Hello readers, welcome back to rsira-economics.com. If you are still reading these posts, hopefully, it’s because you’re finding them interesting and are coming back for more relevant information about the dynamic world in which we live in and not because you are hoping that my next post could be more exciting.
Last time I discussed two major political influences for 2017: Brexit and Trump. Although it may have been a lot to take in, you should now understand where the two countries stand economically, and the possible effects they may have on the rest of the world.
This week, I will be discussing the idea of inflation, what it means for you and why it has recently risen to its highest rate for two and a half years, in the UK. If you have no idea what inflation is, stick with me, as I will be explaining this briefly before I begin. Although I’ve used the term before in many of my other posts, I haven’t actually explained the economic benefits and consequences of it in general terms, and why it is so important in the world of economics.
You’ll be glad to know that today’s post won’t be as intense as last week and by the end of reading it, you should have a sound understanding of inflation. If you have any questions or would like further clarity, please post your comments below or send them to email@example.com. If you would like to know more about a particular economics related story you have read, let me know and I will see what I can do.
What exactly is Inflation?
Economists as Paul Krugman says in his book the ‘Accidental Theorist’, like to use their own complex language to talk about things, which are actually quite simple. Inflation, although it may sound complex is, just the sustained increase in the general price level over a given period of time i.e goods and services are more expensive in one year compared to another year. Now you are probably wondering why we have inflation in the first place. There are many reasons why but these are actually a little more complex and I won’t bore you with it all today. In a nutshell, it’s all to do with the exchange rates, the natural forces of supply and demand and other factors such as interest rates. You can even have negative inflation and this is known as deflation-the sustained decrease in the general price level.
Can Inflation ever be good and what are the consequences?
Let us consider the example of purchasing a new car. If the price of the car started to fall, you would probably wait, to see if the car would fall any further as you could save yourself hundreds maybe even thousands of pounds. But imagine if the price of the car now starts to rise. This would encourage you to buy it before it gets even more expensive. Therefore a little inflation encourages you to buy sooner – and that boosts economic growth. Rising prices also make it easier for companies to put up wages and they can give employers the flexibility not to increase wages by as much as inflation, but still offer their staff some sort of a rise. In a world of zero inflation, some companies might be forced to cut wages. Inflation also benefits the government who has a huge debt, which according to the BBC is getting bigger ‘thanks to a deficit of £90bn’, as it helps to erode some of it and makes it easier for governments to pay it back.
Too much inflation can cause of boom and bust cycles in the economy, producing low growth and higher unemployment. It can also lead to higher interest rates, which might be good for savers, but bad for borrowers and this could lead to housing issues across the country. If wages are not increasing but inflation is, people have less real disposable income and so will have to give up something in exchange (we say there is an opportunity cost). Also if inflation is too high people will have less money to spend on other things and this could lead to the economy contracting in certain sectors. Therefore there needs to be a balance and so the Monetary Policy Committee (MPC) have set an annual target of 2.0% and they control this through a number of different instruments.
How is inflation actually measured?
Inflation is officially measured through CPI in the UK. CPI stands for consumer price index and is essentially a virtual shopping basket of over 700 goods and services, which are weighted according to relative importance. These goods and services such as transportation, food and medical care, are chosen by using the ONS Family expenditure survey and 150 different regions across the country are considered.
The value is calculated by taking price changes over time for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI statistics cover professionals, self-employed, poor, unemployed and retired people in the country and thus can be unrepresentative of certain groups of people as an average figure is produced.
From March 2017 however, the ONS will be changing the official of measure of inflation in the UK to CPI-H, which will add accommodation and the costs of owning a house to the consumer basket. It is thought that this change is to better reflect everyday price changes. The change is likely to show inflation is higher than currently indicated. Although CPI already includes the cost of renting and running a home, it leaves out special costs faced by property owners. CPIH will include what are called the “costs of housing services associated with owning, maintaining and living in one’s own home”.
Why has inflation risen to its highest rate since 2014?
According to the Office for National Statistics, this increase was caused largely by the rising cost of fuel and food, as well as the costs of raw materials and goods leaving factories. This is mainly due to higher oil prices and the weakened pound, thanks to Brexit.
This was offset by low food prices. Over the past three years, food and non-alcoholic drink prices have fallen sharply as supermarkets engaged in a price war. However, the rising cost of imported food has started to alter this trend. As it stands food and non-alcoholic drinks are still 6% cheaper than they were three years ago but this could all change.
Inflation is expected to rise further this year, past the target of 2% as the effect of the weaker pound feeds through to consumer prices. The Bank of England expects consumer price inflation to peak at about 2.8% early next year. Despite this, we don’t know exactly how much of the rise in input prices will be passed on to consumers and how quickly this will happen. Shoppers are already faced with higher prices for imported cars, computers and kitchen equipment, and very soon our own factories could be charging substantially more as well.
In summary, Brexit, although it has not physically changed much in the economy it has created uncertainty and speculation, which has resulted in the fall in the value of sterling. Although this has made Britain’s exports cheaper and more competitive, as well as increasing tourism in the UK, Britain’s imports are significantly more expensive, and once manufacturers and companies start to pass on more of the increased costs to the consumers, retail prices could rocket up. This mean interest rates will almost definitely increase making car payments, mortgages and loans more expensive. It is unlikely that wages will rise by the same amount and this will reduce the real purchasing power of money and could lead to a slowdown in the economy. After Brexit, things could be more positive as confidence rises and the exchange rate improves, however we don’t know how long that could take. It may be two years or 10 years.
Still want some Brexit news to keep you in the loop?
Check out the article by the financial times, which discusses the main challenges Britain will face as it leaves the EU:
If you don’t have time to read the full article or don’t have a financial times subscription I have summarized the key points below:
- Lack of time. Once article 50 has been triggered, Britain will only have two years to exit the EU, unless the European Council unanimously decides to extend this period.“The chances of securing an extension are slim”, thus the limit is two years. However, businesses will need clarity a good year before the end and so the deadline is well before this. As a result, the UK’s leverage will rapidly dwindle.
- Divergent interests. Negotiating with the European Commission, 27 countries and the European Parliament, will be difficult since they will all have different priorities and interests. Many will want to show that exit is costly and many will feel that the longer the talks drag on, the greater the chance of having UK-based business “fall into their laps”.
- Money– As discussed last week, Britain will have to pay a hefty €60 billion. “a far cry from the £350m-a-week bounty promised by Brexit campaigners during the referendum campaign”.
- Complexity– the divorce will cover outstanding commitments such as scientific research and citizens’ rights. London has also decided on a very complex post-Brexit trading arrangement.
- UK trade may shrink by up to a quarter in both services and goods. It is true that the short-term economic effect has been far less than many thought, although we must remember that the exit has not yet begun.
Stay tuned to rsira-economics.com with more interesting posts to come such as ‘will robots replace our workforce’ as well as a few book reviews on economics books by authors such as Paul Krugman and Tim Harford.