Thursday, February 17, 2011

UK: Inflation Hits Four Percent


In January, UK consumer price inflation, or the retail price increase as measured by the consumer price index, rose to 4%. Although many economists predicted this increase, it is still greater than the Bank of England's goal of a 2% increase, and it is the highest annual inflation rate in over two years. This increase is primarily due to two factors: an increase in value-added tax ("VAT") and rising oil prices.

The UK government put a 2.5% increase in VAT into effect in January, bringing VAT to 20%. VAT is a kind of sales-tax in that it is passed on to consumers. However, a value-added tax is different in that it is a government levy on the value that a business adds to the price of a commodity during the production and distribution of a product. The second factor contributing to higher inflation is rising oil prices, which increased by 4.4% between December and January. The retail-price index,unlike the consumer price index, accounts for housing costs, and rose to 5.1% in January, up from 4.8% in December. This index is important because pensions and wages are often based on its measure.

Mervyn King, Governor of the Bank of England, recently stated that he believes inflation will continue to rise to 5% before dropping back down to the Bank's 2% target next year. Bank of England representatives have suggested that if commodity prices continue to rise, it will have to increase interest rates. Charles Bean, Deputy Governor of the Bank of England, believes that a rise in commodity prices is likely due to the economic boom in some emerging markets. Further, some Bank of England representatives argue that the longer an interest rate increase is delayed, the higher the risk that when the increase does come, it will have to be larger, resulting in a shock to investor confidence. However, some analysts fear that a rate increase will threaten the fragile economic recovery.

This inflation rise is hitting UK families especially hard because inflation-adjusted wages have been down over the last six years. Union leaders, arguing that workers deserve a pay increase this year, claim that there is an unprecedented attack on their standard of living. One union leader forecasts that 2011 will be particularly difficult for UK residents due to expected job losses and budget cuts.

Discussion Question: Should the Bank of England raise interest rates?

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