Wednesday, April 21, 2010

Volatile Economy and Inflation

A few weeks ago I might have been more excited at the volatility of CPI inflation which recently rose to 3.4% (CPI). The RPI figure is even higher at 4.4%. However, somehow this kind of volatility pales into insignificance when you are stuck on the wrong side of the Atlantic tentatively praying a small Icelandic Volcano may become less volatile in its outpourings of ash.

CPI Inflation in UK
Source: ONS

Why Has Inflation Risen in the Middle of Recession?
  • Cost Push factors. Rising petrol prices have caused transport costs to rise 11%. The highest rise since 1997.
  • Part of the rise is due to the fact, this time last year prices fell for household services.
  • One reason analysts are not concerned about the rising inflation is that the inflationary pressure is likely to be temporary. It is similar to the inflation spike in September 2008. The rise in inflation is definitely not due to excess demand in the economy.
  • The Bank of England have maintained a very loose monetary policy - 0.5% interest rates, quantitative easing. There has been no premature tightening of monetary policy.
How Much Should We Worry About Inflation Being Above Target?
  • Given state of economy, the positive inflation rate is better than deflation or a very low inflation rate. Deflation would increase the real value of debt - making it more likely people spend less.
  • Moderate inflation helps reduce government borrowing as a % of GDP.
  • The inflation gives the government more room to tighten fiscal policy (higher taxes and lower spending) to reduce government borrowing.
  • These days inflation above 3% feels high, but, it is a far cry from 1970s and 1980s when inflation often reached double figures.
Who Loses From this Inflation Rate?
  • It is a bad time to be a saver. Inflation at 3.4% is much higher than base interest rates. It is a negative real interest rate, reducing the real value of savings.
  • If this inflation continues, bond investors will require higher interest rates to compensate for the decline in the real value of interest payments.
  • There is a danger inflationary expectations may change and it will become more difficult to keep low inflationary expectations.

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