Economics - What price inflation?

(From Financial Director)

Byline: Dennis Turner, chief economist at HSBC.

Since the UK was humiliatingly dumped out of the ERM in 1992, governments have been pursuing a macro-economic policy aimed at creating a stable environment for business, ending the boom-bust cycles which had done so much to undermine performance. Central to this objective has been the control of inflation.

The rise of 0.7% in GDP in the final three months of 2004 made it 50 consecutive quarters of sustained growth since the last recession ended in 1992. This owes much to the fact that inflation has remained remarkably low. Anyone who remembers the double-digit inflation days of the 1970s and 1980s must find it hard to believe that in terms of the official measure, the Consumer Price Index (CPI), inflation in Britain has been 3% or less since 1992. For the last eight years the annual rate has been less than 2%.

Responsibility for sustaining low inflation now rests with the Bank of England's Monetary Policy Committee (MPC), and base rate is the policy tool at its disposal. Just over a year ago, the Chancellor changed the rules. Rather than telling the MPC to keep inflation within 1% point of 2.5%, measured on the Retail Prices Index, he now wants price increases to be held within 1% point of 2%, but on the CPI. This difference is in the methodology used to aggregate the data, and the fact that the CPI excludes housing depreciation and Council Tax. Over the long term, the CPI has been around 0.8 percentage points lower than the RPI measure used by the MPC.

Because changes in interest rates are determined by movements in prices, it is worth considering whether it has been good luck or good management that led to the long period of low inflation. Since, at the end of 2004, annual CPI inflation was only 1.6%, it might seem alarmist to talk about more interest rate rises to counter inflation. But some of the factors that contributed most to the weak price trends during the past few years are now starting to change.

A breakdown of the CPI into its component categories reveals that it has been the prices of goods rather than services that have slowed rises in the overall index.