Friday, May 21, 2010

Inflation Fears and Worries - Are They Justified?


source: ONS

Should We Worry About Inflation?



Recently, UK inflation rose to 3.7%. Again the CPI measure of inflation has exceeded the expectations of the MPC, and inflation is well above the governments target of 1-3%.

The MPC point to temporary factors such as rising petrol prices and rising food prices. Because of these temporary factors they expect (hope) inflation will decrease next year.

However, others are concerned that inflation may not fall and we are in danger of losing the low inflation expectations, we have worked very hard to gain.

Furthermore, the policy of quantitative easing (increasing the money supply) combined with high government debt is often a recipe for inflation. (see: Money Supply and inflation for the usual complications and caveats)

It is true, that the inflation has often exceeded expectations, and even stripping out temporary factors, core inflation still rose to 3.1%. However, I still feel that inflation is not the most pressing problem facing the UK.

Just last week, we had news of record unemployment (the highest since 1994) - Strange that record unemployment seems to get much less coverage and analysis than high inflation.

The problems in the Eurozone are likely to lower growth in the Europe and therefore a slow down UK exports. Combined with fiscal tightenening (prepare for tax rises and spending cuts), it is likely the UK recovery will be fragile. With continued spare capacity and sluggish recovery, underlying inflation is unlikely to take off. To worry about a boom in this stage of the business cycle, - after the deepest recession since the great Depression, doesn't make sense.

Talk Tough on Inflation

It would be a shame if inflation expectations did rise. The MPC have to tread a careful line of talking tough on inflation and trying to keep expectations low, whilst at the same time not panicking if inflation does go above target. The problem is that there is only so many times you can explain inflation away as being a 'temporary factor'. If the MPC are saying in 12 months time we are still having 'temporary inflation' people will have lost confidence.

However, we always need to keep things in perspective. If we had a choice between the deflationary potential of the Eurozone, e.g. Greece, Spain and a small exceeding of the inflation target, I would always be choosing a moderate amount of inflation over deflation - especially in the current climate of high unemployment and high debts. (see: Deflation vs Inflation)

At the same time, it should also be remembered that although inflation has often exceeded expectations, there have also been times when it fell much quicker than expected. For example, the high inflation of 2008, was a misleading indicator given the imminent severe recession. Inflation of 5% soon gave way to inflation of less than 1%

Inflation, Debts and Savings

Although the MPC and government would never want to particularly admit it. A bit of inflation does help in reducing our Debt / GDP ratio. However, it is a tricky balancing act. If the UK gains a reputation for higher inflation, it will lead to depreciation and higher bond yields to compensate for the inflation risk. But, again, it is preferable to trying to reduce Debt combined with deflation.

Savers

Technically, we have a very high negative real interest rate - Base rates 0.5%, CPI inflation 3.7%. This means savers are losing in real terms the value of their savings. You could argue the high inflation is hitting savers hardest.

However, given nature of banking liquidity, there are still generous offers for savers. If you shop around, you should be able to maintain the real value of your savings.

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1 comment:

Peter said...

If anything the problem will be deinflation as money is flowing into business; business is hoarding profits; labour is being starved of cash, and as a result aggregate demand is falling and companies are responding by hoarding even more cash. The end result of companies making more profits as a percentage of GDP will be that their profits will fall.
see: http://www.investmentandbusinessnews.co.uk/headline/papering-over-the-cracks-why-a-radical-solution-may-be-the-only-way-forward/