Inflation, stagflation or deflation

Inflation, stagflation or deflation

Two weeks ago I talked about the coming ‘age of austerity’ and some of the challenges facing the UK Government as it attempts to tackle the budget deficit.  I ended by intimating that much would depend on the degree to which inflation hit the UKand how the Bank of England (BoE) would respond if it did.

This week I believe the picture is a little clearer on the inflation issue.  First though let’s look at some latest statistics relating to CPI (Consumer Price Index) inflation, GDP (Gross Domestic Product) data and the most recent MPC (Monetary Policy Committee) meeting minutes.

The latest CPI for December 2010 shows anannual rate of increase of 3.7%.  This figure came in above most estimates and is significantly higher than the government and BoE’s inflation target of 2.0%. Meanwhile the unrevised figures for UK GDP show a decrease of 0.5% for the final quarter of 2010 (Q4).  And finally the most recent MPC minutes show three of the nine members oppose the current policy of maintaining interest rates where they are.

Now, two of those sets of data would indicate that inflation is getting ahead of itself and that policy makers are prepared to act by raising interest rates soon.  The recent GDP figures suggest the contrary, however, as it would be very difficult for interest rates to rise at a time when the economy is contracting – difficult but not impossible.

Making sense of the picture is of course problematic, but I think the signs point to UK rates remaining where they are for now. I think this is likely because much of the make-up of the currently high CPI figure is accounted for with rising commodity prices and an increase in VAT(Value Added Tax) – which in many instances has been surreptitiously added onalready by retailers to smooth the shock in January.  This type of inflation can in the end turn out to be deflationary because it takes discretionary funds away from household budgets – to pay for increased fuel costs and taxes.

Furthermore the UK economy contracting in the finalquarter of 2010 lends a sizable weight to the argument against a rise in rates.  The Q4 GDP figures were actually way below even the most pessimistic of expectations and the good old British excuse of blaming it on the weather, because of two weeks snow in December, frankly doesn’t wash – or explain such disappointing figures.

So ultimately it comes down to the nerve of the MPC members and whether they will be able to resist calls for them to raise rates aggressively early.  I suspect they’ll hold their course, but then again…they may not!

Sources: Office of National Statistics, Arbuthnort Private Banking, BBC News, Financial Times