UK: Deloitte Monday Briefing: UK's Inflation Problem

Last Updated: 26 February 2013
Article by Ian Stewart

Most Read Contributor in UK, August 2017

The Monday Briefing, written by Ian Stewart, Deloitte's Chief Economist in the UK, gives a personal view on topical financial and economic issues. Please feel free to forward the Monday Briefing to your clients, colleagues and friends who can, in turn, subscribe to it at:

* High inflation has been one of UK's most persistent problems since the financial crisis.

* In the five-year period starting 2008, UK consumer prices have risen at an average annual pace of 3.3% - significantly faster than the Bank of England's 2% target and more than twice as fast as in the decade preceding the crisis.

* This might seem like a call to arms for the Bank which is tasked with maintaining price stability. Yet, it has been missing its inflation target for 38 consecutive months since December 2009.

* In fact, in the five years since 2008, inflation has been above-target for 55 months, more than twice the number of times it exceeded 2% in the decade before the crisis.

* In February 2012, the Bank forecast inflation would fall sharply in 2012 and would be below its 2% target by the end of the year. Three key drivers of inflation had started weakening. First, the sterling that had devalued 25% between mid-2007 and 2008, raising prices of imported goods, had stabilised. Second, the rise in commodity prices was slowing and, finally, previous rises in VAT and petrol prices had dropped out of inflation calculations.

* Inflation did decline in 2012 but not as fast as the Bank had forecast. Moreover, the Bank now expects inflation to remain above target until the first quarter of 2016. Financial markets have also started factoring in higher inflation, raising yields on inflation-linked bonds.

* So, what has caused this radical change in the UK's inflation outlook?

* In its latest Inflation Report, the Bank noted that one of the reasons behind persistently high inflation was higher 'administered and regulated prices', i.e., prices affected by government or regulatory decisions. Of these, a key contributor has been the rising price of education, largely reflecting rises in undergraduate tuition fees. Another contributor is higher domestic energy prices as a result of current climate change and energy policies and further investment into the UK's gas and electricity distribution networks.

* According to the Bank, these two drivers have, together, amplified UK inflation by 0.4 percentage points last year and will do so by 0.6 percentage points this year and the next.

* Another reason behind higher inflation is low productivity growth. While GDP growth, since 2010, has been modest at best, employment has risen strongly, implying a fall in labour productivity. The Bank estimates that private sector output per hour is now 15% lower than its pre-crisis trend. Companies have, therefore, seen a corresponding upward pressure on their input costs.

* While wage growth has also remained subdued during this period, it hasn't been slow enough to offset the effects of falling productivity on input costs. As a result, corporate cost pressures have persisted, thereby supporting the prices of finished goods.

* In this environment, the Bank of England faces the challenge of reining in inflation without adversely affecting growth. In theory, it could just raise interest rates to bring down inflation. Yet, the Bank's stance is that it is unnecessary to raise interest rates now in order to stabilise prices in the medium-term and that doing so would risk derailing the slow recovery.

* This approach has led some analysts to point out that the Bank now seems to place greater emphasis on growth than on its explicit inflation target. It is not just that, in the words of the Bank's governor Sir Mervyn King "policy is exceptionally accommodative to growth". A debate is underway as to whether the Bank of England, and indeed other central banks, should run even easier monetary policy, possibly risking higher inflation in the long term, in order to bolster growth. In December, the US Fed set itself an additional target of bringing down the US unemployment rate to below 6.5%, before it considers raising interest rates.

* Mark Carney, the next governor of the Bank of England, has recently said that central banks should consider radical measures, including commitments to keep interest rates on hold for extended periods of time or scrapping inflation targets, to boost growth. One of the leading contenders for the governorship, Lord Turner, has even made the case for overt monetary financing - printing money to pay the government's bills.

* Economists remain optimistic that UK inflation will, eventually, fall back. The general expectation is that inflation will drop below German and US inflation by 2017.

* The prospect of relatively high inflation for sometime to come is a negative both for the pound and for the spending power of UK consumers. Mr. Carney, the incoming Bank governor, will be keen to ensure it inflicts no lasting damage on the credibility of the Bank of England.

MARKETS & NEWS

UK's FTSE 100 ended the week up 0.1%.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

* Ratings agency Moody's downgraded UK's credit rating from the AAA to Aa1 - credit ratings

* The number of people in work in Britain rose to 29.73m in Q4 2012, the highest level since modern records began in 1971 - employment growth

* Economic growth for the Organisation for Economic Cooperation and Development's (OECD's) 34 member states fell by 0.2% in Q4 2012, representing the first contraction in GDP since Q1 2009 - slowdown

* The European Commission predicted that the eurozone economy of 17 countries will contract by 0.3% in 2013, down from previous forecast of 0.1% growth - eurozone crisis

* German economic sentiment registered its third consecutive monthly rise in February according to survey data from the Zew Indicator of Economic Sentiment - Germany

* Irish Finance Minister Michael Noonan claimed that "things have settled down now in the eurozone and there is an expectation of stability continuing" - eurozone crisis

* Spanish Prime Minister Mariano Rajoy claimed that "Spain's head is out of the water" and the budget deficit for 2012 fell to below 7% of GDP - Spain

* The French government announced plans to freeze spending on defence, higher education and research in an attempt to meet European Union deficit targets for 2013 - France

* The US National Association of Realtors said that existing home sales rose 0.4% in January to a seasonally adjusted annual rate of 4.92m units, representing the second highest rate of sales since November 2009 - US housing recovery

* US automobile repossessions fell to their lowest level in 12 years in 2012, down 31.8% from a 2009 recessionary peak, according to Experian Automotive - repo sector decline

* The US benchmark equity index, the S&P 500, rose to its highest level for 5 years - equity rally

* Data from the Department for Transport shows that the numbers of 17-19 year olds taking driving tests has dropped by 18% since 2007, with the economic downturn and high insurance costs cited as reasons - driving downturn

* The European Central Bank (ECB) revealed that it made €1.1bn in interest payments from its €208bn portfolio of Italian, Greek, Spanish, Irish and Portuguese sovereign debt in 2012 - sovereign bonds

* British exports to Brazil, India, China, Russia and South Africa rose by 113% between 2007 and 2012 according to data from the Office for National Statistics (ONS) - export growth

* French horsemeat sales have risen by up to 15% since the 'horsemeat scandal' broke according to Interbev Equins, the French industry body for horse butchers, due to increased publicity for the meat and falling demand for ready-meals - meat market

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