Inflation

The cost of living is a measure of changes in the average cost for a household of buying a basket of different goods and services. In the UK there are two published measures, the Retail Price Index (RPI) and the Consumer Price Index (CPI). Price data is used in many ways by the government, businesses, and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, maintenance payments and many other 'index-linked' contracts. The consumer price index (CPI) is a weighted price index, which measures the monthly change in the prices of over 600 different goods and services. The weights are revised each year, using information from the Family Expenditure Survey. The expenditure of some higher income households, and of pensioner households dependent on state pensions, is excluded.

Selected Weights in the UK Consumer Price Index

Total weights for the CPI = 1000. Source: Office of National Statistics

140 130 120 110 100 90

1996=100

140 130

Housing, water and fuels

120 110 100

Foods

90 80 70

80 70 60 50 40 30 20 10 0 01 02 03 04 05 06 07 08 09 10 Education Alcohol, tobacco and narcotics Clothing and footwear

60 50 40 30 20 10 0

Source: UK Statistics Commission

Calculating a weighted price index

Category Food Alcohol & Tobacco Clothing Transport Housing Leisure Services Household Goods Other Items Price Index 104 110 96 108 106 102 95 114 Weighting 19 5 12 14 23 9 10 8 100 Price x Weight 1976 550 1152 1512 2438 918 950 912 10408

Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year. The price index for this year is: the sum of (price x weight) / sum of the weights So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%. The UK Inflation Target

Consumer Price Inflation for the UK Economy

Annual percentage change in the Consumer Price Index

5.5 5.0 4.5 4.0 3.5

Percent

5.5 5.0 4.5 4.0 3.5 3.0 2.5 CPI Inflation target = 2% 2.0 1.5 1.0 0.5 0.0

3.0 2.5 2.0 1.5 1.0 0.5 0.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: UK Statistics Commission

Since 2004, the inflation target for the UK has consumer price inflation of 2.0%. This target is set each year by the Chancellor and it is the task of the Bank of England to meet this target. There is a permitted band of fluctuation of +/- 1%. In the early years of this decade inflation stayed comfortably within target range but this changed from 2007 onwards. The target was breached for the first time in the spring of 2007 when inflation edged over 3% before falling back. But in 2008 there was a renewed surge in consumer prices that caused CPI inflation to spike up above 5%. Less than a few months later disinflation had set in and CPI inflation fell back towards the target level. Indeed the expectation is that inflation in the UK is set to fall further in 2009 renewing fears of price deflation. The government has not signalled any official change to the inflation target but, as far as monetary policy is concerned, the Bank of England has interpreted the inflation objective flexibly given the highly uncertain economic situation both at home and in the global economy. Criticisms of the inflation target Setting inflation targets came into fashion in the early 1990s. Macroeconomic policymakers were looking for a way of introducing transparency and credibility into monetary and fiscal policy by having a clear final target or objective namely price stability at a low (positive) rate of inflation. The hope was that an inflation target would provide an anchor for inflation expectations, giving businesses and employees the confidence that the purchasing power of money would be protected and encouraging long term planning and higher levels of investment. Whilst inflation targets seemed to work well during a period of global macroeconomic stability, the inflexible nature of targets has come under growing criticism in the last few years. In respect of the

UK, one criticism has been that the chosen inflation measure and target (CPI inflation of 2%) was not designed to deal with inflation shocks from abroad which, in themselves were not the result of whether UK policy interest rates were at the right level. A few years back when many businesses were outsourcing and off shoring and China and other emerging markets were making big inroads into world trade, there was a collapse in the price of manufactured goods from DVD players to freezers, kettles and iPods. This led to a fall in consumer prices fell relative to wages and profits boosting peoples spending power. One city economist talked about the real product wage i.e. what goods and services could be bought with 100 of wage income. But this heralded a period when official CPI inflation was below the 2% target; indeed policy-makers focussed their attention on preventing price deflation. To prevent this from happening required a boost to domestic spending through a combination of lower-than-necessary interest rates and an expansionary fiscal policy. Cheaper interest rates encouraged consumer borrowing and also acted as a stimulant to the UK property market. In the short term this boosted aggregate demand and GDP growth but at the expense of causing big imbalances shown by a falling savings ratio, huge levels of personal sector debt, and an unsustainable housing boom. Fast forward to 2006-08 when booming emerging market countries were contributing to a sudden and sharp rise in world commodity prices, leading to a burst of cost-push inflationary pressures in the UK. This time, CPI inflation surged above the target but once more for reasons that were not to do with what was happening domestically inflation was being driven by external rather than homegrown headwinds. The response of the Bank of England was to tighten policy by raising interest rates and this did much to bring down the housing market. Thus some economists believe that a narrow inflation-targeting framework has introduced a "stopgo" element into the British economy that has made our cycle more volatile. Perhaps monetary policy in particular should be guided less by a narrow measure of inflation but a broader assessment of inflationary pressures including data on what is happening to asset prices such as property? Limitations of the Consumer Price Index as a measure of inflation The CPI is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people. This has become an important issue both when CPI inflation was rising well above target in 2008-09 and more recently as the risks of a deflationary recession have become more apparent. The CPI is not fully representative: Since the CPI represents the expenditure of the average household, it will be inaccurate for the non-typical household, for example, and 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children. We all have our own weighting for goods and services that does not coincide with that assigned for the consumer price index. Housing costs: The housing category of the CPI records changes in the costs of rents, mortgage interest, property and insurance, repairs and accounts for around 16% of the index. Housing costs vary from person to person, from the young house buyer, to the older householder who may have paid off his or her mortgage. Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality. It is hard to make price comparisons of electrical goods because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

