| Bank says inflation may reach 4% |
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| Tuesday, 17 June 2008 | |
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The Governor of the Bank of England has written to the Chancellor after CPI inflation hit 3.3%.
The Governor, Mervyn King, has to write an open letter to the Chancellor of the Exchequer, Alistair Darling, whenever CPI inflation is more than one percentage point above the official government target of 2 per cent. King pointed out in his letter that inflation had risen sharply this year, from 2.1 per cent in December to 3.3 per cent in May. Sharp price changes He explained that the rise could be accounted for by large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity. These components alone account for 1.1 percentage points of the 1.2 percentage points increase in the CPI inflation since last December. Those sharp price changes reflect developments in the global balance of demand and supply for food and energy. In the year to May, world agricultural prices increased by 60 per cent and UK retail food prices by 8 per cent. Oil prices rose by more than 80 per cent to average $123 a barrel and UK retail fuel prices increased by 20 per cent. Wholesale gas prices increased by 160 per cent and UK household electricity and gas bills by around 10 per cent. “The global nature of these price changes is evident in inflation rates not only in the UK but also overseas, although the timing of their impact on consumer prices differs across countries,” King wrote. HICP inflation in the euro area was 3.7 per cent in May and US CPI inflation was 4.2 per cent. Considerable uncertainties The Bank of England’s May Inflation Report forecast that inflation was likely to rise significantly further above the 2 per cent target in the next six months or so. The report set out three reasons for this:
The Monetary Policy Committee’s central projection was for CPI inflation to rise to over 3.5 per cent later this year. In the past month, however, oil prices have risen by about 15 per cent and wholesale gas futures prices for the coming winter have increased by a similar amount. “As things stand, inflation is likely to rise sharply in the second half of the year, to above 4 per cent. I must stress, however, that there are considerable uncertainties, in both directions, around this, and any such projection is particularly sensitive to changes in domestic gas and electricity charges,” according to King. He said that there were good reasons to expect the period of above-target inflation currently experienced to be temporary. No generalised rise in prices and wages “We are seeing a change in commodity, energy and import prices relative to the prices of other goods and services. Although this clearly raises the price level, it is not the same as continuing inflation,” the Governor said. He pointed out that there was no generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy. In contrast to past episodes of rising inflation, money spending is increasing at a normal rate. In the year to 2008 Q1, it rose by 5.5 per cent in line with the average rate of increase since 1997 – a period in which inflation has been low and stable. Moreover, in recent months the growth rate of the broad money supply has eased and credit conditions have tightened. King said that this would restrain the growth of money spending in the future. He added that it was possible that commodity prices would rise further in the coming months, as oil prices have now been rising for four years. The Monetary Policy Committee (MPC) believes, however, that - in the absence of further unexpected increases in oil and commodity prices - inflation should peak around the end of the year and begin to fall back towards the 2 per cent target. Unnecessary volatility in output and unemployment “Nevertheless, each monthly rise in food, energy and import prices will, by pushing up the overall price level, affect the official twelve-month measure of inflation for a year. So CPI inflation is likely to remain markedly above the target until well into 2009,” the Governor of the Bank of England wrote. The MPC believes that, if interest rates were set to bring inflation back to the target within the next twelve months, the result would bring unnecessary volatility in output and employment. King said that the MPC was therefore aiming to return inflation to the 2 per cent target within its normal forecast horizon of around two years, when the present sharp rises in energy and food prices will have dropped out of the CPI inflation rate. He warned that in the short term prices other than those of commodities, energy and imports did not start to rise at a faster rate. King set out that this would happen if those making decisions about prices and pay began to expect higher inflation in the future and acted on that. It could also happen if employees respond to the loss of real spending power that results from higher commodity prices by bidding for more substantial pay increases. The MPC warned that it would be necessary for economic growth to slow this year. “The prospective squeeze on real incomes associated with higher inflation, together with the reduced availability of credit, is likely to lead to a further slowing in activity this year. This will reduce pressure on the supply capacity of the economy and dampen increases in prices and wages,” King said. Related articles
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