Wednesday, January 27, 2010

Inflation Spikes

We have been in the longest recession since the great depression, so it is somewhat suprising to see a rise in inflation. This includes both the RPI and CPI measures. CPI is 2.9%, RPI is 2.4%. When the inflation rate rises above 3%, the governor of the Bank of England has to write a letter of explanation to the Chancellor. He is already drafting a response as the Bank of England expect inflation to peak at over 3%, when the rise in VAT from 15 to 17.5% is included.

Why Inflation?

  • Depreciation in Sterling makes imports more expensive. About 40% of goods are imported, when the pound devalues as it did in 2008/09, it makes imports more expensive.
  • It is a reflection that prices fell in December 2008 by 0.4%. By contrast last month they rose by 0.3%.
  • Oil prices rising relative to 2008

Factors which aren't causing Inflation?

  • Quantitative Easing. You might expect that if you create £200bn of electronic money this increase in money supply should cause inflation. However, money supply growth is still 'undesirably low
  • Wage growth is very restrained due to the unemployment and impact of recession. Wage growth was just 0.7% in 2009.

The spike in inflation will most likely prove temporary, but, the bad news in the short term is declining real incomes - Many people will be seeing prices rise faster than wages - hardly something to boost the economic recovery to say nothing of the political cost to Labour.

It is important to remember that inflationary spikes can be misleading to underlying state of economy. For example, the inflation spike in early 2008, just before the economy plunged into deep recession.

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