Inflation: Dr. Jekyll and Mr. Hyde

It has been said over the past few years, that the presence of elevated inflation in the economy can help to reduce the debt burden. One way to do this is monetising debt by using the Bank of England printing presses to boost demand.

However, although monetary easing is at full tilt, demand in the UK economy remains weak while CPI and RPI over the last year have averaged 4.5% and 5.2%, respectively.

Figure 1 shows that elevated inflation does often go hand-in-hand with strong GDP, falling unemployment and a reduction of debt-to-GDP but sharp spikes in inflation can also have a detrimental effect.

Figure 1: Charting UK debt-to-GDP, the budget deficit, RPI, GDP growth and the unemployment rate. Source: OECD.

The key is to differentiate between “good” and “bad” inflation where good inflation represents an increase in consumer demand while bad inflation represents an increase in international commodity prices and/or VAT. Good inflation is easier for the central bank to control since it can influence domestic demand through monetary policy while bad inflation is usually due to global macro events and international markets.

The oil spikes of the 1970s can clearly be seen to have had a detrimental effect on GDP, debt-to-GDP, the budget deficit and unemployment, a clear example of bad inflation. But between 1982 and 1990, RPI averaged 5.6% while real GDP growth averaged 3.5%. Furthermore, debt-to-GDP fell from 50.8% to 32.3% and unemployment fell from a peak of 11.9% to 7.2%. Interestingly, debt-to-GDP fell during this period despite the budget remaining in deficit for all of this period except for one year, 1989.

By fast forwarding to the last two years, it can be seen that the inflation rise coincides with rising debt-to-GDP, slowing GDP growth and rising unemployment. Higher inflation in the last two years can be put down to effects that squeeze consumer spending such as higher commodity prices, higher import costs due to weaker sterling and the VAT rise.

In the UK, household consumption expenditure makes up a significantly larger proportion of GDP than in Germany, as can be seen in Figure 2.

Figure 2: Household consumption expenditure is a significantly higher component of UK GDP than in Germany. Source: Eurostat.

Furthermore, the strength of household consumption expenditure has overshadowed the growth of industrial production since before 1999 whereas in Germany the behaviour of these two variables is reversed, as can be seen in Figure 3.

Figure 3: A comparison between quarterly household consumption expenditure growth, industrial production growth, GDP growth, unemployment and effective exchange rates. Source: Eurostat.

The important point to make here is that consumer expenditure has failed to recover to pre-financial crisis levels in the last two years and this not only coincides with weaker GDP growth but also higher unemployment and higher inflation. Furthermore, industrial production has failed to significantly boost GDP, slowing in recent quarters to close to zero growth as the effects of the initial stimulus have worn away despite the drop in the value of sterling.

The drop in household consumption expenditure can easily be explained by the fall in real wage growth. Figure 4 shows that in the period before the financial crisis, nominal wage growth was above RPI (used for consistency instead of CPI) but since the crisis, wage growth has been consistently below RPI.

Figure 4: A comparison between average weekly YoY wage growth, RPI and household consumption expenditure in the UK. Source: ONS, Eurostat.

It indicates that household budgets in the last two years have been squeezed by higher VAT and commodity prices, not to mention the rising housing rental rates especially in London. The cost of living is rising but wage growth has failed to keep up.

The good news is that the effect of last year’s VAT rise from 17.5% to 20% will drop out this year, easing inflationary pressures and household budgets to some extent but wage growth still lags behind and needs a boost.

Targeting unemployment is as important, if not more so, than targeting debt and deficit reduction. Lower unemployment means a lower benefits bill for the government and it would increase the income tax generated for the Treasury’s coffers, not to mention the extra money that the previously unemployed will spend in the economy.

But efforts by the Bank of England to stimulate the economy have struggled and M4 money supply growth is negative despite the near zero interest rates and quantitative easing.

Figure 5: A comparison of M4 money supply growth, RPI and GDP growth. Source: BOE, ONS.

The Treasury’s credit easing scheme may improve access to funding for small- and medium-sized businesses and, as can be seen by recent news reports, some exporters are receiving more orders from Asia.

The government’s plans to upgrade infrastructure through the Green investment bank for energy production as well as Crossrail and the proposed high speed rail line are also important.

But Euro-Zone demand is set to drop this year as the debt crisis rolls on without any solution in sight and since the UK does more than 40% of its trade with the monetary union, a Euro-Zone slowdown will continue to effect UK trade.

The uncertainty surrounding the Euro Zone hinders investment and consumption decisions, not to mention the austerity hitting consumers especially in Greece, Ireland, Portugal, Spain and Italy.

In conclusion, the UK economy is suffering from a drop in demand especially from the household consumption sector. Debts and deficit can be repaid more quickly if GDP grows more quickly and if inflation is allowed to rise, at least in the short term, due to increased demand rather than by increased taxes and commodity prices that squeeze budgets.

Chancellor Osborne’s VAT rise in 2011 may have helped slow GDP growth due to its effect on household consumption but in 2012, its inflationary effects will wane and should help reduce the budget deficit.

But, if Iran continues to sabre rattle in the Gulf Oman, fresh pressures from rising oil prices may resurface.

This entry was posted in Austerity, Bank of England, BOE, Debt, Euro Zone, Osborne, Quantitative Easing, Tax, Tax Cuts, UK, Unemployment and tagged , , , , , , , , , , . Bookmark the permalink.

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