Tuesday, December 1, 2009

Inflation Rate Projections

Projected CPI Inflation: Source: BofE

Note: The fan shows potential inflation rate. The area in the middle (darkest) is the most likely inflation rate. The longer the time period, the more difficult to predict inflation, which is why the fan projection gets wide.

The latest Bank of England inflation predictions suggest the future medium term outlook for inflation will be uncertain. In the short term, inflation could increase sharply. But, in the medium term, spare capacity should keep inflation low.

Inflation could increase in short term because of:
  • VAT rise from 15% to 17.5%
  • Rising oil prices
  • Depreciation in Pound which makes imported goods cheaper.

Should We Be Worrying About Inflation?

Some are worrying about a long term threat of inflation. For example, they suggest
  • The scale of quantitative easing may be difficult to reverse.
  • The unprecedented monetary and fiscal expansion may start to have an increasing effect in the future.
  • The rise in the price of gold suggests markets are nervous about future inflation (or at least just nervous).
In my opinion it is a mistake to be worrying about inflation at the moment.
  • The temporary factors which will push up inflation are misleading. It is like the inflation spike of 5% in early 2008, just as we were heading into recession. This made Central Banks keep interest rates too high. But, the inflation proved to just be a temporary blip rather than an underlying reflection of excess demand.
  • It is hard to see how inflation can be a serious threat, when there is so much spare capacity in the economy. It could take until 2012 to regain the previous level of GDP. Even then, there will still be spare capacity.
  • The costs of inflation are sometimes exaggerated. Of course, inflation can cause real instability in an economy (see: costs of inflation). It is good to avoid unsustainable inflationary growth. But, if inflation does go above an arbitrary target of 2%, it should not be a reason to necessarily panic. It is not just low inflation which is the holy grail of economic policy. At least, not when you have an unemployment rate approaching 10%.
Projections of Economic Growth

projected growth (past forecasts not been very accurate)

Projected GDP Growth (Bank of England)



Basudeb Sen said...

If the Pound is going to depreciate why should it raise the inflation rate in the short term? If Sterling depreciates to make imports cheaper, this shou;d help curb price rise!,
Kindly explain.

Tejvan Pettinger said...

A depreciation in the Pound means it will cost more for us to buy imports. It makes UK exports appear more competitive (cheaper) to foreigners.