By Max Clarke

Bank of England governor Mervyn King discusses the causes and likely effects of the high inflation rates currently affecting the UK economy.

Extracts from the minutes of Mr. King's speech at the Newcastle Civic Centre yesterday.

"Of more immediate concern to the Monetary Policy Committee (MPC) is that we are experiencing a period of uncomfortably high inflation. CPI inflation was 3.7% at the end of last year, and has averaged 3% since the start of 2008, above our 2% target. With the standard rate of VAT rising to 20% this month, and recent further increases in world commodity and energy prices, inflation is likely to rise to somewhere between 4% and 5% over the next few months, before falling back next year.

"So why has inflation risen? Three factors account for almost all the increase in prices over the past four years.

"First, import prices (excluding energy) have risen by over 20%. Much of that reflects the fall in sterling in late 2007 and 2008. In order to rebalance our economy towards net trade and away from consumption a fall in sterling was necessary. At the time, it was far from clear — to either companies or the MPC — for how long the fall in sterling would persist, and pass-through to consumer prices was delayed for a while. But sterling has been broadly stable since the beginning of 2009, and the adjustment of the exchange rate now appears to have passed through to domestic prices. More recently, large and unexpected increases in the prices of a range of commodities, including food, have pushed up import prices. For example, over the past six months the prices of base metals have risen by 25%, foodstuffs by 40% (with wheat prices up by 60%), and cotton prices by no less than 70%. Since imports account for somewhere between a quarter and a third of overall expenditure, higher import prices have driven up the overall price level by around 6%. That can be seen in higher inflation for goods than services early last year, something not seen at all during the period from 1997 to 2008 when the normal higher growth rate of productivity in manufacturing led to goods prices falling relative to services.

"Second, there has also been a rise in world energy prices. Sterling oil prices have risen by 110% since the start of 2007 and gas prices by 130%. Those prices are determined in world markets in which demand, especially from some of the emerging economies, has outpaced supply. That too has pushed up on overall prices. Its impact can be seen in the contributions that petrol and utility prices have made to CPI inflation over the past four years. Through that direct effect alone, energy prices have pushed up on the level of CPI by almost 3% since 2007. But this understates the overall effect of energy price rises on CPI as fuel price increases are likely to feed through indirectly, and with a lag, to the prices of other goods and services. To take an obvious example, fuel is a significant part of an airline’s costs and affects airfares. The total effect of energy price rises on the level of the CPI is probably between 4% and 5%.

"Third, the combined effect of the recent changes to the standard rate of VAT, including the rise to 20% this month, is likely to push up the level of prices by around 1½%.
Taken together, those three factors by themselves would account for a remarkable 12% addition to the price level over four years, or an average increase in the inflation rate of 3 percentage points a year. Since the consumer price index as a whole rose by not much more, the contribution of domestically generated inflation over that period was close to zero, and obviously well below the target. It has always been understood that supply shocks — shocks such as these that move output and inflation in opposite directions — pose a dilemma for monetary policy. Should inflation be brought back to target quickly, reducing the risk of a rise in inflation expectations, or more slowly, reducing the impact of the shock on output?
Let me quote what I said in 1997 about how the MPC would resolve that dilemma:

"Many supply shocks are price level effects. For example, changes in indirect taxes or commodity prices often affect the domestic price level but do not in themselves change the underlying rate of inflation. An appropriate monetary response is to accommodate the first round price level effects, while ensuring that changes in the published twelve-month inflation rate do not alter inflation expectations and lead to second round inflationary changes in wages and prices. … Since shocks may take several months to have their full effect, a horizon of about two years is a reasonable one over which to try to bring inflation back to its target. But if shocks are sufficiently large — in either direction — then it may be sensible to extend the horizon over which inflation returns to its target level."

Mr King concluded his address by saying:

"The UK economy is well-placed to return to sustained, balanced growth over the next few years as a result of
a fall in the real exchange rate combined with a credible medium-term path of fiscal consolidation. Of
course, there will be ups and downs as the squalls from the world economy blow us around. But the right
course has been set, and it is important we maintain it.

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