Inflation affects different people in different ways and few of us experience the same rate of inflation. Since 2007, people have been able to log on to the Office of National Statistics website to use their own personal inflation calculator!

Retail Price and Consumer Price Inflation in the UK

Annual percentage change in the retail price index and CPI

11 10 9 8 7 6
Percent

11 10 9 8 7 6

5 4 3 2 1 0 -1 -2 90 91 92 93 94 95 96 97

All items retail price index (RPI)

5 4 3 2 1

Consumer price index

0 -1 -2

98

99

00

01

02

03

04

05

06

07

08

09

10

Source: UK Statistics Commission

One of the big issues in recent times has been the difference in measured inflation between the Consumer Price Index (CPI) and the Retail Price Index (RPI). The latter includes mortgage interest costs in its calculation. In 2009, RPI inflation became negative for the first time since the 1960s. The wage price spiral expectations-induced inflation Rising expectations of inflation can be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the purchasing power of their incomes. When workers are looking to negotiate higher wages, there is a danger of a wage-price spiral that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation. The diagram below summarises some of the key influences on inflation. Reading from left to right: o o o o o Average earnings comprise basic pay + income from overtime payments, productivity bonuses and other supplements to earned income.

Productivity measures output per person employed, or output per person hour. A rise in
productivity helps to keep unit costs down. The growth of unit labour costs is a key determinant of inflation in the medium term. Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties. Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle. Conversely inflationary pressures decline in a recession when businesses have far more spare capacity and may decide to offer deep price discounts to their customers to get rid of unsold stock.

Basic Pay

Bonuses + overtime

Import Prices

Exchange rate / profit margins

+ Commodity Prices Average Earnings Unit labour costs + + Productivity Taxes + Economic Cycle Secular Influences (e.g. ICT impact) Fiscal Policy Consumer price inflation

Profit Margins

Economic Cycle

Consequences of Inflation High and volatile inflation is widely viewed by economists to have economic and social costs. The impact of inflation depends in part on whether inflation is anticipated or unanticipated: o Anticipated inflation: o When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. Trade unions may exercise their collective bargaining power to negotiate for increases in money wages to protect the real wages of union members. Households may be able to switch savings into accounts offering a higher nominal rate of interest or into other financial assets where capital gains might outstrip price inflation. Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in forward markets. For example, many airlines buy their fuel several months in advance in the forward market as a protection or hedge against fluctuations in world oil prices.

Unanticipated inflation: o o When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when people, businesses and governments make errors in their inflation forecasts. Actual inflation may end up well below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another.

Money Illusion People often confuse nominal and real values because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that peoples expectations of inflation turn out to be some distance from the correct level. Costs of Inflation We must be careful to distinguish between different degrees of inflation, since low and stable inflation is less damaging than hyperinflation where prices are out of control. 1. Impact of Inflation on Savers: When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation leading to negative real interest rates. 2. Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. This process is known as a wage-price spiral. 3. Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. 4. Business Planning and Investment: Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned investment spending. 5. Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. Benefits of inflation Can inflation have positive consequences? The answer is yes although much depends on what else is happening in the economy. Some of the potential advantages of benign inflation are as follows: 1. Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% provides a situation where businesses can raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their pay packers. This can provide a psychological boost and might lead to rising investment and productivity. 2. Tax revenues: The government gains from inflation through what is called fiscal drag effects. For example many indirect taxes are ad valorem in nature, e.g. VAT at 15% - so as prices rise, so does the amount of tax revenue flowing into the Treasury. 3. Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans. 4. Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy can manage to avoid some of the dangers of a deflationary recession (discussed in the next chapter) 2008 The return of rising inflation to the UK economy 2008 was a year when rising inflation came to dominate the newspaper headlines and TV news bulletins almost on a daily basis and the UK economy was not alone in that! In May 2008, the

