By: Dr. Mike Campbell
Inflationary pressure within an economy needs to be held in check. High inflation reduces people’s purchasing power and sparks demands for substantial pay awards to redress the situation. On the other hand, deflation can be harmful to an economy since falling prices stifle demand and reduce economic output in the domestic market (the situation in Japan). For this reason, advanced economies seek to keep inflation close to a target value and will act when it deviates significantly from the goal.
The UK target inflation value is 2%, but inflation is currently running at 4%. This inevitably leads to speculation that the Bank of England will need to increase interest rates from their historic low level of 0.5% to choke it off. However, a low interest rate means that banks can offer “cheap” money to business which they can use to invest in their concerns and stimulate growth with a concomitant reduction in unemployment; so it is a tricky balancing act.
Political upheavals in Africa and the Middle East have sparked hikes in the price for crude oil which increases costs for power generation, fuel etc and has a knock-on effect on inflation. The Governor of The Bank of England has revised the Bank’s projection for inflation, suggesting that it may hit 5% this year on the back of gas and electricity price rises of 15 and 10%, predicted for this winter. Whilst the Bank still expects inflation to fall back in 2012 and 2013, it has reduced its prediction for economic growth from 2% to 1.75% for this year. Some analysts are interpreting this to mean that an increase in UK interest rates is likely sooner rather than later and this has caused Sterling to strengthen.