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Monday August 21, 2006 - 11:02:55 GMT
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Economics Weekly: Import prices will push up UK inflation and interest rates

Import prices are important for UK price inflation
One of the assumptions in the August UK Inflation Report is that consumer price inflation moves back towards the 2% target over the forecast horizon of 2 years. However, it still remains above the target at that time, whether based on the current rate of 4.75% or market interest rates, though closer to 2% on the latter than the former. This implies that official UK interest rates may have to be raised again, possibly before the end of the year and most likely in November. One often neglected factor that is now pushing up UK consumer price inflation is import prices - a sharp turnaround from the previous decade when it was pushing down prices. We look at the impact of this changed trend on inflation and hence on interest rates in this week’s economic briefing.

Import prices are no longer falling…
In the last decade or so, the UK monetary authorities have become used to falling import prices (and perhaps taken falls for granted); this has had the effect of bearing down on UK price inflation and so keeping interest rates lower than otherwise. But this trend has changed around in the last year or so and import prices are rising, see chart a. Moreover, the increase in import prices is not down to higher oil and energy prices. The chart shows that even ex energy and erratic items (silver, gold and precious stones), import prices are rising across the board. So now, instead of importing deflation, the UK is importing inflation. The job of the Monetary Policy Committee (MPC) will therefore become more difficult in future. Chart b shows that part of the reason for the rise in import prices is that the trade weighted exchange rate index is not as strong as it was, but even so the increase in import prices cannot be wholly explained by a fall in the trade weighted index, which takes into account the UK’s exchange rate against that of its most important trading partners. A rising or strong trade weighted index would act to keep down import prices and vice versa.

The importance of import prices to developments in UK consumer price inflation cannot be overstated, as the following analysis will show. As a major exporter and importer, the UK economy is very open to international trade trends. Chart c show that there is a clear link between changes in import price and changes in UK consumer price inflation. This is mainly via the goods price component, as shown in Chart d. Goods prices account for some 55% of the consumer price index in the UK (see chart e for the correlation between them), and chart d shows that import prices play a key role in that relationship. A major influence has been and still is, the fall in manufactured goods prices from the rest of the world, including China, reflecting more open global markets. (Of course, there are also other influences reducing prices such as advances in technology to lower transportation costs.) The point is that these influences, though powerful and still vital, are not as negative as they once were.

…and means that monetary policy needs to be tighter…
The implication of the above analysis for the conduct of monetary policy, both in the UK and in other developed economies, is critical to the evolution of monetary policy in the years ahead. Falling import prices made the job of hitting a given inflation target easier in the 1990s. The opposite will now be the case and so meeting the inflation target will become more difficult. This means, first, that central banks must recognise that this is the case, otherwise they run the risk of underestimating the amount of policy tightening required to control inflation. That would spell trouble for economic stability; if inflation targets are missed, central banks lose credibility, making interest rates less stable and growth more volatile. Second, the equilibrium or neutral interest rate may well be higher in the next decade than it has been in the last decade. We have attempted to estimate what this might mean for UK interest rates going forward.

…with our estimates suggesting by 25 to 50 basis points
What impact would the recent rise in import prices make to this if sustained? We have used a simple model to try and calculate this. Import prices regressed on interest rates suggest that they have a coefficient of 0.23 to 0.4 with respect to interest rates. In short, the UK’s neutral rate of interest going forward may now be at least 25 basis points higher than previously. This may not seem like much but would add some £12 month to the average mortgage, every month, and may be the difference between hitting the inflation target and missing it. The average interest rate in the last decade was 5.25%. Our analysis suggests it could be at least 5.5% in the next decade, based solely on the impact of higher import prices.

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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