It was announced today that the consumer price index (CPI) rose from 3.3% to 3.7% while the retail price index (RPI), which includes housing costs and taxes, rose to 4.8% in December 2010. But what does this actually mean for the UK and more importantly for us?
First of all, let’s understand what inflation is and where it comes from. Price inflation, where there is a decrease in the value of money i.e. our purchasing power as consumers falls, is the result of monetary inflation, where there is more money within the economy. This means that when the supply of a commodity, such as oil, gas and corn decrease then prices have to increase and more money is required to buy them. This happens all along the supply chain and that extra money increases inflation.
Inflation isn’t necessarily a bad thing and this is why the Bank of England has a target of 2%. First and foremost it allows the Bank of England some tools to affect the economy such as (base) interest rates which would not be possible if inflation was close to zero. It can also be argued that it would lead to savers holding more money which would decrease the interest rate. This in turn will increase the level of borrowing and increase investment and boosting output.
However, what makes this situation different from higher inflation rates of the past is that the base rate is so low (0.5%) which means savers lose out, and wages are increasing by a slower rate (on average 2.2%). Those on fixed incomes are also losing out as the rise in prices are not being matched by any increase in their own income further putting the elderly at risk.
Having said this, this inflation is driven by commodity prices (in this case oil and gas), food (corn, maize etc) and a product of quantitative easing to resist the recession. This has led to the effects being felt by the wider public. The price inflation will greatly affect import prices also leading to higher prices of production and could hurt our exports also. The only people to benefit are those with debt and in particular a fixed rate mortgage but this is outweighed by the general discomfort felt.
This rate incorporates taxation such as VAT which was decreased to 15% and then raised back to 17.5%. As of January 2011 the VAT rate will increase to 20% further putting a strain on consumers whilst potentially forcing businesses to cut back on staff.
It is exactly here which could have a bigger impact on the economy and society. High inflation, an increase VAT and large public spending cuts could have profound effects on the UK. A more likely scenario would see unions demanding further wage increases to compensate for the inflation (against a backdrop of big city bonuses) which would push prices up further as the cost of production has increased and will create a wage-price spiral.
The Bank of England can raise interest rates which would come as a relief to savers and would put a halt to stimulating the economy. At any other time this would have been the method adopted but given that the UK has only just come out of the recession the Bank of England does not want to send the country back down that route. If this inflation is a temporary effect due to quantitative easing and short-run commodity supply issues then the economy would naturally return to its 2% rate and the central bank could keep their low base rate. There is also no certainty that this would work in itself – if inflation is coming from commodity prices and a previous (but now stopped) QE then raising interest rates may not have an effect. One thing is for sure; the Bank of England would not risk any further quantitative easing.
Overall, the statistical news is a shock and could have profound effects for the UK. The Bank of England will do well to resist the many calls of an increase in the base rates especially as 30 of the past 36 months has had an inflation rate above the target. A wage-price spiral could worsen the situation whilst a status quo could put excess stress on society.
Mervyn King and the Bank of England will certainly be praying for a decrease in commodity prices and a decrease in January’s inflation results.