Inflation

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What is Inflation?

'Inflation' describes the process of rising prices in the domestic economy, reflected in the reduced purchasing power of a notional sum of money over time.

Necessarily, the rate at which inflation is occurring will depend in a free market on the balance of supply and demand in the economy. The two basic economic theories explaining where inflation "comes from", which are known as "Demand-Pull" (prices rise due to consumer demand outpacing producers' ability to provide goods) and "Cost-Push" (prices rise due to the costs of supplying a certain level of goods going up).

Many other economic factors are known to affect inflation, however, particularly the money supply and interest rates, insofar as both affect the amount of money consumers have and are willing to spend.

Necessarily, however, the rate of inflation will depend on what goods and services are being looked at, and there is a wide range of different measures available, some more suited to some purposes than others. For example, the RPIx formula is known as the "underlying" inflation rate, insofar as it excludes inflation in mortgage repayments.

Every inflation measure is based on monitoring growth in the prices of a "basket" of goods and services, selected for different purposes, over time.

Inflation is important in British politics on account of its effect on the purchasing power of both the consumer and business, and the corresponding linkage that the declining value of wealth and income has to the general economic health of the country.

Background

The existence of inflation was first theorised by the Scottish philosopher David Hume in the 18th century when he proposed that as the supply of money increased, so prices would rise (known as the quantity theory). Since then the theory of inflation has been redefined and two distinct theories, roughly corresponding with political ideologies has emerged.

Milton Friedman (1912-) was the principal figure behind the development of the monetarist school which influenced the 1980s economic policies of Margaret Thatcher and Ronald Regan. This refined Hume's theory to argue that the key to stable economic development and prices was to focus on the supply of money. Friedman held that government should seek to increase the supply of money in the economy and as such government should practise "light touch" regulation and allow the markets fiscal autonomy.

The alternative view is best represented by John Maynard Keynes (1883-1946), who broadly argued that inflation occurs when demand for goods outstrips supply, and that governments had the power to alter the economic situation through manipulating levels of public spending, taxation and interest rates. Socialist and social democratic governments have commonly adopted his ideas of government intervention into the markets.

Historically, as global economic growth has progressed - stimulated by international trade and industrialisation, so pressure on prices has increased over time. Traditionally, inflation has tended to act in a diametrically opposing fashion to unemployment levels; when unemployment has been high, inflation levels have been low, and visa versa, largely resulting from the decreased demand and downward pressure on wages in such periods. Moreover, inflation tends to rise during wartime. It can also be triggered by external shocks to the economic system, most famously the Oil Crisis of 1973, which saw oil prices triple and the whole global economy cast into combined recession and inflation.

The Oil Crisis, along with the end of the Bretton Woods agreement, marked the end of the postwar economic boom which had made Keynesianism so successful. The 1970s saw very different economic landscape, with increasing numbers of experts looking for alternative doctrines for economic management, including monetarism.

In spite of the ideological significance of monetarism to the Thatcher and Reagan governments, neither adhered rigidly to it, and no paradigm shift in inflationary trends were achieved during the 1980s.

The checking of the cycle of inflation and recession, commonly known in Britain as "boom bust" or "stop go" was one of the major objectives of the Labour government when they took office in 1997.

As part of the Chancellor's attempt to fundamentally reform the UK's monetary structure, the Bank of England was granted considerable freedom from the Treasury in terms of interest rates. Working on the principle that interest rates, which govern both how expensive money is to borrow and how much of an income savings provide, are intrinsically linked to inflation, the Bank of England Act 1998 created the Monetary Policy Committee of the Bank of England with a duty to set interest rates, in order to maintain inflation at a certain level.

Though the Treasury still sets the inflation target, the MPC has assumed responsibility for ensuring the target is met. At present, the MPC has a symmetrical inflation target of 2 per cent. If inflation exceeds or falls below this target by more than 1 per cent, the Bank is required to report on the matter to the Chancellor.

Controversies

A principal controversy regarding inflation concerns the method by which it is calculated. The Treasury changed the measure of inflation used by the Bank of England from the Retail Price Index (RPI) measure to the Consumer Price Index (CPI) at the end of 2003. CPI excludes a number of items previously included in RPI, notably mortgages and other housing-related costs. Moreover, the switch made it appear instantly as if inflation had fallen by 0.5 per cent.

The Government explained the switch as necessary to harmonise EU calculation methods and as a prerequisite of joining the euro and argued that the method of calculation provides greater population coverage and represents a more realistic representation of consumer behaviour. The Government refutes the claim that it introduced the new measure to make inflation look lower than it is for electoral purposes by arguing that any disparity between the measures will have been eroded within two years.

Critics also claim that mainstream methods of calculation, based as they are on market oriented/price related calculations, paint a misleading picture of the "real cost of living", by failing to account for increasing externality costs such as rising levels of environmental pollution and health problems.

The Government's current focus on inflation is not widely regarded as a controversial economic priority choice. Certainly in the 1960s, to have focused on inflation at the expense of unemployment would have been unthinkable. The prevailing economic logic being as it is - and the policy having been broadly successful in ensuring economic stability - puts control of inflation at the centre of economic policy orthodoxy, at least until the economy undergoes a fresh paradigm shift.

Statistics

Inflation of 2% a year would lead to prices doubling in 36 years.

UK inflation averaged over 13 per cent per year, peaking at 27 per cent in 1975, during the 1970s. In the 1980s inflation averaged 7 per cent per year
Between 1993 and 2003, inflation has remained between 1 and 4 per cent per annum

A Bank of England survey in 2003 showed that 48 per cent of respondents believed the economy would be weaker if prices rose any faster, compared to 8 per cent who held the opposite view

In the same poll, "net satisfaction" with the Bank of England's management of inflation was +47 per cent

Statistics 1 and 2: (Source: Bank of England, "The MPC five years on", 2002); Statistics 3 and 4: (Source: Bank of England, Inflation Attitudes Survey, November 2003)

Quotes

"I hereby confirm that from today, the new operational target for monetary policy will be 2 per cent as measured by the 12-month increase in the CPI."

Chancellor Gordon Brown, Letter to the Governor of the Bank of England, December 10 2003

"The