Monday, 18 November 2013

The ups and downs of UK inflation

Inflation has become delinked from the UK economy but at least it seems to be heading in the right direction

Something seems off.  Inflation figures for the United Kingdom released this week show that inflation dropped to 2.2% during the 12 months up to October.  Inflation had previously been high despite the sluggish UK economy but inflation is now on the way down just as the economy is picking up again according to data released at the end of October showing the fastest rate of economic growth in more than three years.  Any links between inflation and the health of the economy take on extra meaning due to the level of prices being the primary concern of central banks.  So how is the Bank of England likely to react to such mixed data?

Inflation typically moves in line with the economy – increasing during boom times and falling when times are bad.  But as mentioned above, this relationship does not always hold as economic growth in places other than Western countries, such as China and other emerging markets, can affect prices for global commodities, a situation which was not always the case (for more on this, see Inflation – Then and Now). The strength of the Chinese economy explains how inflation in the UK could briefly exceed 5% near the end of 2011 while the economy was struggling.

Although the main goal for the Bank of England is to maintain price stability which involves keeping inflation close to around 2%, the high inflation in 2011 was not seen as a problem on the basis that the factors behind the higher inflation were judged to be temporary (and this turned out to be correct).  More persistent inflation typically comes with more sustained periods of economic growth as increased wealth pushes up demand and results in rising prices.

Accordingly, it may be a good omen that lower inflation has come at a time when the fortunes of the economy are beginning to brighten.  It will give the Bank of England more leeway to keep interest rates lower for longer.  However, it is not clear whether inflation will continue to fall – energy suppliers are planning to hike energy prices while the government will be keen to limit higher fuel bills.  Energy costs will also be dampened by China no longer experiencing the rampant economic growth of the past decade.   At least inflation will be one less thing that the Bank of England will need to worry about with the tricky prospect of interest rate rises on the horizon.

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