Tag Archives | inflation

Does inflation cause unemployment?

Readers Question: Does inflation causes unemployment?

There are a few different scenarios where inflation can cause unemployment. However, there is not a direct link. Often we will notice a trade off between inflation and unemployment – e.g. in a period of strong economic growth and falling unemployment, we see a rise in inflation – see Phillips Curve.

Also it is important to bear in mind, (especially in the current climate) If the economy has deflation or very low inflation and the monetary authorities target a modest rate of inflation, then this may help boost growth and reduce unemployment.

Inflation can cause unemployment when:

  1. The uncertainty of inflation leads to lower investment and lower economic growth in the long term.
  2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
  3. Inflation leads to decline in competitiveness and lower export demand, causing unemployment in the export sector (especially in a fixed exchange rate).

 

Inflation creates uncertainty and lower investment

One argument is that a period of high and volatile inflation discourages firms from investing. Because inflation is high, firms are less certain investment will be profitable. It is argued that countries with higher inflation rates tend to have lower investment and therefore lower economic growth. Therefore, if there are poor levels of investment this could lead to higher unemployment in the long term.

It is argued that countries with low inflation rates, such as Germany have enabled a long period of economic stability which helps to attain a long term low unemployment rate. Low inflation in a country like Germany also helps them to become more competitive within the Eurozone, which also helps create employment and reduce unemployment.

See also: costs of inflation

Continue Reading →

EU inflation and deflation

The Eurozone inflation rate is 0.4% (ECB database)  (Sept 2014)

Eurozone HCIP inflation rate

eurozone inflation

HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated)

Food inflation

food inflation

Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the headline rate.

Reasons for low inflation in the Eurozone

1. Temporary factors – lower food / energy prices. Core inflation is currently higher than the headline rate. Excluding energy, food, alcohol and tobacco, the inflation rate is 0.9%. However, even this core inflation is still well below the government’s target. Also, the headline rate of 0.4% is important for anchoring low inflation expectations. M. Draghi wrote about his concern of an inflation rate permanently below 1%-  which will anchor low inflation expectations (Der Spiegel interview)

2. Sluggish growth

Economic growth in the European Union has been very weak since the start of the great recession in 2007. Weak economic growth has put downward pressure on wages and prices.

Eu-growth

EU Real GDP Source: St Louis Fred

3. Unemployment

eurozone-unemployment

Eurozone unemployment has been above 10% since the middle of 2009. Persistently high unemployment rates create downward pressure on wages. With large pools of unemployed labour – there is downward pressure on wages, which is big factor in keeping overall inflation low.

4. Inflation expectations

Despite the on-going recession, the ECB and European officials have placed great stress on keeping inflation low. This is one factor that has helped anchor low inflation expectations throughout the Eurozone.

5. Monetary policy

The ECB has recently cut the interest rate, but in 2011 – concerned at a blip in inflation – they increased interest rates. The ECB have always erred on the side of caution with regard to inflation, but the effect has been a relatively tight monetary policy which has kept nominal GDP growth low. The other big difference between Europe and other areas such as the UK and US is that whilst the UK has US have embraced quantitative easing to increase the money supply, the ECB has not sought to create more money to deal with deflationary pressure. There is great resistance to this idea, especially in Germany. This is a reasons Eurozone inflation is lower than elsewhere.

6. Internal devaluation

In the Eurozone, many countries such as Portugal, Greece, Spain became uncompetitive in the Single currency. This led to large current account deficit. But, in the Eurozone, these countries can’t allow their currency to devalue. Instead they are pursuing internal devaluation – trying to restore competitiveness through lower wages, and cutting prices. However, this process inevitably causes lower inflation. Both Greece and Portugal have outright deflation as a consequence of this policy.

6. Austerity measures

The Eurozone crisis led to many countries implement austerity to cut budget deficits. In a recession, austerity measures have slowed down economic growth contributing to lower nflation.

7. Reluctance to reflate the economy

The Eurozone has a big trade imbalance – with Germany having a large current account surplus – indicating domestic demand is relatively low compared to export demand. Germany has room to boost domestic spending which would help the south of Europe restore competitiveness and increase exports. But, Germany is not keen on risking any inflation, so they have held back on domestic spending, keeping overall Eurozone GDP growth low.

Problems of low inflation rate

In one sense a low inflation is good news for consumers who are enjoying low food prices e.t.c. However, the problem is that this low inflation is entrenched and so we are likely to see this leading to wage freezes. Low inflation does not help consumers if wages are not growing (something UK is experiencing at the moment)

The bigger problems of low inflation is that it is increasing EU wide debt burdens. A moderate inflation rate would help reduce nominal debt to GDP ratios. But, with zero inflation, the effective debt burden becomes much harder to reduce.

Very low inflation is also likely to hold back spending and investment. Consumers may prefer to wait before spending – in the expectation prices will continue to fall. Firms may be reluctant to invest given the poor prospects for economic growth. This all contributes to deflationary pressures – which is exactly what the Eurozone should be trying to avoid.

More detail – Problems of deflation

Related

1

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

Continue Reading →

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 →

2

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)
Continue Reading →

0

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 →

0

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 →

0

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

2

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.

Continue Reading →

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 →

Optimization WordPress Plugins & Solutions by W3 EDGE