UK’s New Dilemma: Stagflation

Stagflation, a term coined by a member of the Conservative Party of Britain in 1965, refers to a nasty combination of high inflation and stagnant economic growth. This is also accompanied by high unemployment, which makes it all the more difficult for the central bank to manage. More often than not, attempting to remedy just one part of the inflation-recession-unemployment trifecta would exacerbate the rest.

Normally there’s a trade-off between inflation and unemployment rate since the two are said to be inversely related to one another. Let me draw a simple picture of this relationship:

crosseyed chart

From the chart you can see that an economy’s unemployment rate is high during times of low inflation. Conversely, a period of high inflation is usually accompanied by a low unemployment rate. To reduce a country’s unemployment rate, central bank policy makers make use of monetary easing measures in an effort to ignite economic activity. With an increased money supply, demand picks up, which in turn should lead to an improvement in the labor markets.

Moving on to actual events, we know that the UK is still stuck in recession, contracting by another 0.2% during the third quarter of 2009. Since the country fell into a decline, the Bank of England has injected massive amounts of cash through traditional and non-traditional means in its financial system in hopes of reviving their economy. As the amount of money in circulation increased, price levels have also risen, even when the economy wasn’t showing signs of growth.

In fact, the UK’s annualized headline CPI rose sharply to 2.9% in December from 1.9% in November. The core CPI, which excludes food and energy prices, also soared to 2.8% from 1.9%. Remember, the BOE’s inflation target stands at 2%.

According to our initial premise regarding inflation, the UK’s employment market above should show signs of improvement, right? Not this time around! Instead of improving, the UK’s jobless rate has steadily increased from a low of 5.2% in June 2008 to 7.9% in October 2009 and is even expected to have risen to 8.0% in November!

What is happening here? Perhaps the UK’s colossal monetary easing programs have caused the expectation of consumers and businesses for future inflation to rise as well, pushing the present price levels higher despite a lack of demand.

Yesterday, BOE Governor Mervyn King tried his best to assure the markets that the country’s economic situation is going to be just fine and dandy. In his talk in Exeter University in England, he said that the unexpected rise in December’s CPI was only “temporary.” In addition, he said that low money supply growth would be able to make sure inflation remains near the BOE’s 2% target. Then again, he said later on in his speech that inflation could even rise above 3% during the first half of 2010…

I don’t know about you guys but the fact that the country’s inflation rate is rising twice as fast as employee wages doesn’t look too good. In due course, the rising prices of goods and services will overwhelm income and put downward pressure on economic activity, hurting UK’s hopes of recovery.

Now if the King and his merry men don’t start singing a more optimistic song soon, things could get out of hand. If inflation continues to rise sharply, it would put the BOE in a rut. Pulling out economic stimulus isn’t an option quite yet as income growth is timid and consumer spending is still weak. The UK might just take a cue from F1 driver Lewis Hamilton performance last season and continue to lag behind in the race to recovery.

With that said, the poor outlook of the UK economy will probably drag the pound along with it. More and more investors are souring on the UK’s prospects, which sooner or later will put downward pressure on the pound. If the pound does fall, Susan Boyle better hope that she’s getting paid in dollars.

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