U.K. Price Inflation To Increase Above 3%
U.K. inflation has for the last few years been significantly above the euro area average. In the last two years between November 2007 and November 2009 consumer prices rose a cumulative 6.1% in the U.K. (4.1% in 2008, 1.9% in 2009), versus 2.6% (2.1% in 2008, 0.5% in 2009) in the euro area.
The main reason for this is the weak pound of course. On the other hand, the temporary VAT cut enacted this year helped reduce the gap. Not by as much as 2.1% (2.5/117.5), because first of all this rate doesn't apply to food and many other goods and services and secondly because some producers, wholesalers and retailers used part of the cut to boost their margins rather than to cut prices. Even so, it probably lowered inflation by perhaps 0.5% to 1%.
Now that the VAT cut is reversed, this will help increase the inflation rate by a similar amount. Together with rising commodity prices, this could increase the inflation rate from the current 1.9% to above 3%. At that point, Mervyn King will be forced to write a letter of explanation to Alistair Darling, the Chancellor of the Exchequor. No doubt that explanation will mention the VAT factor and rising commodity prices, but that leaves the question of why inflation didn't fall more in early 2009 despite the fact that the VAT and commodity price factors had the opposite effect then.
The reversal of the cuts will also weaken economic growth. To the extent prices are increased this will of course reduce purchasing power and it will also reduce real output to the extent margins are again reduced as lower margins will make it less profitable to expand operations and hire workers and more profitable to cut back on operations. In some weak businesses, it will cause the entire company to fail.
The effects of the reversal of the VAT cut will thus be stagflationary. For economic growth however, other trends will counteract the negative effect, whereas for inflation other factors will enhance it.
The main reason for this is the weak pound of course. On the other hand, the temporary VAT cut enacted this year helped reduce the gap. Not by as much as 2.1% (2.5/117.5), because first of all this rate doesn't apply to food and many other goods and services and secondly because some producers, wholesalers and retailers used part of the cut to boost their margins rather than to cut prices. Even so, it probably lowered inflation by perhaps 0.5% to 1%.
Now that the VAT cut is reversed, this will help increase the inflation rate by a similar amount. Together with rising commodity prices, this could increase the inflation rate from the current 1.9% to above 3%. At that point, Mervyn King will be forced to write a letter of explanation to Alistair Darling, the Chancellor of the Exchequor. No doubt that explanation will mention the VAT factor and rising commodity prices, but that leaves the question of why inflation didn't fall more in early 2009 despite the fact that the VAT and commodity price factors had the opposite effect then.
The reversal of the cuts will also weaken economic growth. To the extent prices are increased this will of course reduce purchasing power and it will also reduce real output to the extent margins are again reduced as lower margins will make it less profitable to expand operations and hire workers and more profitable to cut back on operations. In some weak businesses, it will cause the entire company to fail.
The effects of the reversal of the VAT cut will thus be stagflationary. For economic growth however, other trends will counteract the negative effect, whereas for inflation other factors will enhance it.
posted by stefankarlsson at 5:30 PM
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