International Monetary Fund (IMF) warned, global inflation had re-emerged as a major threat to the world economy due to soaring energy and food prices. The main cause of the pick-up in inflation was the unexpectedly large rise in world prices of many commodities including oil and foodstuffs. This led to an increase in cost-push inflation (i.e. an inward shift of the SRAS curve). Rising input costs, rising production costs, higher wholesale and retail prices e.g. increased petrol prices and energy bills. An increase in actual inflation led to an upward shift in inflation expectations and the Bank of England feared a return of inflation and a wage-price spiral

Inflation also increased because of: 1. Strong GDP growth / consumer spending 2. A depreciating exchange rate (leading to higher import prices) 3. Higher indirect taxes The Bank of England feared a return to stagflation and 2008 was a year when real wages fell as inflation out-paced the growth of pay. Throughout most of 2007 the Bank of England was raising policy interest rates to control inflation interest rates stayed fairly high at 5% or above for most of 2008 but then the inflation outlook changed because of recession. 2009 The return of deflation In the spring of 2009 the annual rate of retail price inflation became negative heralding many headlines that the British economy was on the verge of a period of sustained deflation. This topic is covered in more depth in the next chapter. The RPI takes account of changes in mortgage interest payments and in June 2009 it was standing at minus 1.6 per cent having being negative for four months in a row. That means the absolute level of prices, not just their rate of increase, has fallen compared to where it was a year ago. Much of the onset of inflation could be explained by the was due to the drop in mortgage repayments after the Bank of England slashed interest rates from more than 5 per cent to 0.5 per cent. But falling gas and electricity prices have also played a role. 2010 Update: Inflation in the World Economy The global recession of 2009 has led to a reduction in average rates of consumer price inflation in many parts of the world. World inflation dipped from 5.4% in 2008 to 1.9% in 2009 and it is forecast to move up to 3.4% in 2010. Developed economies have experienced the brunt of the recession and have seen average inflation fall close to zero. Indeed in some nations there has been a period of price deflation, notably in Japan where CPI inflation was -1.8% in 2008 and -0.9% in 2009. Prices there are expected to continue falling through 2010 and into 2011 partly as a result of the strong Yen which has made imports cheaper. Average inflation in developed countries in 2010 is 1.3% in contrast to emerging nations where the mean inflation rate is 5.9%. Countries where inflation is noticeably higher in 2010 include India (13.6%) Vietnam (9.6%) the Ukraine (9.5%) and Turkey where prices have risen by 8.0% during 2010.

International Inflation
Annual % change in consumer prices
11 10 9 8 7 6 5 4 3 2 1 0 Jan May Sep 04 World Inflation Dveloping Countries 11 10 9 8 7 6 5 4 3 United Kingdom 2 1 0 Jan May Sep 05 Jan May Sep 06 Jan May Sep 07 Jan May Sep 08 Jan May Sep 09 Jan May 10

EU25

Source: International Monetary Fund

Mini Case Study: Inflation takes-off in more than half the world For well over a decade, the IMFs measure of consumer price inflation for the world economy has been stable at or around 2 to 3%. Consumers, governments and central bankers have been able to enjoy a period of price stability - indeed the biggest fear for many countries have been the threat of price deflation along the lines of that suffered by Japan in the 1980s and late 1990s but the days of low inflation seem to be coming to an end. Most of the danger is coming from fast growing emerging market countries. In Ukraine inflation is 30%, Vietnam (25%), Latvia (18%), and Pakistan (17%) Russia (14%) China (8.5%) and India (7.6%). What is fuelling the dramatic acceleration in inflation? As always in macroeconomics the causation is complex, the IMF estimates that nearly two thirds of the inflation shock has come from the steep rise in food prices remember that for many poorer countries, household spending on food is a much higher percentage of the basket used to calculate inflation than in richer developed nations but food and the rising cost of oil, gas and other energy sources is not the only explanation. Many nations have been enjoying super-charged growth rates and their central banks may have been at fault in not doing enough to dampen down domestic demand and control demand-pull inflationary pressures. With nominal interest rates lagging behind inflation, the real cost of borrowing has been negative hardly the right monetary policy stance for countries struggling to bring under control rampant growth of the supply of money and credit. Wage inflation has taken off as workers look to protect their real incomes against an increasingly uncertain economic backdrop. And with rising prices come increased demand for welfare assistance and other forms of government financial support that many countries simply do not have the resources to provide. The danger is that accelerating inflation in emerging market countries will cause problems such as greater exchange rate and international investment volatility and also impart an inflationary shock to the richest advanced nations. Source: Tutor2u Economics Blog, June 2008 Since this blog was written, inflation has fallen back can you think of reasons why this has happened?