Monday September 19, 2005 - 12:21:18 GMT
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Will higher inflation mean the UK is facing stagflation?Economics Weekly: Economic Research and Analysis: Will higher inflation mean the UK is facing stagflation?
A threat of stagflation
UK consumer price inflation is accelerating, and is above target, see chart A, for the first time since 1997. Inflation is also on the rise in categories other than energy - although it remains below 2%, core inflation (which excludes energy, food and tobacco from the headline rate) is also rising, see chart. Figures for September are bound to see inflation go even higher, perhaps hitting 2.7% on an annual basis. Fortunately, producer output price inflation, though rising, remains fairly low and restrained as does wage inflation, see chart B. This implies that companies are taking the rise in their input costs in their profit margins and consumers have taken the hit of higher energy costs on disposable income by cutting spending. In short, since they cannot raise wages, UK households seem to have reduced their outlay on other consumer items. This seems one way in which the rise in energy prices has put a dampener on consumer spending. Chart C shows this most graphically, with the rise in energy prices in the CPI almost exactly correlating with the trend of retail sales volume over the period 1997 to date. Since energy prices have risen sharply from the start of 2004, retail sales growth has fallen off sharply in response. A slowing housing market and rising short term interest rates have undoubtedly helped to slow the growth rate of consumer spending, especially\ given the high level of personal debt, but oil price rises have also played an underrated role. But this may therefore mean that price inflation is not a serious concern, since it is likely to remain low if wages and firms output price inflation remain weak, as they do not respond to high energy prices.
Inflation is higher and growth weaker
But consumer and retail price inflation have turned out to be higher and growth weaker than the MPC predicted in its Inflation Report in February this year. It is this mix that gives rise to worries that it will not now be able to cut interest rates if growth remains weak, and does not recover as expected. This raises the question of whether the UK faces stagflation, depressed growth with high inflation. Consensus forecasts in September show that UK economic growth this year is put at 2.0%, but with consumer price inflation expected to average just 2.0% (bang in line with the inflation target) and interest rates ending the year at 4.4% this means that in reality the UK is a long way from stagflation. However, overall inflation trends in the UK are clearly not as low as they appeared to be a year ago when consensus forecast were looking for consumer prices to rise by just 1.7% this year and growth to be 2.6%.
But no stagflation
Looking ahead at medium term inflation pressures also show why the MPC may still be worried. The UK economy is successfully making the adjustment from being a manufacturing based economy to one where higher value added services (partly to meet demand from skilled manufacturing) is the driving force. This is why employment can be at a record high and unemployment still at a 30-year low even though manufacturing industry is still shedding jobs. But this means that the UK effectively has two inflation rates; one related to the services sector and one to the manufacturing, or goods, sector. Chart D shows that annual inflation is running at 4.5% in the higher value added and faster growing services sector, accounting for some 70% of the economy in terms of output. But inflation is only rising at 0.6% in the goods sector, accounting for 15% of the economy and more open to international price pressure than services. Moreover, it is an area where the UK may have less international competitiveness. However, chart D suggests that the deflationary effect of global competition and technical advances (computers, digital cameras TVs etc.) may be fading. The exchange rate of the pound is no longer rising so is exerting less deflationary effect on UK import prices, oil prices are much higher and the limits to the deflationary effect of falling goods prices globally may have been reached. Rising goods prices means higher overall inflation.
In this case, medium term inflation pressure may yet remain more intense than in the last few years, so making the job of the MPC much more difficult. It may not be stagflation, but the loss of relative freedom to set interest rates that the MPC has enjoyed since 1997 may make it feel like it to them.
UK economic indicators
The minutes of the MPC meeting of September are likely to show that the impact of Hurricane Katrina, high oil prices and UK inflation trends figured highly in discussions. But interest rates were left on hold and that must be due to satisfaction with the 4.5% level reflecting the balance of risks. Government borrowing data this week, Tuesday, are likely to show that the Chancellor may have to raise more this year from the markets than planned in the spring Budget. Money supply growth remains high, suggesting ample liquidity in the economy, but CBI data will suggest that for companies to be encouraged to spend and invest more, their orders need to be higher.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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