A research paper of March 1998 entitled, How long before inflation rises? considered the outlook for...
A research paper of March 1998 entitled, How long before inflation rises? considered the outlook for inflation and concluded the high money growth of 1996 and 1997 posed a threat to low inflation.
In the event the Bank of England maintained a tight monetary policy in the first half of 1998, while a key feature of the year as a whole was the weakness of the world economy, largely a by-product of the Asian crisis.
This cut the prices of both commodities and semi-finished products in world markets, and UK inflation stayed under control. A big fall in the oil price was particularly important. Last year was quite different. It saw a return to growth in all parts of the world economy. Moreover, the unity of the Organisation of Petroleum Exporting Countries (Opec) was restored, causing oil prices almost to treble.
The rising oil price may have added 0.7-0.8% to the UK's rate of target inflation in the year to February/March 2000. (The UK's target inflation rate is an increase of 2.5% per year in the retail price index excluding mortgage interest costs, the so-called RPIX index.)
Oil prices are difficult to predict, but one arithmetical point is obvious. If the oil price now stabilises, the 0.7-0.8% adverse effect will drop out of the RPIX. The increase in RPIX in the year to February was 2.2%. Two conclusions follow. First, with a stable oil price and the same underlying inflation pressures as in the last 12 months, the annual increase in RPIX will drop to about 1.5% by March 2001, in the lower half of the acceptable 1.5% - 3.5% band.
If the annual increase in RPIX were to drop beneath 1.5%, the Governor of the Bank of England would have to write an open letter of justification to the Chancellor of the Exchequer. Secondly, and by extension, some deterioration in underlying non-oil inflation pressures could occur between now and the spring of 2001 without jeopardising an inflation rate close to target.
Much depends here on the exchange rate. The Bank of England has expressed concern that the disinflationary impact of sterling's sharp appreciation in late 1996 is fading. However, for the time the pound remains over-valued and downward pressures on prices in the traded sectors of the economy, manufacturing in particular, are intense.
Over longer periods of time domestic influences are the most powerful forces on the price level. The demand to hold real money balances is ultimately determined by real variables, implying that excessive money supply growth leads to inflation.
Fortunately, the unduly fast growth of money in 1996, 1997 and 1998 has come to an end, at any rate for the time being. In fact, money supply growth in the year to February was only 2.7%.
A reasonable judgement is that RPIX inflation will remain good at least until the middle of next year.
Admittedly, output may be somewhat above trend at present, while the large gains in house price houses in 1999 represent a significant positive wealth effect on consumption and domestic demand in 2000.
There has to be a possibility that RPIX inflation will rise above its 2.5% target in late 2001, but any overshoot is likely to be modest in comparison with the UK's appaling inflation record in the 1970s and late 1980s.
Petrol and fuel oil added 0.8 percentage points to the 2.2% rate of underlying inflation (that is, the 12-monthly percentage change in the retail prices index, excluding mortgage interest payments) in February. There are likely to be some lagged affects from earlier high crude oil prices yet to come through into forecourt petrol prices, as well as the 2p/litre duty increase announced in the March 2000 Budget.
Allowing for these, but assuming crude prices stabilise from March onwards, the contribution to the annual rate of inflation from petrol will peak in the first half of 2000, remain positive over the rest of the year and disappear from March 2001.
Next spring the annual increase in RPIX could fall close to 1.5%, if non-oil inflation pressures remain unchanged. Underlying retail inflation was last below 2% in 1967.
The UK's inflation performance since 1993 has been remarkable by the standards of the preceding 30 years.
For seven years the annual increase in the RPIX index has been close to 2.5% with little variation. From an institutional perspective, the basic cause of this improvement has been the de-politicisation of interest rate decisions, symbolised by the granting of independence to the Bank of England in 1997.
Although UK output may be slightly above trend at present, the outlook for the annual increase in RPIX is fine at least until mid-2001. Nevertheless, some upward pressures on inflation are emerging from the tight labour market.
Labour intensive services purchased on a discretionary basis, such as haircuts and insurance, account for a quarter of the retail price index. In the year to February their prices rose by 5.7%, up from 4.2% in February 1999 and the fastest rate of increase since June 1993.
Rising oil and commodity prices have put producers' margins under pressure. But their pricing power remains weak. Excluding items affected by duty changes, such as tobacco and petrol, or with erratic prices, such as food, output prices were only 0.4% higher in February than a year earlier. Data from the Office of National Statistics (ONS) show that import prices, excluding oil, fell throughout 1997, 1998 and the first half of 1999. But they rose slightly in both the third and fourth quarters.
Survey evidence from the CBI and Chartered Institute of Purchasing and Supply indicates producers are less willing to cut prices. The balance of CBI members expecting to cut prices in the coming four months was 11% in March, half that of a year earlier. But this compares with a 35 year average of 24% of members expecting to raise prices. Sterling, on a trade-weighted basis, is 5% higher than a year ago, argui