UK Economy Revision: Inflation in the last few years

What has been happening to inflation in the UK? Consumer price inflation in the UK has been volatile in the last few years. Partly this is because of external factors over which the UK government and the Bank of England have little control:

(i) Volatile energy and food prices
(ii) Big movements in the value of sterling against currencies such as the US dollar and the Euro
(iii) The impact of the global economic recession including a 12% fall in world trade in 2009

(1) Save for a dip in 2009, CPI inflation has been above the 2% target since the autumn of 2007. It peaked at 5.3% in October 2008 and is currently at 3%.

(2) RPI inflation became negative in the summer of 2009 - largely because of the steep fall in mortgage interest rates - but is now back above 3%.

(3) Inflation expectations spiked up in 2008 when inflation was well above target, but price expectations have fallen back and are now close to 2.5% - consistent with expectations in the middle of the last decade

(4) One of the key recent trends has been a down shift in the growth of wage agreements and average earnings for those in work. Average earnings are rising by less than 2% (millions of workers must experience a pay freeze or a pay cut this year) - and with taxes rising and inflation at 3%, for the majority of people in work, real disposable income will fall in 2010. This will be a factor holding back the recovery.

(5) Crude oil prices have edged higher to $80 per barrel and near-term movements in international fuel and food prices will have an important bearing on UK inflation as we are net importers of both. If the pound strengthens then the inflationary effect of rising world food and fuel prices is reduced. But a hung parliament after the general election might cause a run on the pound, in which case a weaker currency will add to cost-push inflation pressures.

(6) Having suffered a 6.2% decline in real GDP during the 18 months of recession, the British economy has a sizeable amount of spare capacity (i.e. a negative output gap) and this is holding back demand-pull inflation (the pricing power of businesses is weak, many continue to offer deep discounts to consumers in a bid to get them to part with their cash). But there is a debate about how much spare capacity there actually is. The recession may have done some permanent damage to the UK’s productive capacity and labour productivity has fallen in this recession.

Monetary policy is on hold for the moment as the Bank of England waits to see how the monetary and fiscal stimulus policies impact on economic activity. Inflationary pressures are under control, the bigegst inflation dangers come from uncertain external headwinds.

Chart presentation on UK inflation data
Inflation_in_the_UK_Economy.pptx