How can inflation fall, whilst prices are rising?

UK-cpi-inflation-2007-19

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. For example …

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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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EU inflation and deflation

eurozone inflation

The Eurozone inflation rate is 0.4% (ECB database)  (Sept 2014) Eurozone HCIP inflation rate HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated) 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 …

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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.

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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)

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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.

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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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