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Inflation - Cause And Effect
Following the surprise hike in August, the Bank of England Monetary Policy Committee (MPC) increased UK interest rates to a five-year high of 5% on 9 November because of inflation concerns.
UK consumer price inflation (CPI) is currently running at 2.4% year-on-year, above the Government's target of 2%. Indicators of activity and price pressures remain strong, house prices are accelerating and the money supply is expanding rapidly. The MPC also remains nervous about the prospect of a pick-up in wage pressures in the forthcoming January pay-round. As a result, a further rise in UK interest rates is generally anticipated in Ql 2007.
UK Inflation
In the 1970s control of inflation became the overriding priority for governments around the world. In the UK, retail price inflation peaked in August 1976 at 26.9% year-on-year. The economy was in crisis and the UK had to agree to impose stringent economic and financial controls in order to secure a loan from the International Monetary Fund (IMF).
There are three main factors considered by economists when looking at inflation:
More recently, the behaviour of asset prices has also been taken into account as a potential leading indicator of inflation.
Costs
'Cost push' inflation refers to the phenomenon of an increase in costs being passed through the economy to consumer prices. For example, a rise in the costs of commodities or oil (the prices of which are set in world markets and beyond the control of one individual economy) pushes up producers' costs, which they then pass on in the form of higher selling prices. In turn these are reflected in higher consumer prices. If wages are then pushed higher to compensate for higher consumer prices, a wage price spiral develops. Indeed, that process was clearly in evidence when UK inflation became so out of control in the 1970s.
Recently, however, the pass through from higher oil and commodity prices to consumer prices has been lower than most economists forecast, due to two main reasons:
1. The ability of companies to pass on higher costs is more limited than in the past. Highly competitive conditions, in global markets, mean that many companies have limited ability to increase their selling prices, even if costs have increased, putting pressure on their profit margins.
2. With the labour market more competitive than in the past, the link between wage increases and inflation is much looser and the chance of a wage price spiral developing are thereby reduced.
Demand And Output
The second factor influencing inflation is the level of demand in the economy relative to supply. Excess demand in the overall economy will raise prices. To assess such pressures, economists use concepts such as the gap between actual and potential output in the economy; or labour market indicators, eg the number of unfilled job vacancies. These measures try to assess whether demand in the economy is above, below or in line with supply potential. If actual output is running above potential then inflation pressures should increase and vice-versa.
Potential output depends on the ability of the economy to produce and will reflect the trend in the number of people employed and their productivity (output per employee). One difficulty with using such measures is that potential output is very hard to gauge accurately. One current issue in the UK is the extent to which immigration increases the labour force and thereby raises the UK's potential output.
Money And Inflation
The period of high UK inflation in the 1970s coincided with greater emphasis being placed on control of the money supply around the world. The rationale for this was that in many countries, including the UK, a close link between money supply growth and inflation had been found. Many governments and central banks felt that if the money supply could be controlled then so would inflation.
For various reasons, the previous link between money and inflation in many countries broke down in the 1980s and monetary targets were abandoned. However, central banks still pay close attention to the behaviour of money and credit in assessing prospects for inflation.
Asset Prices And Inflation
In many countries the behaviour of asset prices - including house prices - has tended to be a leading indicator of inflation. In the UK the three surges in retail price inflation in the early and late 1970s and again in the late 1980s, were preceded by high house price inflation. In this light, the sharp rise in house price inflation seen in the UK in 2002-2003 was a cause for concern. As yet, the link to future retail price inflation seen in the past has not been repeated.
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