Graph Showing past estimates of Growth and predicted growth 

source: Bank of England 

The Bank predict an upturn in growth during 2009, but, it becomes more difficult to predict future growth more than 12 months in advance.

UK growth rates will play an important role in determining inflationary pressures and interest rates in the UK.

Forecast for UK economy 2008 at Economics Help.org

Central Banks are concerned about rising inflation for the following reasons:

1. Uncertainty / Confusion

Higher inflation creates uncertainty about the future revenue and costs of firms. Therefore, firms become less willing to commit to investment decisions. This can dampen economic growth in the long run. Uncertainty can also extend to consumption and discourage consumer spending.

2. Domestic Goods Become less Competitive.

Higher inflation in the US, would make US exports less competitive. This would result in a fall in exports and a deteriorating balance of payments on the current account. If exports are less competitive it will put further downward pressure on the dollar, causing imports to be more expensive.

3.Inflationary growth is unsustainable.

High inflation is an indication that the economy is overheating. This means that the economy is growing above its long run trend rate and therefore is unsustainable. If growth is too fast it is likely to result in a recession – Boom and bust economic cycle. Generally the Fed wishes to avoid volatile economic growth. It is better to keep inflation low and growth sustainable.

4. Menu costs

When inflation is high firms will need to frequently change prices. This is time consuming and incurs an economic cost. However, this cost is less important given advances in technology.

5. Income redistribution

When inflation is high savers become worse off (unless their savings attract a higher interest than inflation). People on fixed incomes will also become worse off. Borrowers may benefit, because it becomes easier to pay back their debts.

6. Wage Price Spiral

This means when there is inflation, workers demand higher wage increases. This causes further inflation, therefore, in the future, workers demand higher wages. This is an example of how moderate inflation can easily get out of control.

If inflation rises above 2% there are several economic costs. The higher the inflation rate, the more serious the problems become.

Since 1997, the MPC are responsible for keeping inflation close to the government’s target of CPI = 2%. If inflation is forecast to be above the target the government then the MPC will increase interest rates. Higher interest rates reduce the growth of AD and keeps the economy growing at a rate that doesn’t cause inflation. The MPC have been much more successful than previous governments for a variety of reasons:

• Inflation Targetting: The MPC have also benefitted from using an array of economic variables for predicting inflation. In previous years, Monetary policy would often be determined by a narrow range of statistics such as the money supply. However, the money supply can be an unpredictable guide to inflation. Looking at a wide ranging collection of statistics enables the MPC to have a better overall idea of inflation expectations
• Lack of Political interference. In the post war period, the UK economy suffered from boom and bust economic cycles. Often politicians would set interest rates for short term considerations; e.g. cutting interest rates before an election. The independence of the MPC means that they are not influenced by short term political considerations.
• Expectations. Because the MPC is independent people expect inflation to be low. Therefore because they expect low inflation it is easier to keep inflation low. E.g. People don’t demand high wage increases. Firms don’t try to increase prices.

3. Technological improvements.

Improvements in technology means that firms have been able to  cut costs. For example, the advent of the internet has enabled lower costs and has reduced the underlying inflation rate. This improvement in technology is a global phenomena and a reason behind low global inflation

4. Free Market supply side policies.

Policies such as privatisation have helped to increase efficiency in the economy. This increased productivity has led to more competitive prices. Other notable supply side policies in the UK include:

• Reducing power of trades unions – helped reduce wage inflation pressures
• Lower basic rate of income tax.
• Deregulation of financial services – leading to increased competition

5. Global inflation

The effects of globalisation have helped to reduce prices. Increased competition between countries has led to lower prices, especially in manufactured goods. This is particularly due to lower prices of Chinese manufactured goods

6. Raw material prices have been low. Although some like oil have increased in recent years.