Commentary – Inflation

UK Retail Price inflation – an older, close relative of CPI inflation – rose gradually from around 2 or 3% in 1960 to a peak of over 20% in the mid-1970s. In recent years it has been more subdued. Following the financial crisis of 2007 it fell sharply but then rose to around 5% in 2011 since when it has fallen.

UK (CPI) inflation – the inflation rate by which the Bank of England’s monetary policy is gauged – has fallen more or else consistently since mid-2011 and by the end of 2014 was approaching zero. Because some elements in the CPI – notably food and energy prices – are especially volatile attention in recent years has been drawn to ‘core’ inflation which probably gives a better picture of the ‘underlying’ inflation rate. There are different ways of measuring it but a common measure is CPI inflation after eliminating food and energy prices. On this measure UK core and actual inflation at the end of 2014 were very similar – and heading for zero – but in the immediate aftermath of the financial crisis core inflation was noticeably lower than the raw figure. The Bank of England took the view that the high CPI inflation rate was likely to be temporary and did not dictate a rise in interest rates. The sharp fall in energy prices in 2014/5 will probably mean the Bank of England will face the same problem in reverse.

Consumer prices in most countries have shown the same general tendency to rise, though in the immediate aftermath of the financial crisis consumer prices in some countries fell temporarily. More recently there are signs in many countries of prices tending to flatline or even fall.

Some countries experienced noticeably higher inflation than others. For countries in the Eurozone it is especially important that the prices of the good and service they produce do not increase more rapidly than those of other Euro-zone members. If they do then those countries will become uncompetitive and be unable to sell their goods and services; and they cannot restore their competitiveness by devaluing their currency since they don’t have their ‘own’ currency. Instead they have to ‘internally devalue’ i.e. ensure that their prices rise more slowly than those of their fellow members. And if prices elsewhere are rising only very slowly then that means that their prices have to fall or not rise at all. This is the situation that Spain, Ireland, Portugal and Greece found themselves in when the financial crisis broke. Their prices had become relatively high and, given the generally low Euro-zone inflation post-2007, their wages and prices needed to fall. This was one of the aims of the austerity imposed on them. This process has been very painful because wages in particular are downwardly sticky, so the initial effects of austerity were always likely to be felt first on output and unemployment. Eventually, all those countries have seen their GDP deflators relative to Germany’s and the Euro-zone in general fall back towards their 2000 levels. If other Euro-zone members had been prepared to tolerate higher inflation themselves the same result could probably have been achieved with less loss of output and unemployment; but they weren’t.