Friday, 18 February 2011
There is more to UK inflation than just external shocks
The Bank of England are keen to blame external shocks as the primary driver behind the recent surge in inflation. Is it true? To what extent is inflation just another import?
UK import prices have been surprisingly flat for the last 18 months. In December, import prices were up by 2.7 percent compared to the same month the previous year. That is one full percentage point less than a headline CPI inflation rate.
When the financial crisis started, UK interest rates fell sharply, and sterling depreciated significantly. The impact of the devaluation on import prices is easy to see. As sterling tanked, importers hiked prices by around 15 percent, although they gave back some of that increase once sterling settled back to its new lower level.
As an aside, this import price overshoot points to the dangers of trying to depreciate your way out of a financial crisis. Once the exchange rate starts to fall, importers try to anticipate the decline in sterling and add something to prices to compensate for the uncertainty.
Still, the main point is that there is much more driving the UK inflation number than the post crisis exchange-rate depreciation and the rise in import prices.