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Tuesday, 15 January 2008

A necessary evil - Inflation in 2008

The December consumer price index data was released today showing that annual inflation remained at 2.1 per cent in the month. Annual inflation has remained at 2.1 per cent for three months now, but is likely to pick up as the year continues, particularly following Monday’s producer price index and continued high price of oil.

Nevertheless, there are signs that inflation should moderate in the second half of the year. The biggest drivers of inflation in the first half of 2008 will be food and fuel. Food prices are very hard to forecast given the variability of the weather, however, there are a few of factors that should help to increase agricultural yields.

The first is that the European Union has decided to suspend its annual subsidy to farmers that leave ten per cent of their farmland fallow.

The second factor is the fact that record highs in the price of wheat will encourage farmers across the globe to plant more and to reduce the percentage share of their crop being used for bio fuel – particularly as the price of oil is likely to fall back as the world economy slows.

Demand is unlikely to be significantly reduced by the slow down in the world economy, as food is a necessity. Therefore the supply side will be the key to reducing food prices.

Oil prices have risen significantly, almost doubling over the past twelve months. The price of oil has been supported by a number of supply issues throughout the summer and rising world consumption. Despite this, it is likely the price of oil has risen above the level suggested by simple supply and demand. The weakness of the dollar and the wider United States financial system has encouraged investors to move to safer products such as commodities such as gold and oil. Nevertheless as the US economy slows in 2008 so will their demand for oil. A significant slowdown will dampen prices. Many forecasters are now suggesting that oil prices will drop by about 25 per cent in the year. As a result by the final quarter of 2008, the year-on-year price of oil could be having a negative impact on inflation.

The rate of inflation is important because it is the key measure in determining the stance of the Bank of England’s Monetary Policy Committee (MPC). With the consumer price index currently above the target of 2.0 per cent the MPC will be keeping a close eye on this measure. Nevertheless, this is unlikely to stop the MPC from cutting interest rates at least twice (and probably more) in 2008. The MPC is willing to live with above target inflation in the short-term to maintain economic output and stave off a recession.

Tomorrow’s labour market statistics will be particularly interesting to see whether the credit crunch and the wider problems in the economy are starting to have an impact on employment. I would suggest that seasonal employment in December is likely to have hidden some of the early signs of weakness. We will see…

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posted by Carl Malways at

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