Inflation and the purchasing power of money

It was reported last week that the level of inflation in the UK unexpectedly rose to 2.7%. This was higher than the consensus estimates of 2.4%. The outcome, portrayed in some media outlets as a ‘nasty surprise’, is well within the forecast margin for error: short term price fluctuations are tricky to predict with precision.

The Office for National Statistics (ONS), which gathers and reports the data, points out that some of the upward price shifts are likely to subside in the coming months. The components of inflation showing the greatest price strength are transport and recreational goods and services, thus partly seasonal and possibly temporary.

Moreover, the future path of inflation is expected to remain benign, with the Bank of England’s (BoE) forecast showing inflation falling to 2% by 2020. Despite this, some pundits believe the BoE inflation forecast is now looking vulnerable. They are the same voices saying the BoE’s approach to interest rate policy is wrong, meaning they think interest rates will have to head higher than currently predicted.

Source: Bloomberg & Trading Economics, September 2018

*Represents the BOE forecast trend of interest rate rises rather than the increments themselves

The response by those calling for higher interest rates, on the back of the latest inflation release, seem reactive. There are many factors weighing on the inflation series, not least fluctuations in the exchange rate and levels of economic activity. Economists point out that a relatively weak pound pushes up import costs, and pushes up the price of fuel, which is priced in dollars.

The currency translation effect on imported goods and oil is undoubtedly unhelpful but will be mitigated or even reversed if sterling arrests its recent decline and starts to climb back up again.

Rates of growth in the economy also play a part, embedding inflation and sometimes pushing it higher. This tends to happen when economic growth is significantly above trend, whereas constrained investment in some areas of the economy, due to Brexit worries, is thought to be holding back growth.

In terms of interest rate expectations, forecasts suggest the current rate of 0.75% is to remain in the short-term with an initial increase to 1.00% by the third quarter of next year heading towards 1.50% in 2020, according to trend data from the BoE. Interest rates, at these levels, are expected to lag growth, provided it remains below trend (generally estimated at 2.5%). If so, this means policy will be loose allowing interest rates to remain lower for longer. However, if economic growth picks up, creating excessive demand for goods and services, and inflation becomes prevalent, a different monetary policy response should be anticipated.

Inflation effects around ‘loose’ monetary policy, micro and macro factors are largely indeterminable because they are wide ranging and subject to several influences. Therefore, central bankers are often seen to be reacting to inflation as it arises rather than proactively batting it back before it shows up. Since the credit crisis central bankers have been intent on making sure general price levels do not fall. To do this, they have chosen policies to stimulate growth hoping that prices neither fall, nor spiral out of control.

The impact of rising prices with low interest rates is, however, particularly harmful for cash savers. Inflation erodes the real value of money; referred to as the purchasing power of money. In simple terms, with inflation your money won’t buy as much today as it would yesterday.