Duncan’s Economic Blog

Inflation

Posted in Uncategorized by duncanseconomicblog on March 24, 2009

Inflation (CPI) is up, driven mainly by weak Sterling. RPI inflation, is flat year on year for the first time since 1960. But deflation, for the moment, is avoided.

The exchange of letters between the Governor and the Chancellor is well worth reading.

As Mr King says, inflation will fall likely fall:

Despite the increase in CPI inflation in February, we believe that the sharp decline in CPI inflation since its peak in September is likely to resume in the coming months. This reflects two main factors.

First, a number of major gas and electricity suppliers have signalled a reduction in tariffs in response to earlier falls in global energy prices. On its own, we expect that this will act to reduce inflation in the coming months by around a percentage point. And there could be a further round of tariff reductions later in the year.

Second, the growth rates of money and nominal demand have slowed sharply. The contraction in economic activity in recent quarters has created a substantial margin of spare capacity in the economy. Output contracted by 1.5% in the fourth quarter of 2008 – a substantially larger contraction than the MPC expected in December. And indications suggest that the economy will contract at a similar rate in the first quarter of this year. This picture of very weak activity in the UK mirrors the pattern of demand in other countries: GDP contracted sharply in the Euro Area, US and Japan in the fourth quarter of 2008, and is likely to continue to fall in early 2009. And 54 out of 57 countries for which data are now available registered falls in industrial output in the fourth quarter of last year. In 32 of those countries, the fall was larger than that in the United Kingdom.

The outlook for global activity will constrain UK demand prospects and, as a result, the margin of spare capacity is likely to build in the coming quarters, pulling down on CPI inflation. Consistent with that outlook, wage pressures are muted.

As a result of these factors, and notwithstanding the inflation outturn for February, it is likely that over the next year CPI inflation will move below target, although the profile of inflation could be volatile, reflecting Ihe reversal of the temporary change in VAT on CPI inflation.

Whilst the avoidance of deflation is a positive, the news is not all good. Food bills and heating bills are both still rising at over 10% a year, this hits the poorest the hardest.

One final thought. The real interest rate in the UK is now -2.7% (0.5% nominal base rate minus 3.2% CPI inflation). In the Eurozone the real interest rate is +0.3% (1.5% base rate minus 1.2% inflation). Which raises the question, what on Earth is Jean Claude Trichet talking about?

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