U.K.’s climbing inflation separates it from other world nations

U.K.’s climbing inflation separates it from other world nations
07 Oct 2010
Tags: Economics , Developed Markets

Inflation in the U.K. has exceeded the Bank of England’s target rate throughout all of 2010, and shows no signs of easing in the near future. Both core and total CPI inflation have hovered at or above 3% since the beginning of the year, which is well above the Bank’s target inflation rate of 2%. As we enter the fourth quarter, core and total CPI inflation have subsided somewhat, but remain above target, with 2.7% for core* inflation, and 3.1% for total CPI.

Persistent inflation has created a dilemma for the Bank of England: Will it raise interest rates and risk extinguishing the country’s nascent economic recovery, or keep interest rates at their current lows and risk further price increases? On October 7, investors got a short-term answer to this question when the Bank of England voted to hold it's interest rate steady at 0.5% for the 20^th consecutive month.

U.K., the unhappy “leader”

Click each image to enlarge

Among the G7 countries, U.K. inflation is by far the highest, with everyone else’s rates staying below 2%. In fact, the concern for the Eurozone countries is that their inflation is too far below the European Central Bank’s 2% inflation target. Canada’s inflation has also been consistently below the Bank of Canada’s target rate during 2010. At the extreme end of the spectrum, Japan has been experiencing deflation since the beginning of 2009.

What's pushing inflation upwards?

There are three main factors causing the UK’s high inflation. One culprit is the recent increase of the VAT (value-added tax), which is levied on all goods and services produced in the UK. The standard VAT rate was temporarily reduced to 15% in December 2008 in order to stimulate demand, but it returned to 17.5% at the beginning of 2010. In addition, the VAT rate will jump to 20% in January 2011, keeping consumers’ inflation expectations elevated.

The second factor, especially in the first half of 2010, is the jump in oil prices. After dipping below $40/bl in late 2008, oil prices steadily climbed to a high of $85/bl during the second quarter of 2010, where they have pretty much stabilized. Energy costs feed into the overall CPI number through various components. In particular, the transport component, which comprises 15% of total CPI, exhibited double-digit year-over-year growth for the first five months of 2010.

Lastly, the sharp depreciation of the British pound in 2008 may still be working its way through the economy, pushing up the prices of imported goods.

Note that all three of these inflationary factors are considered short-run factors; however, the ongoing persistence of high inflation is leading many analysts to examine whether other structural factors are at work. One thing is clear: the Bank of England will be under close scrutiny in the coming months as they implement their “exit strategy” from the current stimulatory rate environment.

* Excluding tobacco, food, energy, alcohol

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