Inflation Cake

The rise of UK CPI to 4%, double the target set by the Bank of England, is a challenge to policy makers: how to bring inflation to target without crushing economic growth in the process.

Mervyn King, 10th letter to the Chancellor.

As Mervy King the governor of the Bank of England explains in his “valentine” to the Chancellor (hat tip John Authors) inflation has risen for three reasons:

“… the rise in VAT relative to a year ago, the continuing consequences of the fall in sterling in late 2007 and 2008, and recent increases in commodity prices, particularly energy prices.” 

To understand the problem think of inflation as a three layered chocolate cake (yum…) where each layer represents one of the three components: VAT, sterling and commodity prices. The three stack up to a 4 inch tall cake that needs to be brought down to about half that height.

Setting the cake aside for now (oh…), we can examine each factor separately. The VAT rise is largely predicted to pass through the system by 2012, at which point inflation may drop back within target. It could, of course, be retracted but in his reply to the “valentine” the Chancellor, George Osborne, made it clear that was not an option. That leaves sterling and rising commodity prices.

Spot rate Pound - Dollar 15-2-2011

SOURCE: FT

Given all the hoo-ha about currency wars in the press earlier this year it is odd that as the UK appears to be “winning” that war agains the Euro Zone and the US (see charts), its two largest trading partners, this is now causing import price inflation.

Spot rate Pound Euro 15-2-2011

SOURCE: FT

Strengthening the pound to mitigate import prices can be done by raising interest rates but that will cause the money supply to contract and would slow economic growth. It will also make UK goods more expensive thus reducing export demand.

And then there was one: the rising price of commodities. It is something neither the Governor nor the Chancellor can do anything about. And unlike the spike in commodity prices in 2008, many economists believe that this time high prices are here to stay.

Commodity prices are rising as a result of growing demand in emerging economies. Earlier this week China overtook Japan to become the second largest economy in the world. As these economies grow they are like giant newborn stars – consuming raw materials at pace.

One side effect of this growth is a steady rise of inflation in emerging economies (China 4.9%, India 8.2%). Until the crisis, emerging economies exported deflation. Prices of goods made in China, for example, dropped year on year, helping to curb inflation in advanced economies. The rise in commodity prices is reversing that trend, causing China and others to export inflation which is now appearing in the bottom two layers of the UK’s inflation cake.

So how does the UK manage this three layered ‘treat’? Many at the MPC argue that spare capacity and a rising output gap caused by the recession will absorb much of this inflationary pressure in the long run. Adam Posen, in a speech last December, explains this view:

“… we should recognize that things are not fundamentally different in the UK economy at this point from what has happened in other post crisis advanced economies. That means:
– Output and employment still have a meaningful effect on inflation;
– The UK economy still has a large output gap to close, pushing down on inflation;
– UK household consumption will likely decline in response to fiscal consolidation;
– UK inflation will likely decline in response to fiscal consolidation; and,
– UK unit labour costs are declining, pushing down on inflation.”

Posen’s analysis would suggest that we just need to leave the cake alone as the economy will soon lose its appetite.

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About Gideon Benari
Solvency II Wire a site dedicated to informing professionals in financial services industry about Solvency II, the new regulation for the European insurance industry.

One Response to Inflation Cake

  1. MBA says:

    With all that inflation the UK may yet find itself in a situation similar to Egypt, Tunisia, Bahrein ………….

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