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Inflation rate to stay high for two years, OECD reports


The OECD warns that prices in the G20 group of countries are predicted to rise faster than pre-pandemic rates for at least two more years.


The UK economy as well as several other countries have been subject to higher inflation rates as successful vaccine rollouts paired with the relaxation of COVID-19 restrictions has led to a rise in consumer confidence.


Consequently, an increase in consumer confidence yields an increase in consumer spending as individuals within an economy who are more certain about keeping their job, or, retaining their health due to the vaccine, are more likely to spend as they no longer feel the need to sit on a large emergency fund which they have accumulated during the pandemic.


Therefore, because consumer spending is a component of aggregate demand, commodity prices have risen as aggregate demand has risen, with the UK inflation rate reaching 3.2% CPI, which is an increase from the previous month 2.0%, as shown below. The U.S has seen higher inflation rates of up to 5.3% CPI, and the Euro area has an average inflation rate of 3.0% CPI. This places all of these regions above their respective inflation targets of 2.0% CPI. In the UK, this is a target set by the government to ensure that inflation is low and stable as a low and stable inflation rate incentivises firms to set up in the UK as rising price levels mean higher profits and a stable inflation rate helps firms plan much more accurately. However, although this target is set by the government, it is the Bank of England's job, which is independent of the government, to ensure that this target is met. The Bank of England can do this by introducing contractionary monetary policy which involves cutting back on Quantitative easing and increasing the base interest rate. During the COVID-19 pandemic, the Bank of England introduced expansionary monetary policy that involved cutting the base interest rate to 0.1% and increasing Quantitative easing to record highs of £895 billion. These measures are designed to increase the supply of money in the economy, thus making borrowing cheaper which helps to raise aggregate demand as firms are encouraged to borrow more, as lower interest rates make borrowing cheaper and less risky. At the same time, these measures make servicing debt cheaper, meaning that firms and consumers who have outstanding debts which are not on a fixed rate, can benefit from cheaper debt repayments, thus enabling customers to have more disposable income to spend on goods and services and giving firms more retained revenue and profits to reinvest with.

However, with the inflation rate being above target, the Bank of England may have to implement a contractionary monetary policy.

Implementing such measures will stifle economic activity and reduce levels of aggregate demand, however, contractionary measures may do more harm than good. A report from the Financial Times stated earlier this week that for every percentage point rise in the base interest rate, the government will have to pay an extra £25 billion on debt repayments which will make the long term opportunity cost of servicing debts more unfavourable as the government will struggle to decrease the national debt, which is currently at $2.2 trillion. At the same time, implementing the contractionary monetary policy will decrease levels of aggregate demand within the economy, which will decrease tax revenue for the government from sources such as VAT, thus making the budget deficit even worse. Furthermore, this will lead to a weaker economic bounceback, and could possibly lead to higher unemployment rates as firms are forced to fire workers as they see increased operating costs due to a rise in debt repayments.

 

Written by Hubert Kucharski


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