Since the UK was humiliatingly dumped out of the ERM in 1992, governments have been pursuing a macro-economic policy aimed at creating a stable environment for business, ending the boom-bust cycles which had done so much to undermine performance. Central to this objective has been the control of inflation.
The rise of 0.7% in GDP in the final three months of 2004 made it 50 consecutive quarters of sustained growth since the last recession ended in 1992. This owes much to the fact that inflation has remained remarkably low. Anyone who remembers the double-digit inflation days of the 1970s and 1980s must find it hard to believe that in terms of the official measure, the Consumer Price Index (CPI), inflation in Britain has been 3% or less since 1992. For the last eight years the annual rate has been less than 2%.
Responsibility for sustaining low inflation now rests with the Bank of England’s Monetary Policy Committee (MPC), and base rate is the policy tool at its disposal. Just over a year ago, the Chancellor changed the rules. Rather than telling the MPC to keep inflation within 1% point of 2.5%, measured on the Retail Prices Index, he now wants price increases to be held within 1% point of 2%, but on the CPI. This difference is in the methodology used to aggregate the data, and the fact that the CPI excludes housing depreciation and Council Tax. Over the long term, the CPI has been around 0.8 percentage points lower than the RPI measure used by the MPC.
Because changes in interest rates are determined by movements in prices, it is worth considering whether it has been good luck or good management that led to the long period of low inflation. Since, at the end of 2004, annual CPI inflation was only 1.6%, it might seem alarmist to talk about more interest rate rises to counter inflation. But some of the factors that contributed most to the weak price trends during the past few years are now starting to change.
A breakdown of the CPI into its component categories reveals that it has been the prices of goods rather than services that have slowed rises in the overall index.
Consumer goods sold in the UK are produced either in the UK, or imported and it has been the import price inflation which has been negative for much of the past five years and helped to underpin low inflation. Although price pressures were weak in the late 1990s and up to mid-2002, there is now a pick-up in annual inflation rate of domestically-produced goods.
Clearly, some of the lower import prices can be explained not only by exchange rate movements, but also by a switch to lower cost suppliers. Stable retail margins also helped to keep price increases down. The fact that the MPC undershot the inflation target in the late 1990s had more to do with wrong exchange rate forecasts than a deflationary bias.
There is, however, some doubt as to whether these factors will continue to sustain inflation at rates below 2% without some further help from the policymakers. Import prices are unlikely to be so helpful going forward. The strengthening world economy means an upturn in the volume of internationally-traded goods with prices rising. There are already signs that prices of goods coming into the UK have stopped falling, while others are edging up.
Prices of domestically-produced goods have been rising for several years. In the second half of 2004, UK manufacturers output prices rose by just over 3%, while the cost of the material and fuels purchased jumped by close on 6%. Both these inflation rates doubled in 12 months, which points to higher prices this year, unless manufacturers or retailers are prepared to squeeze margins further. When wage pressure is factored in, the MPC’s nervousness about future price trends becomes understandable. The two offsetting factors which might ease the price pressures are productivity growth and the intensity of competition in many product markets, but the relief they are likely to bring is limited.
This is not to imply that consumer price inflation is going to jump back to the sort of rates last seen in the late 1980s. Rather, it is suggesting that if prices of manufactured goods (imported and domestically produced) have turned and are now rising alongside the usual inflation in services, the overall rate will be close to the 2% target. This is perfectly consistent with an economy that has been growing above trend for a year or more and explains why the MPC will not be relaxed just because the CPI is currently running at 1.6%.