Wednesday, March 19, 2008

Avoiding Recession with Inflationary Pressures

Readers Question: We as a UK importer and distributor are seeing price rises of 10-37% on steel and non ferrous based products from Chinese/Taiwanese suppliers. With the continuing fall of the Chinese RMB to the US$, suppliers are seeking further increases. We will have to pass on these costs in the next few months so surely many other importing companies around the world will do the same and thereby fuelling inflationary pressures dramatically. How will this affect the Bank of England's decision to change interest rates when balancing the needs to curb inflation yet prevent a recession?

It is not easy for the Bank of England to balance the different problems. Officially their target is low inflation so they will give importance to cost push inflation factors, but, if the UK economy does enter a recession it will be interesting to see how the Bank responds because at the moment it is not clear.

Yesterday CPI inflation rose to 2.5%[link], largely on the back of rising energy prices. There are also other cost push inflation factors such as food and rising housing costs. As you mention, the weakness of the pound and dollar are contributing to imported inflation. With US interest rates falling to 2.25% the dollar's weakness is likely to continue.

Furthermore, the Bank of England have another problem. CPI seems to underestimate inflation, RPI gives a higher figure for inflation because it includes housing costs. Therefore, although CPI inflation of 2.5% doesn't sound too high, underlying inflation is actually more of a problem. Comparison of RPI and CPI

Producer Inflation in UK

If we look at producer inflation, this suggests an even higher figure. Producer inflation is currently running at 5.7% -[Producer inflation] Record number of producers are reporting increased factory gate prices BBC link (Producer inflation is the price of manufactured goods leaving factories)

Although this is a problem for manufacturers, the MPC will not give too much importance to producer inflation. Their target is CPI 2% - they will not target producer inflation directly. For example, when house prices were rising by 25% in recent years, the MPC did not think it needed to do anything because CPI inflation remained low. (This decision is now criticised by some as fostering a housing boom. )

MPC v Federal Reserver on Interest Rates

Nevertheless, the MPC has shown that it is Hawkish on inflation. Also, producer inflation is often seen as a good guide to future inflation trends because it takes time for factory gate prices to filter through to the economy. Therefore, it is definitely a factor in limiting rate cuts. Since the start of the credit crisis, the Bank of England have been conservative in reducing rates only very slightly to 5.25%. This is in stark contrast to the US Fed reserve who have cut rates aggressively to 2.25%. It is interesting to note that the US have the same cost push inflationary pressures. In fact the US currency depreciation is far worse. However, at the moment, the FED sees its job as avoiding a serious recession it seems to see the inflation problem as rather insignificant. They argue that as the American economy slows down, demand pull inflationary pressure will slow anyway.

The Bank of England still want to maintain a strong line on dealing with inflation, they don't want to appear 'soft' on inflation. But, if the economy does take a nose dive they will be placed in a difficult position as they may have to sacrifice their low inflationary objective. Although in a recession lower demand will reduce demand side inflation.

Threat of Recession in UK?

Compared to the threat of inflation, the prospect of recession is perhaps much more serious.

There are various factors which could lead to recession in the UK:
  • Stagnating housing market - falling prices would cause lower consumer spending
  • Credit Crisis makes borrowing more difficult and expensive.
  • Slowdown in US could spread to rest of the world.
  • High borrowing levels and low savings ratio
  • Declining confidence as a result of financial markets in turmoil

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