Inflation Running out of Puff?

For months now the debate has raged on both sides of the Atlantic: Should we be worried about inflation?

Those arguing that in the UK we should be more concerned about growth and employment than the recent news of inflation hitting 3.7% include the FT and Tax Research UK (scroll down for ‘Does inflation matter?’ blog entry).

On the other side of the debate stand most right-of-centre commentators who are increasingly worried that the monetary authorities have abandoned their inflation target of 2%. They fear that the authorities may be planning to ‘inflate their way out of debt’.

In the face of increasingly polarised arguments, we should perhaps remind ourselves of the causes of inflation. That way, we should be able to judge whether or not we should be concerned about the 3.7% CPI headline rate: Inflation is caused by one of two effects:

  • aggregate demand pulling prices up due to supply constraints – with suppliers able to charge higher prices due to shortages of stocks
  • or, by cost pressures pushing prices up due to higher costs of the factors of production – with firms facing higher fuel bills, raw materials costs as the prices of commodities such as oil, foodstuffs or metals rise or workers demanding higher wages due to shortages of labour.

So which of these two phenomena are we experiencing in the UK economy and beyond? UK unemployment has been rising in the past 18 months and stands at 7.9%. News reports focused on the headline number of unemployed people rising to 2.50 million and youth unemployment reaching almost 1 million, the highest since records began in 1992. With joblessness rising and wage growth steady at around 2% there’s not much sign of cost-push due to pressure in the labour market.

How about shortages due to supply constraints? With UK GDP growth at 0.7% and the rate of growth slowing, according to the British Chambers of Commerce, there’s little evidence of bottlenecks developing in the supply chain. Remember that long-term growth in the UK is around 2.5%. There is clearly a lot of spare capacity in the economy. With the programme of austerity cuts, many observers think this unused capacity will grow in the short-term.

So what is the source of the UK’s inflationary pressure? The answer is that it’s coming from within and without at the same time. On the one hand, there have been two rises in VAT in the past year: one in January 2010 from 15% to 17.5%; the other, this January, up to 20%. It will take time for these price increases to drop out of the CPI data.

The external source of inflation is imports and commodity prices in particular, in other words, a classic cost-push increase in prices driven by external factors. If you strip these out, inflation appears more benign.

No matter, say some analysts, inflation must be snuffed out before it takes hold. In order to achieve this, base interest rates must rise. Many are expecting the MPC to begin this process soon. But, what if this leads to increased pain for already-stretched households? If the impact is a wave of mortgage defaults, depressed demand and lower economic growth - even a return to recession - we should be more worried about the effect on unemployment than temporary price pressures.