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The Causes of England Inflation

Introduction

According to the Inflation report, the government has set up the Bank’s Monetary Policy Committee (MPC) with the mandate to maintain price stability. This committee aims to get the annual rate of inflation of Consumer Prices Index (CPI) of 2% and support in maintaining high stable growth and employment.

Inflation and its causes

Asset prices and the exchange rate

Exchange rates – The sterling effective exchange rate (ERI) is markedly lower than at the time of the November Report. In the fifteen working days to 4 February it was 13% down on its November level. Some of the fall since last summer probably reflects cyclical factors. But it is difficult to explain the extent of the depreciation with cyclical news alone — movements in the UK yield curve relative to expected interest rates overseas can account for only a small part of the fall in sterling.

Equity prices – Before the February Report, the FTSE All-Share was around 1% below its level at the time of the November Report. For example, the small fall in the FTSE All-Share since November is more than accounted for by the financial and car sectors. On average, other sectors’ prices recovered somewhat, despite the worsening outlook for real

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activity.

Property markets – In January, the average of the Nationwide and Halifax measures of house prices was little changed, as Nationwide recorded a further fall and Halifax a rise. The Royal Institution of Chartered Surveyors has noted an increase in property viewings recently, but that has not led to increases in loan approvals or sales. Commercial property prices began falling in 2007 as yields on property fell below the cost of funding investment. But the slowdown has been given greater impetus over the past few months as credit conditions have tightened and the economic slowdown has weighed on the outlook for commercial rents.

Costs and prices – CPI inflation fell to 3.1% in December, driven by sharp falls in energy prices and the temporary reduction in VAT..

Effects of inflation

(a)Effects of inflation on cost and availability of credit to companies and households

Bank lending to non – financial companies slowed sharply over 2008 reflecting a tightening in credit supply. The extent to which tighter credit supply impacts on companies’ behavior depends in part on their demand for loans.

Growth in households’ borrowing has slowed substantially over the past year. A significant part of the slowing in secured lending growth reflects a contraction in supply.

(b)Effects of inflation on Domestic demand

Real GDP fell by 0.6% in Q3 (Chart 1.1), driven by a particularly marked fall in investment. The contribution from stock building also declined, and household spending fell slightly.

Recent household spending data – Consumer spending fell in both Q2 and Q3 (Table 2.1) according to the latest official data. In particular, lower spending on vehicles more than accounted for the total fall in consumption in Q3, comprising only 5% of household spending.

Influences on household spending – The deterioration in labor market conditions is likely to have restrained household spending during the second half of 2008.

Investment and inventories – Whole-economy investment fell by 5.3% in the year to 2008 Q3. That decline can be more than accounted for by a fall in housing-related investment, reflecting the sharp downturn in house prices and business investment.

Government spending – Four-quarter growth in nominal government spending on consumption and investment fell to 7.7% in Q3, from 9.2% in Q2, as projected in the fiscal plans set out in Pre-Budget Report 2008. But in large part it reflects the marked worsening in the economic outlook, which will increase some components of government expenditure such as benefit payments, and reduce tax receipts (Chart 1.3).

(c)Effects of inflation on financial markets

Banks had to continuously restructure their balance sheets and thus remained reluctant to lend. Sterling pound has depreciated by 13% since the November Report and by more than a quarter since mid-2007.

(d)Effects of inflation on output and supply

Output – Output contracted substantially in 2008 H2, according to the latest official data. Output is estimated to have fallen by 1.5% in 2008 Q4 (Chart 1.2); the largest quarterly fall since 1980.

Capacity utilization within businesses – According to the CBI surveys, capacity utilization fell sharply in 2008 Q4, while estimates of labor productivity growth also suggest that businesses are using their inputs substantially less intensively

Labor market developments – In the labor market, developments are central to the outlook for output growth and inflation for two reasons; i.e. reduced employment is likely to push down household spending, as the incomes of those made unemployed falls sharply and  that weaker employment is likely to push down on labor costs, and so on prices.

The government efforts to tackle inflation (Recovery Plan)

The Government announced a package of measures to reinforce the stability of the financial system and support the supply of credit to companies and households. That package was a response to evidence that credit conditions continued to tighten, constraining production and spending. While equity prices were slightly changed, the sterling exchange rate has fallen 13% since last November report and by more than a quarter since the middle of 2007.

On 19 January the Government announced additional range of measures designed to reinforce the stability of the financial system and to support the supply of credit to companies and households. But it will take time for those measures to have their full impact. An Asset Purchase Facility was to be established to be operated by the Bank of England, with an aim of increasing the availability of corporate credit. The measures include Developments in the banking sector, Cost and availability of credit to companies and households, and Asset prices and the exchange rate (in form of exchange rates, equity prices, and property markets).

The impact of the recent change in VAT on CPI inflation

In the Pre-Budget Report 2008, it was made known that the standard rate of VAT would be momentarily reduced from 17.5% to 15%. That change has two effects on inflation. There is a sizable direct effect on the price level of those items in the CPI basket that are subject to standard rate VAT. In addition, there will be an indirect effect on inflation through the impact of the VAT reduction on aggregate demand. So overall, the reduction in VAT will reduce inflation through most of 2009, and boost inflation throughout 2010.

References

Bank of England, 2009, Inflation Report 2009, Main Publications, viewed 26 March 2009, <http://www.bankofengland.co.uk/publications/inflationreport/ir09feb.pdf>.

Economist, 2009, British house prices, Daily chart, viewed 26 March 2009, <http://www.economist.com/daily/news/displaystory.cfm?story_id=13185147&fsrc=nwl>.

Financial Times, 2009, Tax hit to fund £220bn fiscal stimulus, viewed 26 March 2009,

<http://www.ft.com/indepth/pre-budget-report-2008>.

Guardian, 2009, Pre-budget report 2008, Business, viewed 26 March 2009, <http://www.guardian.co.uk/business/pre-budget-report>.

Nationwide, 2009, House prices, viewed 26 March 2009

< http://www.nationwide.co.uk/hpi/historical/Feb_2009.pdf>.

Paul Ellis, BBC news, BBC Recession tracker, viewed 26 March 2009, <http://news.bbc.co.uk/2/hi/business/7915040.stm>.

———, BBC news, 2009, UK Unemployment: 1.97 Million, viewed 26 March 2009, <http://news.bbc.co.uk/2/hi/business/7882745.stm>.

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