Tuesday, August 18, 2009

Economists Shocked-Weaker Currency Raises Price Inflation

Economists were shocked by the relatively high U.K. inflation number for July 2009, 1.8%. By comparison inflation is -0.7% in the Euro area and -2.6% in neighboring Ireland. How could price inflation stay that high given the deep slump in the U.K. economy and the dramatic drop in commodity prices from their peak in July 2008 (the base month for this 12 month number)?

Perhaps it could have something to do with, you know, the dramatic depreciation of the U.K. pound. If you look at the individual inflation numbers for European countries, you can see that countries with the euro (or withcurrency pegged to the euro) have generally much lower inflation than those who have their own freely floating currencies. The exceptions being Switzerland and to a lesser extent the Czech Republic, but that reflects that the Swiss franc and the Czech Koruna has been much stronger than other small floating European currencies.

Some might object that while the pound is down dramatically since July last year, it has stabilized and even appreciated somewhat against the euro since its low late December 2008. But this shows just how these economists are deceived by their "perfect market" models.

Assuming "perfect markets", prices adjust immediately. A 10% depreciation will immediately raise import prices by 11.1% so that prices are equal in all countries.
But in reality, companies are reluctant to change local currency prices too often because they fear it could for example lead to permanent loss of market share even though the currency fluctuation is only temporary. So as long as they think that the currency fluctuation might be temporary they will not raise prices even though prices are unsustainably low in the long run. But eventually as the depreciation appears increasingly permanent theu will raise prices. Alternatively, if the depreciation proves temporary they will not raise prices, but they will abstain from the price cuts that you would otherwise expect.

What this means is that the inflationary effect of currency depreciation has a lagged effect on price inflation. Meaning that even though the pound hasn't depreciated any more this year, previous weakness still continues to create upward pressure on prices.

Eventually, the effect of last year's brutal pound depreciation will pass through entirely, and assuming the pound doesn't depreciate any more, this will cause relative inflation in the U.K. to fall. But the lagged effects of the previous pound depreciation, just like the lagged effects of the depreciation of the Swedish krona and other weak European currencies, could continue to put upward pressure on prices for many more months.


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