Government Strategies to Control Inflation

With reference to the UK, examine and discuss the methods open to a government to control the rate of inflation within an economy.

Introduction

Inflation refers to an increase in the price level of goods and services in a given economy. Since inflation is concerned with increases in the cost of living rather than increases in the cost of a particular good, it is measured using a price index which monitors the price of a weighted ‘basket’ of goods. In the UK, the main price indices are the Retail Price Index (RPI), the Retail Price Index excluding Mortgage Interest Payments (RPIX) and the Consumer Price Index (CPI). Responsibility for the control of inflation was handed from the Treasury to the Bank of England in 1997 at which time the RPIX was used to measure inflation and the inflation target was set at 2.5%. Since December 2003, the CPI has replaced the RPIX as the main inflation measure and the target has been set at 2%. Diagram 1 (below) depicts annual inflation rates in the UK from 1997 to 2007 as measured by both the RPIX and the CPI.

This essay will first outline the main theories put forward to explain the causes of inflation and the methods that each theory suggests would control inflation. The next section considers inflation in the UK from 1997 to date, and then evaluates the measures employed by the Bank of England in order to try to control inflation in that period.

Causes of inflation and methods of inflation control

There are two main schools of thought on the causes of inflation. The Keynesian school posits that changes in the real supply of or demand for goods and services are the key causes of inflation. Thus in order to reduce inflation, an expansion in supply or a contraction in demand is necessary to reduce the price level. This can be achieved through fiscal or monetary policy or a combination of the two. Fiscal policy such as an increase in income tax rates, has the effect of reducing effective demand for goods and services and thus can be used to lower inflation. Furthermore, a reduction in sales taxes (VAT in the UK) can reduce inflation to the extent that that inflation is caused by an increase in consumer prices. Monetary policy, through an increase in interest rates, can reduce aggregate demand through discouraging borrowing, increasing saving and reducing the disposable income of homeowners as the cost of mortgage repayments increases. The monetarists, on the other hand, argue that inflation is caused primarily by changes in the supply of and demand for money. In this view, then, inflation can be reduced either by reducing the supply of, or increasing the demand for, money. Given that either the government or the central bank (as in the case of the UK where the Bank of England has had independence on monetary policy since 1997) sets the price of money (i.e. the interest rate), they are able to control the supply of and demand for money. This suggests that fiscal policy can be used to affect aggregate supply and aggregate demand while monetary policy can be used to affect aggregate demand (particular in an economy with a high level of mortgaged home-ownership) and the supply of and demand for money.

Inflation in the UK and Bank of England control measures from 1997 to 2008

The diagram above shows UK inflation (as measured by RPIX and CPI) from 1997 to 2008 together with the inflation targets set for the Bank of England by the government. This shows that from 1997 to 2003, inflation was held within 0.5% of its target. In 2004, inflation as measured by its (then new) CPI target was on the low side but from 2005 to 2007, it was within a healthy 0.5% range of target. In recent months, however, inflation has been climbing and is predicted to go over 3% at some point before the end of 2008.

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In order to understand inflation and inflation control in the UK, it is necessary to understand some of the specificities of the UK economy. In the first place, the nature of the UK housing market (which is characterized by high loan-to-value ratios, relatively few long-term fixed rate mortgages, and ease of re-mortgaging) makes house prices particularly responsive to interest rates. Cameron (2005:3) explains that ‘a one percentage point rise in the short-term real interest rate would reduce house prices over a five year period by 2.6% in the UK, 1.8% in the US, and 1.3% in Germany.’ Furthermore, in the UK, house prices have a major impact on consumer spending. Cameron (2005:3) explains that house prices are more volatile in the UK than elsewhere in the developed world, and that the impact of house prices on consumer spending is also particularly heavy in the UK – according to the OECD, a 1% fall in UK housing wealth correlates with a 0.07% fall in consumer spending. This can be seen as due to the high levels of home ownership and the high loan-to-value ratios of mortgages. This demonstrates that while monetary policy can be very effective in reducing aggregate demand via just a small increase in interest rates, the converse is also true – in other words, a small reduction in interest rates will have a significant effect on aggregate demand and so will lead to a significant increase in inflation.

This last point is well illustrated by the current situation in the UK. The Bank of England is mandated to control inflation (as mentioned previously the target is 2% as measured by the CPI) but has control only over monetary policy and not over fiscal policy. Monetary policy impacts economic growth as well as inflation and therefore when the economy is slowing (as is currently the case) and potentially heading towards recession, interest rates may be used to stimulate growth even if this may also increase inflation to an unacceptable level (when it goes over 3% the governor of the Bank of England must write an explanatory letter to the Chancellor of the Exchequer). As the Economist (2008:38) explains, in January of this year, ‘consumer prices were 2.2% higher than a year ago—a bit above the government’s 2.0% inflation target. The bank’s central forecast shows inflation heading up to 3% by the third quarter of this year.’ The Bank of England (2008) itself certainly blames the predicted escalation of inflation over the acceptable 3% level on the problem of balancing growth objectives with inflation targets given that monetary policy is the only tool at its disposal, claiming that the ‘combination of slow growth and above-target inflation poses substantial challenges for policy.’

Conclusion

The Bank of England (2008) explains that ‘higher energy, food and import prices push inflation up sharply in the near term.’ This is echoed by analysis in the Economist (2008:38) which claims that increasing ‘home-energy bills, which have jumped by nearly 15% so far this year, will add almost half a percentage point to consumer-price inflation in February. Food-price inflation, which is currently 6.6%, is likely to rise further. Import prices will be pushed up by a weaker pound, whose 6% fall in the last three months was the biggest since sterling’s ignominious exit from the European exchange-rate mechanism in 1992.’ In order to address this kind of inflation without stifling economic growth at a time when growth is already slowing, policies need to be directed at aggregate supply of goods and services. As was outlined above, monetary policies have an impact on the supply and demand for money and also on aggregate demand for goods and services. However, only fiscal policy impacts the aggregate supply of services. Thus in the context of low levels of growth and high levels of inflation, monetary policy (as controlled by the Bank of England) is not sufficient because if it focuses on controlling inflation it cannot also reverse the slowdown in economic growth, and if it focuses on economic growth, there is a danger that inflation will get out of control. Thus inflation controls should draw on a combination of fiscal and monetary policy.

References

Bank of England (2008) ‘Overview of the Inflation Report February 2008’ (downloaded from http://www.bankofengland.co.uk/publications/inflationreport/infrep.htm on 4 March 2008)

Cameron, G. (2005) ‘The UK Housing Market: Economic Review’ (downloaded from http://hicks.nuff.ox.ac.uk/users/cameron/papers/ukhousingmarket.pdf on 4 March 2008)

Economist (2008) ‘Economic woes: Fighting on two fronts: Britain’s central bank gets gloomier about growth and inflation’ in The Economist, February 16^th-22^nd 2008, p.38

OECD (2005) ‘Economic Survey of the United Kingdom, 2005 (downloaded from http://www.oecd.org/dataoecd/18/34/35473312.pdf on 4 March 2008)

Office for National Statistics (2008a) ‘RP07 RPI all items excluding Mortgage Interest Payments (RPIX) percentage change over 12 months (CDKQ)’ (downloaded from http://www.statistics.gov.uk/downloads/theme_economy/RPIX.pdf on 4 March 2008)

Office for National Statistics (2008b) ‘CPI12 CPI all items percentage change over 12 months (D7G7)’ (downloaded from http://www.statistics.gov.uk/downloads/theme_economy/CPI.pdf on 4 March 2008)