Saturday, February 19, 2011

Exchange Rate and Inflation

In recent post, Will higher interest rates reduce inflation, I should have mentioned higher interest rates in UK would increase the value of the Pound. A stronger exchange rate will have the effect of reducing inflation. An appreciation in the Pound:
  • Makes imports cheaper (approx 40% of goods are imported), a stronger pound makes these cheaper for UK consumers.
  • Reduced demand for UK exports should put downward pressure on prices.
Another graph showing how underlying inflationary pressures are still hard to see. This graph shows how wage growth is close to 2%. Also CPI-CT is 2.3% (CPI - CT, excludes the effect of changes in taxes on prices). Both these important measures - wages and CPI - taxes, show underlying inflationary pressures are close to the government's target.

Since 2008, wage growth has been more or less below CPI.

Recent evidence makes me think there is a stronger case for a higher headline inflation target, at least when you have a situation of high unemployment and rising commodity prices.

Another graph showing impact of rising energy prices on recent rise in CPI

Source: ONS - Time Series data


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