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Monday July 3, 2006 - 10:03:01 GMT
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Economics Weekly: Inflation is rising - how much of a threat to price stability?

Industrial Country Inflation Is Rising
As chart a shows, consumer price inflation is on the rise. The increase is not restricted to one country but to a number of the major economies. However, much of the increase has been blamed on rising energy costs, so to that extent it is argued that it is less of a risk and policy makers should focus on the ‘core’ measure - consumer price inflation excluding food and energy. Our analysis suggests that it would be a mistake for the monetary authorities to ignore or downplay the headline inflation rate and focus on the core rate, as it is headline price inflation that matters most for wage inflation, which poses the biggest transmission risk to price stability.

Inflation is on the rise in all of the major economies…
There is currently a lot of focus on inflation from central banks. Consumer price inflation is on an upward trend in all of the major economies, see chart a. Since the world economy has been growing by nearly 5% in each of the last three years, the fastest sustained pace in thirty years, some of this increase in inflation must be related to there being less spare capacity to meet demand and should therefore be of no surprise. But some of the increase is due to higher energy and other commodity costs. Understanding whether to focus on the headline rate or the core rate is therefore important from the standpoint of deciding upon the appropriate level of interest rates. If inflation is due to energy costs, then as the effects of the increases this year fall out next year, headline inflation will fall back, unless core inflation picks up in the interim. Most assume that headline inflation will fall back, so raising interest rates too much or too quickly risks weakening economic growth unnecessarily.

...and has already led to an increase in interest rates but core inflation remains relatively low…
Fear of actual and potential price inflation is what lies behind the increase in interest rates seen in all of the major economies in the last year or so. But many are calling for a halt to rate increases and worrying that there may already be overkill, i.e. interest rates have been increased too far or certainly far enough, since core inflation, which excludes food, drink and energy costs, still remains subdued. In the UK, for example, headline consumer price inflation accelerated to 2.2% in May from 2% in April, but core inflation fell to 1.2%, which underlines the extent to which higher energy prices are having an impact on the headline rate.

…however, a focus on core price inflation at the expense of headline inflation would be a mistake
The big proviso is whether core inflation will stay subdued in the interim, our analysis suggests that it will not and will increase if the headline accelerates. What leads? Headline inflation or core? Our calculation of the relationship between headline consumer price inflation and core inflation suggests that it is headline that leads, by around 12 months. The relationship is highly correlated, from 0.6 to 0.8 in the US, UK and EU, where 1 is a perfect match, see chart b through to d. A further analysis of the extent to which the pass through from the headline rate to the core occurs shows that generally a 1% rise in headline consumer price inflation leads to a 0.7% to 0.8% increase in core inflation over 12 months.

What explains this link? Our view is that wage inflation plays a big part. Charts e, f and g, show that it is headline consumer price inflation that links closest with wage inflation in all of the major economies in this study. It does not matter therefore what is causing the rise in headline CPI, if it accelerates and the rise is sustained it will lead to an increase in pay settlements, in wage inflation and in core inflation. This means that the ECB is right to argue that it is concentrating on the headline CPI rate, which is at 2.5% in the year to May, not the core rate, which is at 1.3%.

In the US, they argue that the headline annual CPI rate, which stood at 4.2% in May, is less important than the core rate, which is 2.4%. However, given the rise in the core rate in the last year it is not surprising that official short term US interest rates have risen to 5.25%. Worryingly, the link between the headline rate and wage inflation suggests that US core inflation may rise further, see chart e. For the UK, annual CPI is still only 2.2% and the core rate is at 1.2%, although the rise in the headline rate looks like it will soon start to push up wage inflation, and a rise in core price inflation rate in the months ahead becomes likely. Until then, the UK central bank may not raise official interest rates, but if the headline CPI rate continues to rise and the core rate follows, a rise in interest rates seems almost

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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