Inflation discussion

Milarky

Sorry if this is off topic for this board but just reading the press today about Mervyn King's comments and looking into the rationale for their rate-setting; it appears to be based on 'subjective probablility' [Bayesian Probabilty] assumptions that rates stay at their present level [5%] and this gives rise to a 'fan of inflation' of which this is the latest:



(taken from: http://www.bankofengland.co.uk/publications/inflationreport/irfanch.htm )

Remember what they assume to construct this forecast chart - they assume no change in the current base rate.

This adherence to a 2 year time horizon is the 'philosophical' underpinning of the whole exercise and explains - I believe - why they they don't change rates very often. They actually base rates today on where the chart appears most probable (deepest red) You'll see the the vertical hashed line which is positioned '8 quarters' (2 years) from now - and '2 percent' [CPI] is right in the 'crosshairs'

So what BOE rate setting seems to be about is defintely not keeping inflation close to 2 percent at all times. It is about inflation 'becoming' 2% on a 2 year horizon.

Something which occurred to me while looking at this was that the average rate of inflation still has to be 2% or else the policy lacks credibilty. In other words the BOE must forecast (and subsequently realise) inflation below 2 percent for roughly the same amount of time as it remains above 2%

Q. Has CPI averaged 2% since 2003 - when it became the replacement index for RPI?

A The result are that CPI stood at 108.2 in 2008 Q2 and had been 98.0 in 2004 Q2 - 4 years. Inflation has averaged 2.5%.....
[Longer term the picture looks better. CPI sood at 89.6 in 1997 Q2. Thus 7 years inflation (1997 - 2004) averaged 1.3%!]

http://www.statistics.gov.uk/statbase/tsdataset.asp?vlnk=7174&More=N&All=Y

Surely the Bank of England - having already averaged +0.5% for 4 years above the figure it is meant (by any test of the policy) to average - has to now 'give' this back - by having CPI average less than 2% for at least the next 4 years? Well that's impossible simply on account of the the current overshoot - and target inflation not even being 'at' 2% for the next two years. Inflation in a year's time is predicted to be at least 3% [Say '112' in 2009 Q2] still - and a year after that about 2%.

So that implies a cumulative overshoot of the target by 3% or so over 5 years - 2.7% average from 2004 to 2009.

Assuming they don't then undershoot for next five years, it is only possible to defend past interest rate setting with reference to the previous era of low inflation from 1997 to 2004 - the period of BOE independence. Using those very flattering historical figures [like picking and choosing the start and end of the 'ecomonic cycle'] you get back to an average CPI of about '1.9%' for the 12 years 1997-2009

neil324

Rates should be going up. As soon as Merv spouted all that crap this morning Sterling tanked agaisnt a raft of currencies. 6 months to a year this country is going to be in serious deep !!!!.

Lokolo

Heres a question.

The BBC says the economy is slowing - I thought inflation was a way to determine how fast the economy is growing, so its just gone upto 5% and now BBC are saying its slowing.

Anyone care to explain?

Milarky

It just occured to me.... The chart for May shows +8Q at '2.2%', The August chart shows +Q7 at '2.1%' [practically unchanged] suggesting that their 2-year predictions are 'wonderful'. Now look at the same charts for 'peak' inflation rate at just Q+3, Q+2 and the figure has gone up from from 3.7% to about 5.1%!

In other words, experience has shown that short term, the BOE can't hit the proverbial 'barn door' - yet in the smeary nether-world of 'Bayesian Finance', as I think I shall put it, they're always 'on target'.

I've also notice that BOE has rescaled its chart without mentioning it. So I've correctly scaled May and put the actual rate of inflation for August in - showing that inflation has moved right up the 'edge' of (upper estimate) of the fan.



..and I remind the Hon. gentleman that these fan graphs assume the bank has not made any change of interest rate in the meantime....

[I dunno, this inflation stuff is clearly well above my paygrade. Port anyone?]

Just a few more observations on CPI (same will apply to RPI)

The historic series shows that the INDEX (as opposed to the annual measure based on it) consistenly falls in the months of January and July - with January being more marked. For instance

2004.. 07.. 97.8 1.4 -0.3

2005.. 01.. 98.6.. 1.6.. -0.5
2005.. 07.. 100.1.. 2.3.. 0.1

2006.. 01.. 100.5.. 1.9.. -0.5
2006.. 07.. 102.5.. 2.4.. -0.1

2007.. 01.. 103.2.. 2.7.. -0.8
2007.. 07.. 104.4.. 1.9.. -0.6

2008.. 01.. 105.5.. 2.2.. -0.7

Thus a critical time for inflation is these months. If price don't fall in January next year or even raise slightly this will throw back the chances of a quicker fall in the inflation rate. In particular this would cause a 'spike' that month...so that's probably how we'd hear about it.

If 'prices' DO fall in January then (as Mervyn hopes) CPI/RPI may have peaked in November or December and the seasonal pattern of prices (and thence CPI movements) can be expectd (hoped?) to guide CPI back towards 3% by late Summer.

Time will tell.....

MiserlyMartin

Lokolo wrote: »

Heres a question.

The BBC says the economy is slowing - I thought inflation was a way to determine how fast the economy is growing, so its just gone upto 5% and now BBC are saying its slowing.

Anyone care to explain?

Inflation is more of a measure of changes in consumer or retail prices as an index. Inflation may be rising, but we can still have rising inflation combined with a slowing economy. I guess if this scenerio becomes very apparent then this is what they call 'stagflation'. But the issue of if we actually officially are experiencing stagflation I will leave to another poster more knowledgeable than me...

As far as the MPC go, I do find it scandalous that they appear to have changed their remit of keeping CPI around 2%. And even the average rate seems to be too high as Milarky calculated above. Newsnight were saying last night if you strip out Oil related inflation then the rate will be back to 2%. They are hoping inflation will slow with the economy.

But I'd say interest rates need to rise: As moneysavers, inflation is eating into our savings and this policy is hitting the pound too. I only wish stuck more money into an index linked to rpi product. 5% inflation RPI (and the rest!) and even the best accounts are only paying 5.2% net interest at lower rate tax! make me wonder if I shouldn't be a saver and had joined the borrowing binge that the government encouraged instead! Hey all us careful people will pick up the tab in tax for those government bailouts and benefit payments to those who lost their houses from borrowing beyond their means. I wonder really who are the winners here?

robpitt

It is mind boggling how little incentive there is to save right now. The best accounts are paying circa 6.25% which after basic rate tax is no better than inflation. And if you're a higher rate tax payer then you're utterly screwed.

At least in the 80's, despite the other problems, everybody knew it made sense to live within your means and building up some savings, right now ... sheesh.