Tag Archives | inflation

Prices rising, but inflation rate down?

Readers Question: Would it be possible for a nation to claim that is reducing inflation rate successfully through economic measures,  however at same time is allowing increase of commodities prices such as bread, meat, and etc…

Firstly a fall in the inflation rate, means prices are still rising. Just at a slower rate.

monthly-inflation

For example in late 2008, the UK inflation rate was falling from 5% to 2%. Prices were still rising at the start of 2009.

Two useful definitions

  • Headline inflation rate – measures the overall cost of living. In the UK, the headline rate is measured by the CPI
  • Core inflation rate – this measures the inflation rate, excluding volatile factors, such as raw materials (oil and food)

Inflation measures the average cost of living. Therefore, it is possible for some goods to be increasing in price by a greater amount than the average price level.

A common example, is petrol prices rising at 10%, when the headline inflation rate is 4%. If we stripped away petrol from the inflation index, we would get an underlying inflation rate of 3%.

Rising oil prices were a major factor in causing the UK inflation of 5% in 2008.

At the present moment, the fall in oil prices are causing the headline inflation rate to be lower than it would be otherwise. Headline inflation is running at 1% in many European countries, but without the downward pressure from oil, headline inflation may be closer to 2%.

An example of core inflation being more stable than headline inflation

Core CPI

Source: [1. Paul Krugman, New York Times: Core Logic, Still ]

This graph shows that headline inflation is more stable. However, if we exclude energy and food, we had inflation go over 5% and also slip into deflation in 2009.

Food prices

Food prices often change at a greater rate than overall inflation. Food prices tend to be more volatile because they are determined by factors, such as the weather. Also, with inelastic supply and demand, this makes prices more volatile. Continue Reading →

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 1.3% (headline rate)
  • CPIH – 1.3% in the year to Aug 2014
  •  (page updated 18 November, 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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Inflation target during deflation

Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

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Problems of Deflation

  • Deflation is defined as a fall in the general price level. It is a negative rate of inflation.
  • It means the value of money increases rather than decreases.
  • Deflation is not necessarily bad, but often periods of deflation / low inflation can lead to economic stagnation and periods of high unemployment. This is because deflation can discourage spending because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.

deflation

In the twentieth century, periods of deflation have been relatively rare. Generally, western economies have experienced inflation. The most significant period of deflation for the UK was in the 1920s and 1930s. These decades (especially, the 1930s) were characterised by economic depression. Prolonged deflation is often considered to be very damaging as it can exacerbate an economic downturn leading to higher unemployment.

Problems of Deflation

  1. Discourages consumer spending. When there are falling prices, this often encourages people to delay purchases because they will be cheaper in the future. In particular, it can discourage consumers from buying luxury goods / non-essential items, e.g. flatscreen TV) because you could save money by waiting for it to be cheaper. Therefore, periods of deflation often lead to lower consumer spending and lower economic growth; (this in turn creates more deflationary pressure in the economy. Certainly this fall in consumer spending was a feature of the Japanese experience of deflation (Japanese financial crisis).
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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

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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

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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 →

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 →

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 →