The last blog post looked at interest rate and house prices (http://wp.me/pTU04-1S). Recall that the base rate is the main instrument of monetary policy used by the BOE. The primary purpose of the BOE is monetary stability. BOE defines monetary stability as “Monetary stability means stable prices – low inflation – and confidence in the currency. Stable prices are defined by the Government’s inflation target…”(BOE). The current inflation target is 2%.This blog post analyses the relationship between the UK inflation, as measured by the Retail Price Index (RPI) and the Consumer Price Index (CPI); the BOE base rate and house prices.
Chart 1 shows the long term peaks and troughs of the annual change in the UK Retail Price index and the UK Base rate. Evident from the chart is reduction in volatility in both the base rate and retail price index.
Chart 1 Inflation and BOE Base Rate
Interestingly the after the annual change retail price index bottomed in Jun’93 (1.2%), the growth rate, did not rise above 5 % until Apr ’08. A similar pattern can be observed in the late 1950’s (see red dashed lines) to late 1960. However, the range of the peaks and troughs was higher in 1950s- to 1960’s when compared to the early 1990’s to 2008.In addition there has only been 2 periods where annual change in the RPI went below zero.
Table 1 below shows the correlation coefficient between the BOE base rate and the UK inflation measured using retail price index. Noteworthy, is the high correlation between annual inflation rate and the base rate level. This may indicate that the monetary policy making authorities target annual inflation as opposed to month on month.
Table 1 Contemporaneous Correlation between RPI and BOE Base Rate (Jan’84 to May’10)
What is most interesting is the decline in volatility of both the inflation and the BOE base rate. It will be interesting to assess the impact of low volatility of economic indicators to that of house prices.
Also the impact of inflation or anticipated inflation on interest rates is an important factor to consider. Typically rising inflation coincides with rising central bank rates. The blog post on interest rate and house prices (see link) http://wp.me/pTU04-1S, highlighted that the BOE base rate has reached its nadir, following a secular downturn that began in early 1980’s. Has inflation reached its bottom? Could we be set for a period of rising inflation?
Current inflation rate stands at 3.4%, a rate above the target set by the government of 2%. In the latest inflation report , the BOE explains that the rate of inflation should be temporarily above the inflation target. They have attributed the elevated level of inflation to cost push factor such as: return to VAT levels of 17.5%; depreciation in sterling and rising oil prices. The BOE believes, once the impact of the factors mentioned above dissipates, inflation will be dragged down by level of spare capacity in the economy. Future posts will analyse the view of the BOE and also opposing views from other economists.