Find Financial Freedom

I filled up my car the other day and for the first time in a while I noticed that the price of a litre of petrol had risen to well over 90p. This took my by surprise as the price of petrol had been getting lower until recently, and I had rather hoped that for the health of the nation’s finances, it might stay low.

But with sterling being worth less than monopoly money at the moment, it’s no surprise that petrol prices are rising, you see, oil is traded on the global market in US Dollars, which have been getting relatively more expensive for us here in the UK. This pushes up prices at the pumps, though there is a bit of a lag due to the nature of forward contracts etc etc.

Another issue that is going to affect the price of petrol at the pumps is the fuel duty rise 1st April 2009 of 1.84p per litre on petrol and diesel.

I wonder how this will effect the consumer price index over the next few months? With the Bank of England doing everything within their powers to stop deflation and stimulate the economy, will the weak pound contribute to UK inflation thanks to higher petrol prices. It’s an interesting situation that we could be faced with, if the economy is still very weak and the pound weaker, we could see ever rising oil prices and that will lead to inflation. To combat this inflation, the BoE will have to raise interest rates, which will either lengthen or deepen the recession that we are in, or worse still both!

My suspicions are that eventually the government will ask the Bank of England to revert back to using the retail price index, and thus with house price deflation being fed back into the equation, they will have some justification to keep the base rate at it’s all time low of 0.5%, and thus the weak pound causing higher energy prices will not effect the inflation statistics as much and we’ll all be able to carry on delaying the inevitable.

We regularly make predictions on this site about where the Bank of England base rate will be on our interest rate predictions pages, and following on from the popularity of these pages, we have decided to expand this into inflation predictions, with this being the inaugarul post about UK inflation predictions.

It’s quite pertinent predicting the inflation coming off the back of yesterday’s interest rate reduction, which I completely didn’t predict - I expected it to be held, as I stated in my interest rate predictions for Thursday 5th March.

So what does the rest of the year hold?

Well let’s firstly consider what impacts inflation. There is always upward (inflationary) pressure on an economy, as well as downward (deflationary) pressure on an economy.

What causes inflationary pressure on the economy?

This can vary, so here are some of the usual culprits:

• Short supply of goods/services (demand is outstripping supply)
• Higher costs of importing raw materials (this can be caused by a weak £ or higher global prices)
• Monetary policy, in effect increasing the supply of money by making credit cheaper
• Fiscal policy, in effect increasing the supply of money by reducing the tax burden on consumers/businesses

What causes deflationary pressure on the economy?

This can also vary, but here are some of the usual suspects:

• Excess supply of goods services (supply outstrips demand)
• Lower costs of importing raw materials (can be caused by strong £ or weak global prices)
• Monetary policy, by decreasing the supply of money by making borrowings more expensive
• Fiscal policy, decreasing supply of money by increasing the tax burden

Some of you may have noticed that the factors that have inflationary effects, have deflationary effects when the opposite occurs, wierd that? Not really, it’s the age old rule of every action has an equal and opposite reaction.

So what is causing inflationary pressure on the UK economy at the moment?

• The weak £ - making it more expensive to import raw materials and goods into the country
• Easing of monetary policy (base rate being lowered to all time low of 0.5%) thus increasing the amount of disposable income for UK consumers and businesses

However, the monetary policy doesn’t seem to be working, most UK consumers who have variable rate borrowings are doing the smart thing (from their point of view) and banking the money in savings or simply overpaying their debts.

So that leaves the weak £, which is only going to get weaker with the base rate being so low. So that states to me that we could be facing a long period where there is very little inflationary pressure on the economy, and this could prolong the recession. This also means that the policy makers at the BoE and the Govt may have to rethink how they handle this recession and the strategies they employ for recovery.

And what is causing deflationary pressure on the UK economy?

• Weak demand, similar to excess supply, means there are less buyers than sellers effectively, making it more of a buyers market, just witness the housing or new car market to see this in action
• Falling energy prices, this again is largely due to falling demand worldwide, but it has a direct impact on the economy as so many products and services are dependent on energy either directly or indirectly
• Cut in the VAT rate from 17.5% to 15% late 2008, however this is scheduled to revert back to 17.5% in 2010 so will only have a deflationary effect for 2009
• Strength and length of the recession, the longer it goes on, the longer there will be weak demand, which will continue to have a deflationary effect on the economy

The weak demand will continue until consumer confidence returns, so this should last for quite some time yet. This impacts energy prices, as the longer the advanced and emerging economies have weak demand, the longer energy prices will remain low, however, the cartel that controls oil production could vote to lower production levels and thus increase the price of oil by shortening supply.

The cut in VAT will only be a temporary, and largely ineffectual, so not really worth mentioning. The strength of the recession will not be known until after the recession has blown over, we are in effect in the eye of the storm and unable to see how wide the hurricane is that surrounds us, if you pardon the slightly bonkers metaphor.

So what are my inflation predictions for the UK?

Given all the factors that I’ve mentioned so far, it’s hard to see any real good news. The only thing that I haven’t mentioned is the artificial effect that the credit crunch is having on the supply of money. In a normal recession, if the base rate was lowered, there would usually be a subsequent increase in the supply of money, however with the banks trying to re-capitalise and thus not lending money out at anywhere near the rate they are able to, the UK economy is in effect being held to ransom. So it’s really in the hands of the banks to sort this recession, which means that unless credit and cash start flowing again in the economy, there will be far more deflationary pressure on the economy that inflationary pressure, which will lead to the a longer than usual period of recession. I expect that inflation will continue to decline through 2009 and into 2010, but things may start to get better sometime in 2010, but it’s difficult to predict given the unique circumstances facing the economy.