation in China

Between 2003 and 2008, the GDP deflator showed higher inflation than the official CPI measure. However,  in recent months, GDP deflator is becoming negative. Thus using GDP deflator, the Chinese economy is not doing as well. Growth is much lower (using GDP deflator, growth is only rather than )

Diana Choyleva, from Lombard Street, said the official Chinese figures show that the economy contracted by 0.2pc in the second quarter, rather than growing 1.7pc (7.5pc year-on-year) as claimed by the government. The discrepancy comes from the inflation assumptions used by Beijing. The government relies on a fixed basket of prices that can flatter the true health of the economy.

A better benchmark is the “GDP deflator”, which uses an evolving measure of prices that better reflect the reality of China’s fast-changing economy. “If you measure it that way, China is much closer to deflation than people realise,” China risks deflation trap

Deflationary pressures in China are coming from:

  • Falling factory gate prices
  • Appreciation in currency, leading to higher import prices
  • Investment boom coming to an end.

Related

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Producer Inflation

Another guide to inflationary pressures is the producer price index (PPI).

Producer inflation measures the price of goods produced by manufacturing firms. This is sometimes referred to as ‘factor gate prices’

producer-inflation

In the year to February 2013 the output price index for home sales of manufactured products rose 2.3%. In the same period the total input price index rose by 2.5%.

Narrow measure of producer prices

The narrow measure of producer prices excludes industries which tend to be more volatile. This volatile industries included food, beverages, tobacco and petroleum industries. Excluding these industries, the producer price inflation has been lower during this period.

Input prices

Input prices are the cost of raw materials used in the manufacturing process. This will involve the cost of metals, plastic, oil and other raw commodities.

input-prices

Again, there is a narrow measure of input prices, which excludes the more volatile industries of food, oil, tobacco, beverages and petroleum. This graph shows the quite significant input price inflation during 2011.

Leading indicators

Producer and input prices are known as ‘leading indicators’. This is because they will tend to influence future inflationary pressures. If input prices rise, firms will put up their producer prices, and in turn, this is likely to translate into higher consumer retail prices.

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Index of labour costs per hour

A new series from the ONS shows an index of labour costs per hour.

unit-labour-costs

Source:  ONS 

(this is an experimental series and looks as if it is not seasonally adjusted) Labour costs seem to be persistently highest in Q1.

Labour costs per hour are primarily comprised of 

1. Wage costs per hour

but also

2. Non-wage costs.

Non wage costs of labour include:

  • National Insurance Contributions, (NI)
  • Employee Pension Contributions,
  • Sickness, Maternity and Paternity Payments
  • Benefits in kind

Growth in wage costs per hour

index-labour-costs-hour-percent-change

As expected, since 2008, we have seen very modest increases in unit labour costs. In the last quarter Q4 2012, labour costs were actually 0.8% lower than the previous quarter in 2011. Continue Reading →

RPIJ – a new inflation measure

For those who like to keep track of the myriad different rates of inflation, the ONS will shortly be publishing a new measure – RPIJ.

  • RPIJ will be basically RPI, but calculated in the same way as CPI which uses a geometric mean.
  • CPI = official household inflation measure (CPI) – calculated using a geometric mean.
  • RPI = CPI + Mortgage interest payments and council tax. RPI is also calculated using an arithmetic mean. (The RPI doesn’t mean international standards for calculating inflation.)

gap-between-rpi-cpi

RPI is traditionally higher than CPI. The DWF state since its introduction in 1988, the RPI has averaged 0.73% more than the CPI which is mainly attributable to the “formula effect”. Some argue, because of the way it is being calculated, the RPI is over-estimating inflation. However, with pensions often linked to RPI, changing the way it is calculated could lead to lower annual increases in pensions. Therefore, the decision was taken to introduce a new measure RPIJ and keep the old measure RPI going.

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Different Measures of Inflation

In the UK, there are quite a few different measures of inflation. All measures seek to show the annual change in living costs. However, different measures of inflation give different inflation figures. For example, RPI often gave a higher rate of inflation than CPI. CPI can also be misleading. For example, an increase in VAT would cause CPI to increase, but a core inflation measure like CPI-CT, would stay lower

It is important to be aware of different measures of inflation because the rate of inflation has an important bearing on monetary policy.

Usually, an inflation rate of CPI 4.5% would encourage the Bank of England to raise interest rates. But, if this inflation rate was due to cost-push factors, such as higher taxes, the inflation rate may not be due to overheating in the economy.

Inflation is calculated by:

  • Finding out the most commonly bought goods (e.g. Family expenditure survey)
  • Measuring the change in prices and then applying the weight of the good to the price change.

 

Different Measures of Inflation

1. Consumer Price Index (CPI) – official measure. Based on the EU HCIP (Harmonised Consumer index prices)

  • Includes taxes.
  • Excludes mortgage interest payments and housing costs
  • Includes some financial services not included in RPI

cpi-inflation

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